If adequate interest (based on the Applicable Federal Rate or AFR) is charged on a loan arrangement, then Code section 7872 generally does not apply (i.e., the loan is not a below-market loan). As a result, especially when interest rates are low, some planners suggest that the best course of action may be to arrange the transaction as a term loan that states adequate interest so that the loan arrangement interest rates can be locked in for a period of time. Because adequate interest is stated, it can be paid annually, or even accrued until the end of the term, instead of being treated as transferred upon creation of the loan. However, if an employer directly or indirectly pays the interest to the employee (e.g., through bonus compensation), the stated interest is disregarded, and the loan is treated as a below-market loan under section 7872.
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