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Interest Free Loans and the Applicable Federal Rates (AFR)

‘Recently being in the market to upgrade my car to a more fuel economic vehicle, I went to the neighborhood dealership.  Financing the vehicle is probably the only way I could afford the purchase until I saw the terms of the loan, which were approximately $32,000 at almost 4.5% interest over the next five years.  Perhaps the economy has not turned for me as quickly as it has for others, but I left the offer on the table and began to look at my options.  Maybe I could ask my grandfather for the money and then I could pay him back the $32,000, which may work out well for me and my credit?’ –A FICTIONAL SCENARIO

 

Typically, we would see the grandfather agree to make the loan of $32,000 and tell his grandson he can pay him back when he can.  There are no written terms, no stated interest rate and no real expectation to receive repayment in a timely fashion.  After all this is a loan between family? This model can be defined as a demand loan and further categorized as a gift loan by the IRS standards outlined in §7872.  The IRS defines multiple loan arrangements like this in §7872 including compensation related loans, corporate-shareholder loans, certain qualified care contracts and the aforementioned gift loans.  Now de minimus exceptions may apply to these loans under $10,000, however, the IRS attempts to enforce guidelines on these types of loans which are generally offered at below market interest rates and/or ‘interest-free.’ (i.e. – loans to business partners, family members, etc.)

 

Back to our fictional scenario, does this mean that even you would have to charge your grandson interest?  Essentially, yes.  In other words, if you were to give a family member a fixed amount of money with the expectation of being repaid, you have entered into what the IRS would consider a debt transaction.  Like many debt transactions between two parties, one might assume two key components exist such as a fixed principal amount and an interest rate associated with the repayment of the loan.  The IRS is no different in this assumption except the IRS requires recognition of the forgone interest on the outstanding balance of the loan. 

 

Now we have two new questions to answer: How does the IRS determine the interest rate if one is not explicitly stated? And how does the IRS compute the interest?

 

In one of our earlier blog postings from November 2010, Eric Fletcher describes ‘the wealth transfer silver lining’ while outlining briefly both the applicable federal [interest] rates and imputed interest rules on outstanding debt.  These points are very helpful in addressing our two questions and we can use them to build upon the fictional example from above, as well.

 

First, think of the Applicable Federal Rates (AFR) as the adequate, minimum and acceptable interest rates used as a starting point for many types of loan transactions.  The AFR is issued monthly by the IRS in a Revenue Ruling prescribing interest rates for various terms including short-term (0-3 yrs.), mid-term (3-10 yrs.) and long term (10+ yrs.).  The rates are determined based on the average market yields on outstanding marketable obligations of the U.S. relative to their specified terms. 

 

The current rates for June are as follows:
• Short-term (annual) - .46%
• Mid-term (annual) – 2.27%
• Long-term (annual) – 4.05%

 

The AFR is applied to a determinable debt obligation absent a ‘stated’ rate of interest.  If you do not include interest in your debt obligation, say perhaps in a $32,000 loan to your grandson and it is later determined by the IRS that an outstanding debt obligation exists from you, the IRS will compute the interest on your behalf using these rates.  This is most commonly referred to as the ‘imputed interest rules.’

 

Rarely do we see a written promissory note between family members specifying the terms of the loan and interest rate.  Even when a note exists the interest rates are below market.  Enter the IRS. 

 

If the IRS were to review this fictional transaction with unstated terms and unstated interest, the IRS can assign the appropriate interest rate using the AFR and compute the amount of interest income that should have been previously recognized.  Now, we have a scenario where the person whom loaned the money is recognizing taxable interest income on money he or she has never actually received dating all the way back to the origination of the loan.

 

This unfortunate scenario is easily avoided.  Simply drafting a promissory note stating the terms of the debt obligations that the borrower can sign regardless of whether the note is between a business partner, friend or even a family member can help to mitigate the exposure.  Be sure to include the interest rate in the note set to at least the minimum, acceptable and adequate amount using the appropriate Applicable Federal Rate based on the defined terms of the loan. 

 

In our scenario the lender (grandfather) could have used the mid-term rate of 2.26% and saved the borrower (grandson) approximately 2% with this 5-yr. loan transaction avoiding any further IRS scrutiny. 

 

Now our example fails to factor the gift tax and transfer tax planning issues necessary to consider when making loans to family members.  However, I refer you to Eric Fletcher’s earlier blog post under the Estate Tax section of our “It’s Taxing” blog for more considerations regarding the wealth transfer tax ‘silver lining.’

 

Our fictional scenario, albeit basic, is far too common to ignore and transactions like this are often challenged by the IRS resulting in the unintended consequences unless proper steps are taken at the origination of the loan.  Our example is not exclusive to gift loans between family members and we see frequent examples of below-market interest rates on outstanding loans between shareholders and even in compensation arrangements.  Overall, it is important to understand there are general guidelines to consider and follow when entering into debt transactions. 

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