Applicable Federal Rate

The Applicable Federal Rate (AFR) refers to the lowest cut-of-interest rate permissible by the IRS for private lending. The primary purpose of the applicable federal rate (AFR) is to establish a minimum benchmark for interest rates in various financial transactions.

Various tax-related purposes use these rates, particularly for requiring the minimum interest rates on certain loans or calculating the imputed interest on certain financial transactions. Additionally, estate planning, valuation of charitable gifts, and other financial and tax planning scenarios utilize AFRs.

• The Applicable Federal Rate (AFR) is the IRS's lowest permissible interest rate for private lending.
• It can be used by knowing the type of AFR, checking the monthly AFR rate, determining the loan term, selecting the best-suited AFR type, calculating the AFR rate, implementing the AFR rate, and considering the tax implications while ensuring proper documentation.
• Additionally, the IRS sets it as the minimum permissible interest rate, while the adjusted applicable federal rate derives from the AFR and applies to specific transactions."

The Applicable Federal Rate (AFR) is a pivotal interest rate benchmark for private lending that the IRS sets. It establishes minimum interest rates concerning various loans. As an outcome, it prevents tax evasion by employing favorable loan terms. Moreover, AFRs are also used in estate planning, valuation of charitable gifts, and other financial and tax planning scenarios.

Here's how the AFR works:

• Categorization: The IRS categorizes AFRs into three main groups based on the duration or term of the financial transaction.
• Short-term AFR
• Mid-term AFR
• Long-term AFR 

• Monthly updates: The IRS updates applicable federal rates every month, typically around the middle of each month. These updates are based on prevailing market interest rates, specifically the yields on U.S. Treasury securities.

• Minimum Interest Rates: For tax purposes, various financial transactions should charge or credit the AFRs as minimum interest rates. Suppose the actual interest rate in a transaction is below the AFR for the relevant category and term. In that case, the IRS may impose an appropriate interest rate to ensure tax compliance.

• Tax Compliance: AFRs are primarily used to ensure tax compliance in situations where interest rates might impact the tax treatment of transactions. Therefore, typical examples include loans between family members, gift loans, intra-family loans, specific trust arrangements, and estate planning transactions.

• Investment Income: AFRs are also used in some cases to determine the taxable interest income that individuals or entities receive from loans or investments.

Hence, the IRS's applicable federal rate is a crucial benchmark for setting minimum interest rates on loans. Moreover, the applicable federal rate calculator is a valuable tool for those seeking clarity on interest calculations. Also, understanding the appropriate national rate long-term is essential when dealing with long-term loans.

To avoid tax implications and compliance, one must determine the AFR as follows:

• Visit the IRS website: Visit the IRS website to find the AFR table. 
• Find the appropriate AFR table: When the loan was sanctioned, try to find the AFR table.
• Select the Rate: Once the relevant category is identified along with the current month's AFRs, select the appropriate rate based on one's transaction's term.
• Interest rate calculation: Then multiply the loan duration in years by the principal loan amount. It provides the lowest interest rate threshold that one needs to charge.

However, besides the above points, one must keep the following in mind while determining the AFR:

• The yield of marketable debts like treasury bills and government bonds is the base of AFR.
• Prime rate and AFR are different from each other. So, AFR must be distinct from the prime rate.
• AFR changes monthly, so one must watch for it every month. 

AFR is a valuable metric to determine the eligible loan level that lenders can grant without evoking tax triggers. Hence, one must know how to use AFR as listed below:

• Understand the type of AFR: First, one must understand various kinds of AFR, like short-term AFR, mid-term AFR, and long-term AFR, and their maturity term.
• Check monthly AFR rate: Monthly checking of the AFR rate on the IRS website must be carried out.
• Determine loan term: Next, the determination of loan terms has to be done, like short-term, mid-term, or long-term loans.
• Select the best-suited AFR type: After that, the applicant must match the AFR category with the appropriate loan term as below:

• Calculate AFR rate: Once selected, the appropriate loan category corresponding to the AFR category, look out for the rate published by the IRS.
• Implement AFR rate: The AFR rate must be applied n the loan amount. As a result, the chargeable interest rate will be calculated. Therefore, the interest rate will remain above the permissible IRS rate.
• Consider tax implications: If the interest rate comes out to be less than the IRS permitted, calculate its tax implication. Besides, if it is equal to or more than the IRS permissible rate, no tax implication must be considered.
• Documentation: Finally, one must carefully note down the loan term, charged interest rate and tax implications, if any. So, such accurate documentation ensures IRS compliance and removes all sorts of compliance concerning gifts and loans. 

Let us use a few examples to understand the topic.

Example #1

Imagine Transcend Services, a US-based company, is interested in issuing bonds to raise capital for an expansion project. They approach a bank for a loan, but the bank requires that the firm pay interest at a rate consistent with the current AFR for long-term loans, which is 3.0%. Hence, the firm ensures that the bond interest rate meets the minimum threshold set by the IRS.

Besides, the firm agrees to the terms and issues the bonds with an interest rate of 3.5%, higher than the AFR. By doing so, they secure financing for their expansion and ensure that the bond interest rate complies with IRS regulations, avoiding potential tax issues and demonstrating financial responsibility to investors.

Example #2

The IRS has released Revenue Ruling 2023, which includes the August 2023 applicable federal rates (AFR). These rates are used, among other things, to figure out how much should be distributed from retirement savings plans that satisfy the criteria for essentially equal monthly payments (a tax exception from the 10 percent early distribution penalty)—also known as "72(t) payments."

The table below lists the AFR rates for August 2023 for the current month for Internal Revenue Code section 1274(d).

• Short Term, Mid- Term and Long-Term AFR

Short Term AFR

Mid-Term AFR

Long–Term AFR

Let us use the table below to understand the difference using the table below.

This has been a guide to What is Applicable Federal Rate. We explain how to determine & use it, examples, & comparison with adjusted applicable federal rate. You can learn more about it from the following articles –

• Default Rate
• Interest Rate Cap
• Reverse Repo Rate