Long-Term AFR’s Hit All-Time Lows
The IRS issues the Applicable Federal Rates (AFR) each month. These rates are broken down into short-term (less than three years), mid-term (between 3 and 9 years) and long-term (more than 9 years). The IRS just issued the rates for July, 2016 and the long-term rate hit an all-time low of 2.18%. The old low was March, 2015 at 2.19%. The short-term and mid-term rates are not close to all-time lows and that is due to the flattening of the yield curve. With a lot of negative interest rates around the world, long-term rates are getting lower and lower.
Many farmers always wonder why CPAs talk so much about AFR’s. About 25 years ago, Congress was worried about farmers (and other taxpayers) having loans between related parties and not charging any interest. This allowed taxpayers in higher brackets to pass “income” onto family members in lower tax brackets. Also, many corporations had loaned money to/from their shareholders and since interest was not being charged, Congress felt that this was wrong. Therefore, they passed a new law that would “impute” interest in those situations based upon minimum interest rates published each month by the IRS (the AFRs).
There is no requirement for family members or related parties to charge interest, however, if you do not, then the Tax Code requires us to impute interest. This can lead to some surprising taxable events. Here is oneexample.
Suppose ABC corporation (a C corporation) has loaned $500,000 to its farmer shareholder with no interest. The Tax Code requires us to impute interest and let’s assume it is an 1% rate. This results in interest income to the corporation of $5,000, a taxable dividend to the shareholder of $5,000 and likely non-deductible personal interest expense of $5,000. In this case, the corporation and individual each paid tax on $5,000 of interest without any offsetting deduction for either party (the dividend is non-deductible to the corporation). If both parties were in a 25% tax bracket, this results in $2,500 of extra tax being paid.
If the corporation was an S corporation, then the income would only be $5,000 flowing through and taxed to the shareholder with only $1,250 of tax being owed.
I would hazard a guess that there are many situations like this in the farm economy and interest is not being imputed. However, this is the law and if you are in this situation with a large loan balance, make sure to discuss it with your tax advisor.
Paul Neiffer, CPA