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protect Brad from the scenario of his bankruptcy nightmares, but it does protect him from a corporate
change of heart regarding his eventual payout. From Morris‟s point of view, he may not object to
contributing to a rabbi trust, since he was willing to pay all the money to Brad as salary, but he should
be aware that since Brad escapes current taxation, the corporation will not receive a deduction for
these expenses until the money is paid out of the trust in the future.
Interest-Free Loans
As a further enticement to agree to work for the new ownership of the plastics plant, Morris might
additionally offer to lend Brad a significant amount of money to be used, for example, to purchase a
new home or acquire an investment portfolio. Significant up-front money is often part of an executive
compensation package. While this money could be paid as a bonus, Morris might well want some
future repayment (perhaps as a way to encourage Brad to stay in his new position). Brad might wish to
avoid the income tax bite on such a bonus so he can retain the full amount of the payment for his
preferred use. Morris and Brad might agree to an interest rate well below the market or even no
interest at all, to further entice Brad to take his new position. Economically, this would give Brad free
use of the money for a period of time during which it could earn him additional income with no
offsetting expense. In a sense, he would be receiving his salary in advance while not paying any
income tax until he earned it. Morris might well formalize the arrangement by reserving a right to
offset loan repayments against future salary. The term of the loan might even be accelerated should
Brad leave the corporation‟s employ.
Under current tax law, however, despite the fact that little or no interest passes between Brad and
the corporation, the IRS deems full market interest payments to have been made and further deems
that said amount is returned to Brad by his employer. Thus, each year, Brad is deemed to have made
an interest payment to the corporation for which he is entitled to no deduction. Then, when the
corporation is deemed to have returned the money to him, he realizes additional compensation upon
which he must pay tax. The corporation realizes additional interest income but gets a compensating
deduction for additional compensation paid (assuming it is not excessive when added to Brad‟s other
compensation). (See Exhibit 9.4.)
Exhibit 9.4 Taxable interest.
Moreover, the IRS has not reserved this treatment for employers and employees only. The same
treatment is given to loans between corporations and their shareholders and loans between family
members. In the latter situation, although there is no interest deduction for the borrower, the deemed