This is not a trick question.
The minimum interest rate issue typically comes up in closely-held businesses and other friend and family loan situations where people are tempted to forego formalities and lend money as a personal favor.
Simply stated, a loan is an amount of money given to another person or entity with the understanding that the borrower will repay that amount.
The minimum required interest rate is called the Applicable Federal Rate (or “AFR”), sometimes the “arm’s length” rate. The IRS effectively requires the AFR to be charged by imposing tax consequences on loans with interest rates lower than the AFR (even zero percent) and loans that are silent as to interest.
While the AFR is usually far lower than current market rates, it can still be a surprise with unpleasant consequences to both borrowers and lenders.
If a lender charges too little or no interest, Internal Revenue Code (“IRC”) Section 7872 allows the IRS to reassess the lender and impose an income tax on the lender as if the lender collected interest at the AFR, rather than the rate actually paid by the borrower. This is done using the “original issue discount.” Section 483 of the IRC may treat a portion of the payments as interest in certain other situations, like agreements relating to the sale or exchange of property. The IRS may also treat the interest as nondeductible interest expense to the borrower and charge other penalties.
If money is given with the understanding that it will not be repaid, then the transaction will likely be treated as something other than a loan, like a gift, a capital contribution to a business, or employee compensation depending on the circumstance. Each treatment has different tax consequences. If the loan is determined to be a gift and is in excess of the annual gift tax exclusion, it may trigger a taxable event causing taxes to be owed.
Calculating the AFR
The minimum interest rate required by the IRS ultimately depends on the duration of the note. Loans are grouped into three ranges: a) short term (under 3 years); b) mid-term (between 3-9 years); and c) long-term (over 9 years).
The short-term AFR is determined from the one-month average of market yields from “marketable obligations” like US government T-bills with maturities under three years. The mid-term AFR is determined from obligations with maturities of more than three but less than nine years. The long-term AFR is determined from bonds with maturities of more than nine years.
In addition to the basic rates, the IRS also publishes other rates that vary depending on the compounding period (i.e. annual, semi-annual, quarterly, and monthly) and other criteria. Generally, the shorter the term of the loan, the lower the AFR. Open-ended lines of credit are treated as long-term, while callable “demand” loans will have a blended rate described in Section 7872(e)(2)(A) of the IRC. The IRS publishes the AFR, which changes on a monthly basis in accordance with Section 1274(d) of the IRC. The AFR on a loan is the published rate on the date the loan was made and is retained even if market rates or the AFR subsequently increase or decrease.
Here is a link to find current and historical AFRs.
Avoiding the Problem
Often, loans to friends, family, and business partners can feel like informal personal favors. The temptation for those with the ability to loan money is to do so for “free.” Due to IRS regulations, such an act of charity can backfire if not carefully planned. To avoid unintended tax consequences, loan transactions should be properly documented using interest, even if just the minimal amounts required.