There are tax laws, specifically two code sections, requiring that minimum interest rates must be charged for transactions involving loans, or sales of property, between taxpayers. These are Internal Revenue Code Section §483 and Code Section §1274.
Code section 483 covers any transaction where payments are due more than six months after the sale and at least one of the payments is due more than one year after the sale. Interest must be charged at an adequate stated rate (known as “Applicable Federal Rates”**).
Code section 1274 covers transactions involving debt instruments, due more than six months after the sale or exchange, that are not discounted by an adequate interest rate (known as Original Issue Discount, or “O.I.D.”) when the debt matures. The discount rate must be equal to or greater than the Applicable Federal Rates (A.F.R.’s).
Impact of the tax laws:
If loans or debt instruments do not require interest rates at least equal to the A.F.R’s, then the lender must “impute” interest income every year on the difference between the rate actually charged and the A.F.R. rates.
This will, for Code Section §483, result in additional interest income to the lender with no adjustment to the loan amount owed by the borrower.
If under Code Section §1274 the lender has issued a non-interest bearing note due in the future, the lender must apportion the note as if it was issued to include a present value apportionment between interest and principal. The apportioned interest again will be reportable annually and “amortized” just like a mortgage schedule.
Exceptions and Tax Elections:
The Code Sections include a number of exceptions for small amounts and short loan durations. There are also tax elections that apply depending on whether the lender is a cash or accrual based taxpayer. The result is a complicated set of rules and exceptions that can be traps for the unwary.
The above rules are enforced by tax auditors, thus taxpayers need to be aware that these rules exist and that they are an integral part of the tax landscape.
** These rates are published monthly by the IRS with different rates for short-term, mid-term and long-term loans.