Alan Huberman | April 29, 2019
Each month, the IRS provides various prescribed rates for federal income tax purposes. These rates, known as Applicable Federal Rates (or AFRs), are regularly published as revenue rulings and are available on the IRS website here.
AFRs are used for loans that are considered to be below-market loans, which are defined as loans in which the stated interest rate is lower than the rate required for tax purposes. Various types of below-market loans exist, such as gift loans, compensation-related loans and corporation-shareholder loans.
As noted above, AFRs are used for a number of federal tax provisions to determine the appropriate amounts under a multitude of provisions such as:
Loans with below-market interest rates, under Internal Revenue Code (IRC) §7872 (such as gift loans, compensation-related loans, corporation/shareholder loans and tax avoidance loans);
The present value of an annuity, life interest, term of years interest, remainder interest or reversionary interest under IRC §7520;
Insurance reserves under IRC §807, as well as insurance provisions under §811 and §812;
The present value of golden parachute payments under IRC §280G (120% of the AFR, compounded semi-annually);
Payments for the use of property or services under IRC §467;
Unrelated business income and debt-financed income under IRC §514;
The recharacterization of gain from straddles under IRC §1058; and
Limit the use of net operating loss carryforwards and built-in losses following an ownership change as determined under IRC §382.
AFRs are based on the average market yield on outstanding marketable obligations of the United States government. Under IRC §1274(d), the AFR includes the federal short-term rate (based on the interest rates for debt instruments of three (3) years or less); the federal mid-term rate (based on the rates for debt instruments of three (3) to nine (9) years); and the federal long-term rate (based on the rates for debt instruments exceeding nine (9) years).
Imputed Interest on Below-Market Loans
Individuals who make a below-market gift or demand loan generally must report as interest income any forgone interest from that loan (IRC §7872). The borrower may be able to deduct the forgone interest, unless it is personal interest.
Forgone Interest
For any period, forgone interest is:
- The amount of interest that would be payable for that period if the loan’s interest accrued at the applicable federal rate (AFR) and was payable annually on December 31, minus
- Any interest actually payable on the loan for the period.
Gift and Demand Loans
A gift loan is any below-market loan in which the forgone interest is in the nature of a gift. A demand loan is payable in full at any time upon the lender’s demand.
The lender is treated as paying the borrower the forgone interest each year. This deemed transfer is treated as a gift, payment for services or other payment, depending on the substance of the transaction. The borrower is generally treated as transferring the forgone interest back to the lender, who must report it as interest income. These transfers are deemed to occur each year, generally on December 31.
For demand loans, taxpayers should use the short-term AFR in effect for each semi-annual period that the loan is outstanding.
Imputed interest on demand loans with a fixed amount outstanding for the entire year can be calculated using the blended annual rate of 0.73% (for 2016), per Rev. Rul. 2016-17 (table 6).
Term Loans
A term loan is any loan that is not a demand loan. A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan (computed at the AFR).
A lender who makes a below-market term loan (other than a gift loan) is treated as transferring an additional lump-sum cash payment (payment for services rendered, etc.) to the borrower on the date the loan is made. The deemed payment amount is the loan amount minus the present value (computed at the AFR) of all payments due under the loan.
An equal amount is treated as original issue discount (OID). The lender must report the annual part of OID as interest income. The borrower may be able to deduct the OID as interest expense.
For term loans taxpayers should use the rate in effect on the day the loan was made based on the term of the loan, as follows:
- Short-term = three (3) years or less
- Mid-term = over three (3) years, but not over nine (9) years
- Long-term = over nine (9) years
Exceptions
The below-market loan rules do not apply to:
- Loans between individuals of up to $10,000, unless used to purchase income-producing property.
- Gift loans between individuals of up to $100,000 if the borrower’s net investment income is under $1,000.
- Compensation-related loans up to $10,000 between an employer and an employee, or an independent contractor and a person who hires the independent contractor.
- Loans up to $10,000 between a corporation and a shareholder of the corporation.
Exceptions 3 and 4 will not apply if the principal purpose of the interest arrangement is the avoidance of federal tax.
Determining AFRs
The IRS computes AFRs for each calendar month and publishes them in a revenue ruling. As an example, Rev. Rul. 2014–23, published April 2014, provided the AFRs for May 2014. AFRs may be compounded (and therefore applied) monthly, quarterly, semiannually, or annually.
As you can see, these rates can play a large role in some cases regarding how certain calculations are made. Individuals as well as business owners alike would be well advised to work with their accountant to ensure that they are in compliance with any rules and regulations, as well as making sure that they are taking advantage of any opportunities and/or related planning strategies.
Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statutes, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.
