Unpaid accrual expenses [closed]

Question

Let's say for-profit corporation ALPHA INC. borrowed $1M from person JOHN DOE, who is also an executive officer of the corporation. The corporation ALPHA INC. uses accrual accounting method, while JOHN DOE uses cash accounting method.

Furthermore, let's say that the contract between those two parties says that an interest is due on December 31 of each calendar year.

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Question #1:

If the corporation ALPHA INC. decided to not pay this interest on time, it still counts to the corporation as the taxable expenses, correct? However, because the JOHN DOE was not yet paid, he should not pay any taxes from such unpaid interest, correct?

Question #2:

For the scenario described in the above question, has any of the parties to report some unpaid asset/liability?

Question #3:

Continuing with the above scenario, is there some limit (maximum) for how many years may such interest stayed unpaid? (e.g. JOHN DOE is not in a need of such money and he is waiting/hoping for some favorable tax reform)

Question #4:

Since IRS sets applicable federal rates (AFR) as minimum rates for loans, how this affects the unpaid interest? Has such unpaid interest to be adjusted accordingly? If so, with which interest rate, the one in the contract, or the AFR? (assuming the contract doesn't explicitly specify such scenario of unpaid interest)

Answer 1

If JOHN DOE uses the accrual method, he would claim interest income when the interest is due, just like the corporation. If that interest was never paid, he could then claim a "bad debt" loss at some point in the future (there is no IRS guideline for the actual timeline, only that you've attempted to collect and there's no reasonable expectation that you will). The debt itself doesn't have to be reported - only claimed as a loss once it's noncollectable. It's basically refunding you for income that you didn't ever actually get.

If he uses the cash method, he would not claim income until it is actually paid, whether that's the next day or 100 years from now. He would not claim any income (unpaid or otherwise) until the interest is actually paid. There is no "bad debt" deduction under the cash method since there was never any income reported to refund.

AFR doesn't really apply here, except that the actual interest rate of the loan must be greater that the AFR.