The Applicable Federal Rate and the Need to Apply Interest to Loans

By Baker Newman Noyes June 23, 2014

Have you ever loaned money to or borrowed money from a friend or family member? Not just $100 here or there, but a more substantial amount of money? Have you instead loaned to or borrowed from your closely held business? If so, it is important that the loans call for an adequate rate of interest. Otherwise, some tax rules may step in and re-characterize the transaction.

What constitutes a loan?

This may seem like a simple question with a simple answer, but it is a very important aspect of lending money and is sometimes overlooked. Simply put, a loan is an amount of money given to another party with the understanding that the borrower will eventually repay that amount with interest. The payback period does not necessarily need to be fixed; it could be an open-ended line of credit.

If money is given with the understanding that it will likely not be returned, then the nature of the transaction is not that of a loan; it would more likely be a gift (to another person) or a contribution/distribution (with a business) or compensation (to an employee). There are different tax consequences for these transactions. To ensure it will be treated as a loan, you should document the agreement carefully.

What should the interest rate be?

Interest rates can be set at any level based on negotiation between lender and borrower. Between parties with a close relationship, sometimes a loan is given a 0% interest rate. Issues with the IRS occur when the rate is 0% or any level below the market rate.

Loans that do not possess a market rate of interest are deemed for tax purposes to have such interest, even if it is unstated. The lender is deemed to have transferred money to the borrower, which the borrower is in turn deemed to return to the lender as interest. The deemed transfer from lender to borrower may be treated as a personal gift, a contribution to capital or even compensation, depending on the nature of the underlying loan. The interest is treated as income by the lender and deductible or nondeductible interest expense by the borrower. To avoid this fictional treatment, parties to a loan should be sure the agreement references an adequate interest rate, and the IRS has a prescribed rate that can be used for this purpose: The Applicable Federal Rate (“AFR”), which is updated and published here by the IRS on a monthly basis.

Use of the AFR is often attractive, because it generally is below the current market rate. The IRS breaks AFRs into several categories: short-term (loans of 3 years or less), mid-term (3-9 years), and long-term (more than 9 years or indefinite). Open-ended lines of credit may be treated as long-term, while demand notes generally should use a blended rate. The AFR for your loan would be the published rate on the date the loan was made, and it can retain that rate even if market rates or the AFR subsequently increase. Generally, the shorter the term, the lower the AFR.

Conclusion

When lending money to a close or related party it is often tempting to bypass formalities and perhaps forgo interest. However, it is very important to document the terms of the loan and utilize interest to avoid the potential tax consequences. The IRS’s AFR represents a convenient minimum guideline to follow.

If you have questions, please call your BNN advisor at 1-800-244-7444.