IRC 7872: Below-Market Loan Rules and the AFR

By Yarik Yarosh, CPA ·September 5, 2026 ·Updated October 16, 2026 ·7 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

IRC 7872 treats an interest-free or below-market loan as if it charged interest at the applicable federal rate (AFR). The forgone interest is treated as moving from the lender to the borrower and then back as interest. A family loan becomes a gift plus interest income, an employer loan becomes wages plus interest, and a corporation-to-shareholder loan becomes a dividend plus interest. The rules cover gift, compensation-related, corporation-shareholder and tax-avoidance loans, with a $10,000 de minimis exception for gift loans between individuals.

✓Key takeaway

Below-market loan categories:

Loan Type	Imputed Transfer	Tax Consequence
Corporation to shareholder	Corporation deemed to pay dividend, shareholder deemed to pay interest	Dividend income to shareholder, possible interest deduction
Employer to employee	Employer deemed to pay compensation, employee deemed to pay interest	Wages to employee (FICA + income tax), interest income to employer
Family member to family member	Lender deemed to make gift, borrower deemed to pay interest	Gift tax implications to lender, interest income to lender
Corporation to corporation (related parties)	Deemed dividend, contribution, or intercompany transfer	Depends on ownership structure
Tax-avoidance loans	Imputed based on purpose	IRS scrutinizes motive

Applicable Federal Rates (AFR) structure:

Loan Term	Rate Category	Compounding Options
Short-term (3 years or less)	Published monthly by IRS	Annual, semi-annual, quarterly, monthly
Mid-term (over 3 years, up to 9 years)	Published monthly by IRS	Same
Long-term (over 9 years)	Published monthly by IRS	Same

Exemptions from imputation:

Exemption	Requirement
$10,000 de minimis (individual loans)	Total loans between the parties do not exceed $10,000, AND the loan is not directly attributable to the purchase of income-producing assets
$100,000 limited imputation	Total loans between the parties do not exceed $100,000; imputed interest limited to borrower’s net investment income for the year. If net investment income is $1,000 or less, imputed interest is $0.
Compensation-related and corporation-shareholder loans under $10,000	Same de minimis applies

How do imputed interest rules work?

Hypothetical example

Round numbers. An S-Corp shareholder lends $200,000 to the corporation at 0% interest, repaid in one payment at the end of 5 years. That’s a term loan, and a 5-year term uses the mid-term AFR. For a loan made in October 2026, Rev. Rul. 2026-19 sets the mid-term AFR at 4.56% compounded semiannually.

Step 1: Find the day-one transfer under IRC 7872(b)

Item	Amount
Loan amount	$200,000
Stated interest rate	0%
Mid-term AFR, October 2026 (semiannual compounding)	4.56%
Present value of the $200,000 repayment (10 half-years at 2.28%)	$159,633
Excess of the amount loaned over that present value	$40,367

A term loan doesn’t get the year-by-year treatment a demand loan gets. IRC 7872(b)(1) treats the lender as transferring the whole $40,367 to the borrower on the date the loan is made, and 7872(b)(2) treats the loan as having $40,367 of original issue discount (OID).

Step 2: Tax consequences

Deemed Transaction	Amount	Tax Treatment
Shareholder deemed to transfer $40,367 to the S-Corp on the date the loan is made	$40,367, once	A transfer from the shareholder to the corporation, not an S-Corp distribution
OID accrues on the loan over the 5 years	$40,367 in total ($7,362 in the first loan year, rising to $8,817 in the fifth)	Interest income to the shareholder as it accrues, and an interest deduction for the S-Corp as it accrues

The net effect: over the 5 years the shareholder reports $40,367 of interest income and the S-Corp deducts the same amount, roughly $8,000 a year, with no cash interest changing hands. If the shareholder’s marginal rate equals the S-Corp’s pass-through rate, the economic impact is roughly neutral, but the reporting complexity and potential for errors is real.

The better approach: charge interest at the AFR

If the loan charges 4.56% interest, paid every 6 months	Result
Interest payments	$4,560 every 6 months, $9,120 a year (actual cash from S-Corp to shareholder)
Shareholder reports	$9,120 interest income a year
S-Corp deducts	$9,120 interest expense a year
Imputed interest	$0
IRS issue	None

Charging the AFR eliminates the imputation problem entirely. The economic result is the same, but the reporting is clean.

Scenario 2: Family loan ($150,000 parent to adult child, 0% interest, demand loan)

Item	Amount
Loan amount	$150,000
Stated rate	0%
Short-term AFR	4.0%
Annual imputed interest	$6,000

Since the loan exceeds $100,000, the full imputation applies:

Deemed Transaction	Amount	Tax Consequence
Parent deemed to make gift of $6,000 (forgone interest)	$6,000	Counts toward $19,000 annual gift exclusion (no gift tax if total gifts < $19,000)
Child deemed to pay $6,000 interest to parent	$6,000	Parent reports $6,000 interest income; child gets no deduction (personal interest is non-deductible)

If the loan were $90,000 (under $100,000), the limited imputation rule applies:

Child’s net investment income	Imputed Interest
$1,000 or less	$0 (deemed zero)
$2,500	$2,500 (limited to net investment income)
$5,000 or more	$3,600 (AFR x $90,000; limited to actual NII if lower)

Scenario 3: Employer-to-employee demand loan ($50,000, 1% interest)

Item	Amount
Loan amount	$50,000
Stated rate	1%
AFR (short-term, loan payable on demand)	4.0%
Below-market spread	3.0%
Annual imputed interest	$1,500

Deemed Transaction	Amount	Tax Consequence
Employer deemed to pay $1,500 compensation	$1,500	W-2 wages (subject to FICA and income tax withholding)
Employee deemed to pay $1,500 interest to employer	$1,500	Employer reports interest income; employee gets no deduction (personal interest)

The employer must:

Add $1,500 to the employee’s W-2 as imputed compensation
Pay employer FICA on the $1,500 (7.65% = $115)
Report $1,500 in interest income
Report the $1,500 compensation as a deductible expense

Business interest deductibility (IRC 163(j)): Even when interest is properly charged at or above the AFR, IRC 163(j) limits business interest deductions to 30% of adjusted taxable income (ATI) for businesses with average annual gross receipts exceeding $32 million (for 2026). Small businesses under this threshold are exempt.

Business Size	Interest Deduction Limit
Average gross receipts <= $32 million (2026)	No limit (fully deductible)
Average gross receipts > $32 million (2026)	Limited to 30% of ATI
Excess interest	Carried forward indefinitely

Documentation checklist for related-party loans:

Document	Purpose
Written promissory note	Establishes the loan as debt (not equity or gift)
Stated interest rate at or above AFR	Avoids imputation under IRC 7872
Repayment schedule	Shows bona fide debt with intent to repay
Actual payments made per schedule	IRS looks at whether payments are actually made
Board resolution (corporate loans)	Corporate formality documenting the loan
Security/collateral (if any)	Strengthens debt characterization
Arm’s-length terms	Compare to what a bank would offer

Illustrative numbers only, not a real client and not advice for your facts.

Related guides:

Bare trust reporting in Canada: the T3 rules
Farm Hobby Loss Rules: How the IRS Decides and How to Defend Your Deductions
IRS Statute of Limitations: The 3-Year, 6-Year, 10-Year, and Unlimited Rules

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Cite this page

Yarik Yarosh, CPA. "IRC 7872: Below-Market Loan Rules and the AFR." Blue Cloud CPA, September 5, 2026, updated October 16, 2026. https://bluecloudcpa.com/guides/small-business-below-market-loan-rules-irc-7872

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.