An applicable federal rate, also commonly known as an “AFR,” is the minimum interest rate required of a private loan. It is enforced and designated by the IRS and applies to loans with an interest rate lower than the tax rate if the loan is considered income. There are differing AFRs assigned to various loan term lengths, whether it be short-, mid-, or long-term. Rates are subject to change monthly and are updated by the IRS in accordance with market conditions.
Key takeaways:
- Interest rates below the AFR are subject to potential tax implications.
- When issuing a loan, the current AFR must be utilized based on the associated repayment term.
- The current AFR can be used as a benchmark for determining the cost of borrowing funds.
How the applicable federal rate works
IRS’s AFR is used to determine the minimum rate of interest assigned to a loan transaction between two parties under US law. Its rules apply to all loans, whether facilitated privately between parties (such as friends or family) or via a traditional lending institution.
Rates must be implemented to avoid tax consequences, even if the lending party charges no additional interest rate. That said, it can also be used as a benchmark when assigning an interest rate when pricing the cost of borrowing.
The IRS publishes updated AFRs monthly in accordance with Section 1274(d) of the IRC, and the index is posted on the IRS’s AFRs rulings page. The AFR is calculated based on a variety of economic factors, including a one-month average of the market yields of US Government Treasury securities.
AFR types
There are three options associated with an AFR, each of which is categorized based on the loan term. Along with rates based on term, there are rates in accordance with compounding period — whether it be annually, semi-annually, quarterly, or monthly — in addition to other lending criteria or scenarios.
Short-term AFR | Mid-term AFR | Long-term AFR |
|---|---|---|
For terms of 3 years or less. | For terms over 3 years but not exceeding 9 years. | Any term above 9 years. |
When an applicable federal rate is used
An AFR is used to determine imputed interest income, original issue discount, and gift tax of below-market loans A below-market loan is any type of loan that has a lower interest rate than the corresponding AFR. . That said, it is most likely to be used when issuing a private or personal loan and is common with borrowing funds from friends and family or obtaining financing through less formal means.
Essentially, it’s considered to ensure lending practices comply with IRS tax rules and regulations. When funds are issued, the current published AFR must be utilized at the time the loan is facilitated.
Why using an AFR is important
Ensuring the use of an AFR when lending money is important to remain in compliance with the IRS. Loans with no or low interest rates may be viewed by the IRS as a gift and, in turn, may impose tax law complications such as gift taxes on the lender. Using an AFR allows parties involved in the transaction to avoid such implications.
Example of using an applicable federal rate
As an example of how an AFR might be utilized, let’s consider a scenario in which a family member is loaning you money to help financially support your business. Assume the following facts:
- Loan amount: $20,000
- Repayment term: Two years
As this loan is considered AFR eligible, we would reference the AFR index to determine the current rate. Since the repayment term is less than three years, we would
- use the current short-term interest rate in accordance with the corresponding period of compounding interest; and
- assign a rate equal to or higher than the minimum AFR; any rate less than the appropriate AFR could lead to tax implications.
Once the terms and conditions of the loan have been set, you’ll need to draft an agreement signed by both parties to make it legally binding. From this point forward, you would repay the loan in accordance with the terms of the agreement and comply with tax requirements.
Other types of interest rates
If you’re looking into getting a small business loan, there may be other types of rates associated with pricing the loan. The AFR is one of many rates that can be used, although it’s not as widely used by traditional lending institutions, such as banks, credit unions, or online lenders.
In fact, you’re more likely to see the following benchmark rates when pursuing more traditional forms of financing:
- Prime rate is a commonly used benchmark favored by lenders when issuing financing for qualified borrowers.
- SOFR, or Secured Overnight Financing Rate, was introduced as an alternative to LIBOR London Interbank Offered Rate . Published by the Federal Reserve Bank of New York, it acts as a benchmark rate index that’s used by financial institutions to price various lending products like loans, derivatives, and bonds.
- Federal Funds rate is the interest rate that’s charged when banks lend to one another. This rate isn’t as common with small business financing but is still worth mentioning.
Frequently asked questions (FAQs)
Essentially, you’ll need to check the current rates and use the one applicable to how long you need financing for. This can be short-, mid-, or long-term. It can also vary based on the corresponding period for compounding interest.
The current AFR is available via the IRS website and is updated monthly.
Yes, but it’s highly recommended to work with a lending, tax, or legal professional to ensure proper documentation and understand the small business loan requirements of the agreement.
Bottom line
The IRS Applicable Federal Rate is a type of interest rate that can be used on its own or as a benchmark rate when determining the minimum pricing for financing. It is regulated by the IRS and will need to be followed to avoid tax penalties. Before entering into a financing agreement, be sure to reference rates, terms, and conditions to ensure you’re in compliance and can manage the details of the proposed agreement.
