Any time a farmer loans money to a corporation that they own (or vice versus), the income tax laws require these loans to bear interest. If the loans do not bear interest, then the law requires the farmer to calculate an "imputed" interest amount based upon the applicable federal rates published by the IRS each month. Lately, these rates have been very low (less than 1%).
In the past if the farmer loaned money to an S corporation and did not charge interest, the imputed interest rules normally did not affect the bottom line tax. The amount of interest income the farmer would report would be offset by the same interest deduction reported on the S corporation. However, if the S corporation had loaned money to the shareholder, it would change the bottom line tax since the interest "paid" by the farmer would usually be non-deductible.
With the imposition of the 3.8% net investment income tax (NIIT) for this year, this is no longer true for higher income farmers.
If your adjusted gross income (AGI) is $250,000 or less ($200,000 for singles) this tax does not apply. However, if your AGI is over these levels, then the imputed interest will create an additional 3.8% tax on part or all of this income even though your AGI does not change.
Let's take a look at some examples on how this works.
Suppose, we have a farm couple with exactly $250,000 of AGI. In this case, their income tax is $52,213. They owe no NIIT since their AGI is exactly $250,000 (remember NIIT is computed on the LESSOR of net investment income or AGI minus $250,000).
Now let's impute $10,000 of interest income on loans they made to their S corporation. In this case, they have net investment income of $10,000 subject to the 3.8% tax, but their AGI is still $250,000. It went up by $10,000 of imputed interest income reported on their Schedule B, but the S corporation income went down by the same $10,000, therefore, they do not owe the extra $380 of NIIT since their AGI still is not over $250,000.
Now let's assume this is a regular C corporation. In this case, the farm couple would owe the $380 of NIIT since their AGI went up by $10,000 and the offsetting deduction is reported on their corporation, not their personal return.
Let's assume their AGI was $255,000 with no investment income. With the imputed interest of $10,000, they now have investment income of $10,000, but since their AGI is still $255,000, their NIIT is only $5,000 time 3.8% or $190.
Let's assume their AGI was $260,000 with no investment income. In this case, the $10,000 imputed interest will be subject to the full 3.8% NIIT since the difference in AGI and net investment income is exactly $10,000.
The rule of thumb is if your AGI is less than $250,000 before imputing interest, then imputing interest will not create the NIIT (assuming a loan to an S corporation). If the amount of AGI over the $250,000 is less than the imputed interest, then only this amount is subject to the tax and if this amount is greater than imputed interest, then all of the imputed interest will be subject to NIIT.
This is just another added layer of complexity that many farmers will face this year. Since these applicable federal rates are extremely low right now, it makes sense to "lock" in these low rates so minimize the imposition of this new tax. Talk to your tax advisor now.