Applicable federal rates are used for a number of federal tax provisions. For example, Code Sec. 1274 uses AFRs to determine whether a debt instrument has original issue discount (OID) or imputed interest. This determination requires the calculation of the present value of payments made on the debt instrument; present value is calculated using a discount rate equal to the AFR, compounded semi-annually. Many other Internal Revenue Code sections use AFR rates as a starting point for determining valuation, income or deductions.
With the AFR rates currently at fairly low levels, but with the likelihood that interest rates will rise sooner than later, strategies that involve taking advantage of low AFRs should be considered before the door closes on them.
DETERMINING AFRS
AFRs are based on the average market yield on outstanding marketable obligations of the federal government. The Internal Revenue Service computes AFRs for each calendar month and publishes them in a revenue ruling. As an example, Rev. Rul. 2014-1, published Jan. 6, 2014, provided the AFRs for January 2014. AFRs may be compounded (and therefore applied) monthly, quarterly, semiannually or annually. In addition, some amounts are calculated using a higher percentage of the basic AFR. The monthly revenue rulings provide AFRs equal to 110 percent of the base AFR, 120 percent, 130 percent, 150 percent and 175 percent. The blended annual rate is published annually and is a composite of the AFRs principally used for demand loans outstanding for the entire year.
IMPUTED AND UNSTATED INTEREST
Under Code Sec. 1274(d), the AFR includes:
- The federal short-term rate (used to test adequately stated interest for debt instruments of three years or less);
- The federal mid-term rate (for testing debt instruments of three to nine years); and,
- The federal long-term rate (for testing rates for debt instruments exceeding nine years).
Because commercial, private or bank loans on the open market usually charge interest at a rate higher than the U.S. government on Treasury securities, those loans paying adequately stated interest based upon AFRs generally will pay less than market. For term loans that are not required to recalculate adequately stated interest each year, a bet that interest rates are going up soon will reward those looking to avoid imputed interest with a relatively favorable interest rate, particularly for terms longer than three years.
Likewise, loans with below-market interest rates under Code Sec. 7872 are measured against the AFR, depending on the term of the loan. Foregone interest in this respect is considered the excess of the amount of interest that would have been payable if interest had accrued at the AFR over any interest payable on the loan properly allocable to the year in question. For example, if a split-dollar loan is a below-market loan, then the loan is recharacterized for tax purposes as a loan with interest at the AFR, coupled with an imputed transfer by the lender to the borrower under Sec. 7872.
Low interest rates may make intra-family loans that stay within the bounds of prevailing AFRs particularly desirable. Intra-family loans at a low AFR rate can provide a lower-bracket family member with funds that can be placed into higher-yield investment, yielding an overall net gain for the family unit.
"True interest" is usually protected by the natural, competing interests of borrower and lender without the need for the IRS to impose AFR floors. Nevertheless, for those instances in which the lender either wants to give the borrower a gift of low interest, or the lender is a tax-exempt entity that may not have much concern over imputed interest income, the AFR floors will come into play. The strategy in these cases is to lock in the low AFR rates now, without the requirement to reset imputed interest every year. There should be a binding and non-negotiable obligation in place.
PRESENT VALUE
AFRs are applied to determine the present value of an annuity, life interest, term of years interest, remainder interest, or reversionary interest under Code Sec. 7520. Specifically, the present value of an annuity, interest for life or for a term of years, or a remainder or reversionary interest is generally determined by using the IRS valuation tables. The interest rate component of the valuation tables is based on a rate that is 120 percent of the applicable federal mid-term rate compounded annually for the month in which the valuation date falls.
As a consequence, low AFRs impact, among other estate and wealth planning techniques, the use of private annuities, grantor retained annuity trusts, qualified personal residence trusts, charitable remainder trusts, and charitable lead trusts. Lower current AFR interest rates make private annuities, GRATs and CLTs more attractive. CRATs and QPRTs, however, generally benefit from a higher interest rate, a consideration that might persuade some taxpayers to postpone these strategies in the hope of higher rates over the coming months.
IRS OVER- & UNDERPAYMENT RATES
The interest rates on overpayments and underpayments of tax under Code Sec. 6621 for each calendar quarter is set currently for the third quarter of 2014 at 3 percent for overpayments, in cases other than corporations; 2 percent for overpayments in the case of a corporation (except 0.5 percent for the portion of a corporate overpayment exceeding $10,000); and 3 percent for underpayments (except 5 percent for large corporate underpayments). These amounts represent the lowest rates allowed by statute, with the required addition of the AFR federal short-term rate rounded to the nearest whole number equal to zero for the past 12 quarters. Of course, these low rates rarely stand alone, with a failure to pay or negligence penalties raising "true interest" considerably.
OTHER AFR APPLICATIONS
The code also uses AFRs to determine appropriate amounts of provisions, including:
- Insurance reserves under Sec. 807, as well as insurance provisions under Code Secs. 811 and 812;
- The present value of golden parachute payments under Sec. 280G at 120 percent of the AFR, compounded semiannually;
- Payments for the use of property or services under Sec. 467;
- Unrelated business and debt-financed income under Sec. 514;
- The recharacterization of gain from straddles under Sec. 1058;
- The Sec. 382 limits on NOLs following ownership changes; and,
- OID on tax-exempt obligations under Sec. 1288.
CONCLUSION
Saving a few basis points of interest should not determine the underlying validity of a tax strategy in which interest rates are a variable. Accelerating the consideration of a strategy to take advantage of low AFRs while they are still available, however, may prove a win-win: locking in the tax savings gained from low interest rates while benefiting from the underlying tax strategies that probably should be considered sooner, rather than later, irrespective of AFR levels.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer, CCH.
