Parents and grandparents often lend money to their children or grandchildren to help with major expenditures like education, a wedding or the purchase of a new home.
Similarly, closely held businesses may lend money to shareholder-employees. And business owners sometimes lend money to the business to assist with expansion plans.
All of these transactions are examples of related-party loans.
Not surprisingly, the IRS requires that loans be structured in a business-like manner with terms that reflect current market conditions. If the loan terms are deemed too favorable, the IRS has the ability to recharacterize the loan – perhaps as a gift, additional compensation, or a corporate dividend or distribution – with all the tax implications that a recharacterization implies.
For no-interest or below-market interest loans, the IRS also has the right to reflect the current “market” interest rate for tax purposes by requiring that the lender take into income more interest than was actually received under the terms of the loan. The interest for tax purposes is calculated based on the Applicable Federal Rate (AFR).
The IRS publishes AFRs each month. They represent the minimum acceptable interest rates for most loans. If the interest rate on your loan at its inception is equal to or exceeds the relevant AFR, the IRS cannot challenge the appropriateness of the rate during the term of the loan.
AFRs include annual, semiannual, quarterly and monthly rates for short-term loans (terms of three years or less), mid-term loans (terms over three years but not exceeding nine years) and long-term loans (terms longer than nine years).
To ensure that the IRS recognizes your transaction as a loan for tax purposes and does not recharacterize it as something else – a gift, additional compensation, or a corporate dividend or distribution, for example – you should have a written loan document or promissory note with an interest rate at least equal to the applicable AFR.
The borrower should sign and date the document, which should describe the terms of the loan, including loan amount, interest rate, payment schedule and any other terms. If your borrower is providing collateral, include a detailed description.
If the IRS determines that the interest rate for your loan is below the prescribed minimum established by the AFR, the loan is subject to the below-market loan rules. These rules generally require the lender and the borrower to recognize interest income and interest expense for federal tax purposes based on the relevant AFR rather than the loan’s actual interest rate.
For a demand loan, without a fixed loan term and end date, the Applicable Federal Rate used to calculate interest for tax purposes varies each month, based on fluctuations in the AFR. For a term loan, with a documented loan term and end date, the interest calculation is based on the relevant AFR as of the loan’s start date.
There is an exception to the below-market loan rules for a loan with a total amount outstanding between lender and borrower that does not exceed $10,000, if the loan is not for tax avoidance purposes.
If you create a new term loan now, when the AFR is near its all-time low, you can lock in a very favorable interest rate.
The tax rules governing below-market and related-party loans are complex with a number of exceptions. To understand all of the tax implications, consult your tax adviser before you enter into or renegotiate any loan.