Applicable Federal Rate

Cite this article as:"Applicable Federal Rate," in The Business Professor, updated April 16, 2020, last accessed October 21, 2020, https://thebusinessprofessor.com/lesson/applicable-federal-rate/.

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Applicable Federal Rate (AFR)

The applicable federal rate (AFR) refers to the minimum interest rate that is permissible on private loans by the Internal Revenue Service (IRS). AFR serves as the minimum market rate for loans and is published by the IRS every month. Every lender is expected not to charge an interest rate below the applicable federal rate. An interest rate below the AFR benchmark is defiant of the IRS regulation and subject to tax implications.

A Little More on What is the Applicable Federal Rate (AFR)

Section 1274(d) of the Internal Revenue Code gave provision for the applicable federal rate, it is the interest rate allowable for private loans. Private lenders can charge above the AFR but are not permitted to charge below. Through the AFR, the IRS is able to compare the interest rate charged on loans by different parties in the market. Also, when family members or related parties are involved in a loan transaction, they must not charge an interest rate that falls short of the AFR. For instance, if you give a loan to your sister or mother, you are required to charge the AFR or an interest rate a little above and not below.

Three Distinct Rates

There are three categories of the applicable federal rate (AFR) that the IRS publishes every month, these are the short-term AFR rates, mid-term and long-term AFR rates. Short-term AFR rate is charged on loans with a maturity period of three years or less, while the mid-term AFR rate is charged on a loan with a maturity period of between three years and nine years. The long-term AFR rates are applicable to loans with maturities of more than nine years.

Key Takeaways

Here are some important things about the applicable federal rate (AFR);

  • AFR refers to the minimum interest rate that can be charged on private loans as stipulated by the Internal Revenue Service.
  • There are three categories of AFR rates published by the IRS every month, these are the short-term, mid-term and long-term AFR rates.
  • Other factors that the IRS considers when publishing the AFR rates are the compounding periods of the loans which can be monthly, quarterly, semi-annually and annually.
  • Lenders can charge above the AFR rates but not below.

When lenders charge below the AFR rate, there are tax implications faced by both parties.

Example of How to Use the Applicable Federal Rate (AFR)

In 2019, the Internal Revenue Service published an applicable federal rate of 2.72%, 2.89%, and 3.15% as short-term, mid-term and long-term AFR rates respectively. If a party is issuing a loan to a family member, for instance, let’s say a $50,000 for four years, the mid-term AFR rate will be applied. If the loan is for a period of three years or less, 2.72% or more will be charged as the interest rate. If an interest rate below the AFR rate is charged, both parties are exposed to tax implications. The IRS makes changes to the AFR rate given specific considerations.

Practical Uses of AFR

The applicable federal rates are used by the IRS to monitor the market compliance with the published interest rates. Parties in a loan agreement must consider the length and maturity of a loan so as to select the corresponding AFR rate. The IRS also uses the AFR rates to determine the original issue discount, unstated interest, and income tax implications that will be meted out to interest rates below the AFR rates. In real-life situations, the parties in a loan agreement must adhere to the AFR published by the IRS.  A lender that charge interest at a rate lower than the published AFR faces tax implications or any other penalties as determined by the IRS and the level of defiance from AFR.

Reference for “Applicable Federal Rate (AFR)”

https://www.investopedia.com/terms/a/applicablefederalrate.asp

https://apps.irs.gov/app/picklist/list/federalRates.html

https://tax.thomsonreuters.com/us/en/checkpoint/afr-rates

resources.evans-legal.com/?p=2591

https://www.timevalue.com/applicable-federal-rates

Academics research on “Applicable Federal Rate (AFR)”

Taxation of Loans Having Below-Market Interest Rates, Chvisuk, G. S. (1985). Taxation of Loans Having Below-Market Interest Rates. Idaho L. Rev., 21, 257.

The Estate Tax Non-Gap: Why Repeal a Voluntary Tax, Caron, P. L., & Repetti, J. R. (2009). The Estate Tax Non-Gap: Why Repeal a Voluntary Tax. Stan. L. & Pol’y Rev., 20, 153.

How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note, Blattmachr, J. G., Crawford, B. J., & Madden, E. O. (2008). How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note. Intrafamilial arrangements labeled as loans have long invited special scrutiny from the Internal Revenue Service. In some cases, the IRS has successfully established that the arrangement was not a loan but another type of transfer, such as a gift. In the wake of several IRS victories in cases where somewhat “informal” financial arrangements between family members were held not to be loans, many advisors to individual taxpayers counsel that when a child borrows money from a parent, for example, the loan should be documented, interest-bearing, secured and repaid (at least in part), if the transaction is to be free of unexpected and in some cases adverse tax consequences. In any event, even where the financial arrangement is respected as a loan, tax effects, such as generation of interest income taxable to the lender or the trigger of a gift tax on either the borrower or the lender, may arise. This article briefly will discuss some of these consequences. It also will discuss in more detail some effects of substituting a new note at the so-called “applicable federal rate” which is lower than the interest rate payable on the old note.

An introduction to federal income tax issues relating to the issuance of high-yield securities, Hooker, K. L. (1998). An introduction to federal income tax issues relating to the issuance of high-yield securities. The Business Lawyer, 799-812. This Article describes the basic federal income tax considerations relevant to the issuance of high-yield securities in the form of debt and preferred stock. In the case of debt securities, these issues include whether its classification as debt will be respected for federal income tax purposes, the application of the original issue discount rules, various potential limitations on the deductibility of interest, special considerations with respect to convertible debt, the taxation of exchange offers and defeasances, state tax planning concerns, and special concerns in the case of foreign subsidiaries. In the case of preferred stock, the issues include the application of the preferred stock discount rules, potential deconsolidation issues, and the impact of conversion and exchange features.

Frequency of restoration replacement in posterior teeth for US Navy and Marine Corps personnel, Laccabue, M., Ahlf, R. L., & Simecek, J. W. (2014). Frequency of restoration replacement in posterior teeth for US Navy and Marine Corps personnel. Operative dentistry, 39(1), 43-49. The results for this study show that no difference existed in the rate of replacement for amalgam vs resin composite. When restorations increased from just a single occlusal surface to additional surfaces, the rate of replacement was elevated and statistically significant for both materials. A higher caries risk status was also significant in elevating replacement rates for both materials.

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