Understanding Employee Loans and AFR

Employers may choose to lend money to employees for personal needs. While this might seem generous and informal, it is critical to understand the tax rules that govern such transactions—especially when the loan carries little or no interest. One key requirement to be aware of is the Applicable Federal Rate (AFR).

What is an AFR?

The Applicable Federal Rate (AFR) is the minimum interest rate set by the Internal Revenue Service (IRS) for loans. This rate is published monthly and is used to help prevent lenders—including employers—from avoiding tax consequences by offering loans with little to no interest.

Below-Market Loans

A below-market loan is one that either carries no interest or has an interest rate lower than the AFR. For example, when an employer lends money to an employee at an interest rate below the AFR, it is considered a below-market loan. The IRS considers the difference between the AFR, and the actual interest charged to be “imputed interest.”

For Example:

Why Does This Matter for Employers?

When you lend money to an employee at a rate below the AFR, the IRS may treat the imputed interest as additional compensation. This means:

·       The employee must report it as taxable income.

·       The employer must report it on their Form W-2.

·       Payroll taxes apply to the imputed interest for both parties.

In some cases, where the loan lacks a clear repayment structure, it may be reclassified as a gift, triggering the gift tax.

Risks to Employers If the AFR Is Not Followed

Failing to follow AFR rules can:

·       Unexpected payroll tax liabilities

·       Issues during an IRS audit

·       Strained employer-employee relationships due to unclear terms

Best Practices for Employers Lending to Employees:

Do:

·       Have a written loan agreement in place.

·       Follow the applicable AFR interest rates.

·       Consult with tax professionals, such as the team at Griffin & Furman, LLC, to ensure compliance.

Don’t:

·       Ignore imputed interest rules.

·       Neglect proper documentation.

·       Overlook the tax implications for employees.

If you are considering lending to an employee—or already have a below-market loan in place—it is essential to ensure compliance with AFR rules to avoid costly mistakes.

Ready to ensure your loans comply with IRS regulations? Contact Griffin & Furman today for expert guidance on AFR compliance and tax planning. Let our team help you navigate the complexities and avoid costly penalties.

Sources:

• “Below-Market Executive Loans.” Henssler Financial, https://www.henssler.com/below-market-executive-loans/. Accessed 17 June 2025.

• Kenton, Will. “Applicable Federal Rate (AFR): Definition, History, and Purpose.” Investopedia, Dotdash Meredith, https://www.investopedia.com/terms/a/applicablefederalrate.asp. Accessed 17 June 2025.

• “Applicable Federal Rates (AFRs).” Internal Revenue Service, https://www.irs.gov/applicable-federal-rates. Accessed 17 June 2025.