What Are Blended Annual Rates for Demand Loans?
Understand the tax treatment for below-market demand loans and the IRS's blended annual rate, a tool for determining imputed interest for both parties.
The Internal Revenue Service (IRS) has regulations for loans with interest rates below the market standard to address their tax implications. When a loan is provided with little or no interest, the IRS may impute interest, treating the transaction as if a market rate were charged. For certain loans, the blended annual rate is a figure the IRS provides to simplify these calculations for lenders and borrowers. This mechanism ensures the transaction is taxed appropriately, regardless of the stated interest rate.
The Concept of Below-Market Demand Loans
A demand loan has no fixed repayment schedule and can be called due by the lender at any time. These are common between family members or between a corporation and its shareholders. A demand loan is classified as “below-market” when its interest rate is lower than the applicable federal rate (AFR), the minimum rate the IRS considers market rate for loans. The AFRs are published monthly and vary based on the loan’s term.
The issue with below-market loans is the potential for tax avoidance, which is addressed by Internal Revenue Code Section 7872. This section prevents parties from disguising taxable payments as tax-advantaged loans. For instance, an employer could provide a low-interest loan to an employee as a form of compensation, or a corporation could do the same for a shareholder to distribute what is effectively a dividend.
To counter this, the law creates “imputed interest,” also known as “foregone interest.” The lender is treated as having received interest income at the AFR, and the borrower as having paid that same amount of interest. The character of this foregone interest, such as a gift or dividend, has tax consequences for both parties.
Defining the Blended Annual Rate
The blended annual rate is an interest rate published by the IRS each year to simplify calculating foregone interest on below-market demand loans. This single, annualized rate is for use only with demand loans that have a fixed principal amount and have been outstanding for the entire calendar year. If a loan’s principal changes or it was not outstanding for the full year, the monthly AFRs must be used instead.
The IRS releases the blended annual rate in the middle of the year through a Revenue Ruling. The rate is determined by a formula that compounds the semiannual short-term AFRs from earlier in the year. The use of a single blended rate provides a practical alternative to tracking and applying fluctuating monthly AFRs.
This rate allows for a straightforward, once-a-year calculation for qualifying demand loans, avoiding complex computations. For example, the blended annual rate for 2024 was 5.03%. This figure would be used for all qualifying demand loans that were outstanding for the entirety of 2024.
How to Calculate Foregone Interest
Calculating the foregone interest on a qualifying demand loan is a direct process. The calculation determines the amount of interest the IRS considers transferred from the lender to the borrower. This amount is the difference between the interest that should have been charged using the blended annual rate and the interest that was actually paid on the loan.
The formula is: (Loan Principal) x (Blended Annual Rate) – (Interest Actually Paid). To illustrate, consider a corporation that provided a $100,000 interest-free demand loan to its sole shareholder. Assume the loan was outstanding for all of 2024, when the blended annual rate was 5.03%. The first step is to multiply the loan principal by the blended annual rate for that year.
The calculation would be $100,000 multiplied by 5.03% (0.0503), which equals $5,030. Since the loan was interest-free, the interest paid is zero, so the foregone interest for the year is $5,030. If the loan had charged $1,000 in interest, the foregone interest would be $4,030 ($5,030 – $1,000).
Tax Consequences and Reporting Rules
The calculated foregone interest has direct tax consequences. The lender must report the amount as interest income on their tax return. The lender is also deemed to have made a payment to the borrower for the same amount, which could be characterized as compensation, a dividend, or a gift, depending on the relationship.
For the borrower, the situation is mirrored. The borrower is treated as having paid the foregone interest to the lender, which may be deductible on their tax return. Deductibility depends on how the loan proceeds were used. For example, if funds were used for investment, the interest may be deductible, but if used for personal expenses, it is generally non-deductible.
There are de minimis exceptions that can negate these reporting requirements. For gift loans between individuals, if total outstanding loans do not exceed $10,000, the imputed interest rules generally do not apply, provided the loan is not used to purchase income-producing assets. A similar $10,000 exception exists for compensation-related and corporate-shareholder loans, as long as tax avoidance is not a principal purpose of the interest arrangement. If loan amounts are below this threshold, the accounting for foregone interest is not required.