How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note

Intrafamilial arrangements labeled as loans have long invited special scrutiny from the Internal Revenue Service. In some cases, the IRS has successfully established that the arrangement was not a loan but another type of transfer, such as a gift. In the wake of several IRS victories in cases where somewhat "informal" financial arrangements between family members were held not to be loans, many advisors to individual taxpayers counsel that when a child borrows money from a parent, for example, the loan should be documented, interest-bearing, secured and repaid (at least in part), if the transaction is to be free of unexpected and in some cases adverse tax consequences. In any event, even where the financial arrangement is respected as a loan, tax effects, such as generation of interest income taxable to the lender or the trigger of a gift tax on either the borrower or the lender, may arise. This article briefly will discuss some of these consequences. It also will discuss in more detail some effects of substituting a new note at the so-called "applicable federal rate" which is lower than the interest rate payable on the old note