What Are the Requirements for an Arms Length Loan?

An arm’s length transaction is a dealing between two independent parties, where each acts in their own self-interest. When applied to lending, an arm’s length loan has terms that would be expected between a typical lender and borrower, free from the influence of a personal relationship. The purpose of formalizing a loan this way is to ensure it is treated as a genuine debt for financial and tax reporting.

Tax Implications of Non-Arm’s Length Loans

Failing to structure a loan at arm’s length has tax consequences enforced by the Internal Revenue Service (IRS). When a loan carries an interest rate below the market rate, the IRS can impute interest. This means the lender must recognize and pay income tax on the interest they should have collected, even if no money was actually received.

Imputed interest is calculated using the Applicable Federal Rates (AFR), which the IRS publishes monthly. For example, if a parent lends a child $150,000 interest-free when the AFR is 4.0%, the IRS would treat the parent as having received $6,000 in taxable interest income for that year. The transaction is viewed as the lender gifting the forgone interest to the borrower, who then pays it back as interest, preventing income shifting without tax consequences.

Beyond imputed interest, a non-arm’s length loan can be recharacterized. If the forgone interest on a loan between family members exceeds the annual gift tax exclusion of $19,000, the lender may have to file a gift tax return. While tax may not be due immediately, this filing reduces the lender’s lifetime gift tax exemption. The IRS presumes that transfers between family members are gifts unless there is clear evidence of a debtor-creditor relationship.

In a corporate context, a loan from a corporation to a shareholder that isn’t at arm’s length can be reclassified by the IRS as a constructive dividend or a salary. If treated as a dividend, the shareholder pays income tax on the amount, and the corporation gets no deduction. If it is deemed a salary, it becomes subject to payroll taxes, preventing tax-free distributions disguised as loans.

Key Characteristics of an Arm’s Length Loan

To be recognized as a legitimate debt, a loan must possess specific characteristics that mirror a transaction between unrelated parties. The primary characteristic is a commercially reasonable interest rate. The IRS provides a baseline for this through the Applicable Federal Rates (AFRs), which represent the minimum interest that should be charged on private loans.

A formal, written agreement, usually a promissory note, is another component. This legal document outlines the borrower’s promise to repay a specific amount of money to the lender under defined terms, serving as strong evidence that the transaction was intended as a loan.

The loan must also feature a defined repayment schedule specifying the frequency and amount of payments, including allocations to principal and interest. A structured repayment plan demonstrates a clear intent for the loan to be paid back over time and includes a final maturity date.

Finally, collateral may be necessary if an independent lender would require security for a loan of a similar size and purpose. Collateral is an asset pledged by the borrower to secure the loan, providing the lender with recourse in the event of a default.

Required Documentation and Information

The promissory note is the core document and must contain the full legal names and addresses of both parties, the principal amount of the loan, and the date it was made. The note must also detail the financial terms, including the interest rate and a comprehensive repayment schedule with due dates and a final maturity date.

Clauses specifying penalties for late payments or the consequences of a full default should also be included to reinforce the seriousness of the obligation.

A key task is selecting the correct Applicable Federal Rate (AFR). The IRS publishes these rates monthly, and the appropriate rate is determined by the loan’s term: a short-term rate for loans up to three years, a mid-term rate for loans from three to nine years, and a long-term rate for loans over nine years.

Maintaining Loan Compliance

Once an agreement is signed, the conduct of both parties is as important as the document itself. The borrower must adhere to the repayment schedule, as consistent, timely payments are evidence that the arrangement is a legitimate debt. Deviating from the schedule without a documented amendment can weaken the loan’s standing.

The lender must keep diligent records for the life of the loan. This involves tracking each payment received, noting the date and amount, and maintaining an amortization schedule showing the breakdown between principal and interest. These records demonstrate that the lender is actively administering the loan as a creditor would.

The lender has a tax reporting obligation for the interest received. This income must be reported to the IRS on the lender’s annual tax return, often on Schedule B of Form 1040. The lender may also need to provide the borrower with Form 1099-INT if the interest paid during the year is $10 or more.