The applicable federal rate (AFR) is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans. Each month the IRS publishes a set of interest rates that the agency considers the minimum market rate for loans. Any interest rate that is less than the AFR would have tax implications. The IRS publishes these rates in accordance with Section 1274(d) of the Internal Revenue Code.
Key Takeaways
If the interest on a loan is lower than the applicable AFR, it may result in a taxable event for the parties involved.
AFRs are used to determine the original issue discount, unstated interest, gift tax, and income tax consequences of below-market loans.
Parties must use the AFR that is published by the IRS at the time when the lender initially makes the loan.
Understanding the Applicable Federal Rate (AFR)
The AFR is used by the IRS as a point of comparison versus the interest on loans between related parties, such as family members. If you were giving a loan to a family member, you would need to be sure that the interest rate charged is equal to or higher than the minimum applicable federal rate.
The IRS publishes three AFRs: short-term, mid-term, and long-term. Short-term AFR rates are determined from the one-month average of the market yields from marketable obligations, such as U.S. government T-bills with maturities of three years or less. Mid-term AFR rates are from obligations of maturities of more than three and up to nine years. Long-term AFR rates are from bonds with maturities of more than nine years.
In addition to the three basic rates, the rulings in which the AFRs are published contain several other rates that vary according to compounding period (annually, semi-annually, quarterly, monthly) and various other criteria and situations.
Example of How to Use the AFR
As of Apr. 2022, the IRS stated that the annual short-term AFR was 1.26%, the mid-term AFR was 1.87%, and the long-term AFR was 2.25%. Please bear in mind that these AFR rates are subject to change by the IRS.
Which AFR rate to use for a family loan would depend on the length of time designated for payback. Let’s say you were giving a loan to a family member for $10,000 to be paid back in one year. You would need to charge the borrower a minimum interest rate of 1.26% for the loan. In other words, you should receive $126 in interest from the loan.
In our example above, any rate below 1.26% could trigger a taxable event. For example, let’s say you gave the same loan, but you didn’t charge any interest. By not charging any interest, you would have “foregone” $126 in interest income, and according to the IRS, it would be considered a taxable gift. Any interest rate charged below the stated AFR for the particular term of the loan would be considered foregone interest and, as a result, be taxable.
Special Considerations
When preparing to make a loan between related parties, taxpayers should consider two factors to select the correct AFR. The length of the loan should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).
If the lender charges interest at a lower rate than the proper AFR, the IRS may reassess the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. Also, if the loan is more than the annual gift tax exclusion, it may trigger a taxable event, and income taxes may be owed. Depending on the circumstances, the IRS may also assess penalties.
An asset swap is similar in structure to a plain vanilla swap with the key difference being the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating assets are being exchanged.
All swaps are derivative contracts through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount agreed upon by both parties. As the name suggests, asset swaps involve an actual asset exchange instead of just cash flows.
Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts between businesses or financial institutions.
Key Takeaways
An asset swap is used to transform cash flow characteristics to hedge risks from one financial instrument with undesirable cash flow characteristics into another with favorable cash flow.
There are two parties in an asset swap transaction: a protection seller, which receives cash flows from the bond, and a swap buyer, which hedges risk associated with the bond by selling it to a protection seller.
The seller pays an asset swap spread, which is equal to the overnight rate plus (or minus) a pre-calculated spread.
Understanding an Asset Swap
Asset swaps can be used to overlay the fixed interest rates of bond coupons with floating rates. In that sense, they are used to transform cash flow characteristics of underlying assets and transforming them to hedge the asset’s risks, whether related to currency, credit, and/or interest rates.
Typically, an asset swap involves transactions in which the investor acquires a bond position and then enters into an interest rate swap with the bank that sold them the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a LIBOR-based floating coupon.
It is widely used by banks to convert their long-term fixed rate assets to a floating rate in order to match their short-term liabilities (depositor accounts).
Another use is to insure against loss due to credit risk, such as default or bankruptcy, of the bond’s issuer. Here, the swap buyer is also buying protection.
The Process of an Asset Swap
Whether the swap is to hedge interest rate risk or default risk, there are two separate trades that occur.
First, the swap buyer purchases a bond from the swap seller in return for a full price of par plus accrued interest (called the dirty price).
Next, the two parties create a contract where the buyer agrees to pay fixed coupons to the swap seller equal to the fixed rate coupons received from the bond. In return, the swap buyer receives variable rate payments of LIBOR plus (or minus) an agreed-upon fixed spread. The maturity of this swap is the same as the maturity of the asset.
The mechanics are the same for the swap buyer wishing to hedge default or some other event risk. Here, the swap buyer is essentially buying protection and the swap seller is also selling that protection.
As before, the swap seller (protection seller) will agree to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread in return for the cash flows of the risky bond (the bond itself does not change hands). In the event of default, the swap buyer will continue to receive LIBOR plus (or minus) the spread from the swap seller. In this way, the swap buyer has transformed its original risk profile by changing both its interest rate and credit risk exposure.
Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after Dec. 31, 2021.
How Is the Spread of an Asset Swap Calculated?
There are two components used in calculating the spread for an asset swap. The first one is the value of coupons of underlying assets minus par swap rates. The second component is a comparison between bond prices and par values to determine the price that the investor has to pay over the lifetime of the swap. The difference between these two components is the asset swap spread paid by the protection seller to the swap buyer.
Example of an Asset Swap
Suppose an investor buys a bond at a dirty price of 110% and wants to hedge the risk of a default by the bond issuer. She contacts a bank for an asset swap. The bond’s fixed coupons are 6% of par value. The swap rate is 5%. Assume that the investor has to pay 0.5% price premium during the swap’s lifetime. Then the asset swap spread is 0.5% (6 – 5 – 0.5). Hence the bank pays the investor LIBOR rates plus 0.5% during the swap’s lifetime.
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The average daily balance is a common accounting method that calculates interest charges by considering the balance invested or owed at the end of each day of the billing period, rather than the balance invested or owed at the end of the week, month, or year.
Key Takeaways
Interest charges are calculated using the total amount due at the end of each day.
The average daily balance credits a customer’s account from the day the credit card company receives a payment.
Interest charges using the average daily balance method should be lower than the previous balance method and higher than the less common adjusted balance method.
Understanding the Average Daily Balance Method
The federal Truth-In-Lending-Act (TILA) requires lenders to disclose their method of calculating finance charges, as well as annual percentage rates (APR), fees, and other terms, in their terms and conditions statement. Providing these details makes it easier to compare different credit cards.
TILA permits the interest owed on credit card balances to be calculated in various different ways.The most common methods are:
Average daily balance method: Uses the balance on each day of the billing cycle, rather than an average balance throughout the billing cycle, to calculate finance charges.
Previous balance method: Interest charges are based on the amount owed at the beginning of the previous month’s billing cycle.
Adjusted balance method: Bases finance charges on the amount(s) owed at the end of the current billing cycle after credits and payments have been posted.
Important
An investor must understand how an institution’s choice of accounting methods used to calculate interest affect the amount of interest deposited into his or her account.
How the Average Daily Balance Method Works
The average daily balance totals each day’s balance for the billing cycle and divides by the total number of days in the billing cycle. Then, the balance is multiplied by the monthly interest rate to assess the customer’s finance charge—dividing the cardholder’s APR by 12 calculates the monthly interest rate. However, if the lender or card issuer uses a method that compounds interest daily, the interest associated with the day’s ending balance gets added to the next day’s beginning balance. This will result in higher interest charges and the reader should confirm which method is being used.
The average daily balance credits a customer’s account from the day the credit card company receives a payment. To assess the balance due, the credit card issuer sums the beginning balance for each day in the billing period and subtracts any payments as they arrive and any credits made to the customer’s account that day.
Cash advances are usually included in the average daily balance. The total balance due may fluctuate daily because of payments and purchases.
Average Daily Balance Method Example
A credit card has a monthly interest rate of 1.5 percent, and the previous balance is $500. On the 15th day of a billing cycle, the credit card company receives and credits a customer’s payment of $300. On the 18th day, the customer makes a $100 purchase.
The average daily balance is ((14 x 500) + (3 x 200) + (13 x 300)) / 30 = (7,000 + 600 + 3,900) / 30 = 383.33. The bigger the payment a customer pays and the earlier in the billing cycle the customer makes a payment, the lower the finance charges assessed. The denominator, 30 in this example, will vary based on the number of days in the billing cycle for a given month.
Average Daily Balance Method Vs. Adjusted Balance Method Vs. Previous Balance Method
Interest charges using the average daily balance methodshould be lower than theprevious balance method, whichcharges interest based on the amount of debt carried over from the previous billing cycle to the new billing cycle. On the other hand, the average daily balance method will likely incur higher interest charges than the adjusted balance method because the latter bases finance charges on the current billing period’s ending balance.
Card issuers use the adjusted balance method much less frequently than either the average daily balance method or the previous balance method.
Special Considerations
Some credit card companies previously used the double-cycle billing method, assessing a customer’s average daily balance over the last two billing cycles.
Double-cycle billing can add a significant amount of interest charges to customers whose average balance varies greatly from month to month. The Credit CARD Act of 2009 banned double-cycle billing on credit cards.
Articles of incorporation are a set of formal documents filed with a government body to legally document the creation of a corporation. Articles of incorporation generally contain pertinent information such as the firm’s name, street address, agent for service of process, and the amount and type of stock to be issued. The articles of incorporation are used to legally form the corporation.
Key Takeaways
Articles of incorporation is the documents filed with a government body (usually the state) that signifies the creation of a corporation.
In the U.S., articles of incorporation are filed with the Office of the Secretary of State where the business chooses to incorporate.
Broadly speaking, articles of incorporation include the company’s name, type of corporate structure, and number and type of authorized shares.
While the articles of incorporation are used almost exclusively outside of the company, other documents such as bylaws, operating agreements, or business plans are more useful internally.
By filing articles of incorporation, corporations may gain favorable tax advantages, the ability to issue stock and raise capital, or shield owners from liability.
Understanding Articles of Incorporation
Many businesses in the U.S. and Canada are formed as a corporation, which is a type of business operation that is formed in the state where the company carries out its operations. To be recognized legally as a corporation, a business must incorporate by taking certain steps and making certain decisions required under corporate law. One such step is filing a document known as articles of incorporation.
Articles of incorporation are in the document necessary to register a corporation with a state and acts as a charter to recognize the establishment of a corporation. The document outlines the basic information needed to form a corporation, the governance of a corporation, and the corporate statutes in the state where the articles of incorporation are filed.
Articles of incorporation are also referred to as the “corporate charter,” “articles of association,” or “certificate of incorporation.”
Where to File Articles of Incorporation
In the U.S., articles of incorporation are filed with the Office of the Secretary of State in the state where the business chooses to incorporate. Some states offer more favorable regulatory and tax environments and, as a result, attract a greater proportion of firms seeking incorporation.
For example, Delaware and Nevada attract about half of the public corporations in the U.S., in part because of the state laws that protect their corporations. Once established, the articles become a public record and provide important information about the corporation.
Many states charge filing fees for a business that incorporates in the state, whether the business operates there or not. A business that is incorporated in one state and is physically located or doing business in another state must register in the other state as well, which involves paying that state’s filing fees and taxes.
Depending on the state of incorporation, a company may pay filing fees ranging from $50 (as in Iowa, Arkansas, and Michigan) to $275 (as in Massachusetts) as of 2020. The fees can vary depending on whether the articles of incorporation were filed online or by mail.
Articles of Incorporation Document Requirements
The articles in the document vary by state, but the following items (i.e. “articles” are typically included:
Name of corporation
Name and address of the registered agent
Type of corporate structure (e.g., profit corporation, nonprofit corporation, non-stock corporation, professional corporation, etc.)
Names and addresses of the initial board of directors
Number and type of authorized shares
Duration of the corporation, if it wasn’t established to exist perpetually
Name, signature, and address of the incorporator, who is the person in charge of setting up a corporation
Most states also require the articles to state the firm’s purpose, though the corporation may define its purpose very broadly to maintain flexibility in its operations. Amazon’s certificate of incorporation, for example, states that the corporation’s purpose is “to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware.”
Other provisions outlined in a company’s articles of incorporation may include the limitation of the directors’ liability, actions by stockholders without a meeting, and the authority to call special meetings of stockholders. Each state has certain mandatory provisions that must be contained in the articles of incorporation and other optional provisions that the company can decide whether to include.
While domestic companies will submit an article of incorporation, foreign corporate entities must file a certificate of registration to operate in a given state.
Articles of Incorporation vs. Other Documents
Articles of Incorporation vs. Bylaws
While the articles of incorporation are externally-filed formation documents, bylaws are more of use to a company when used internally. Bylaws set the internal processes and organization of how the company should be run. Bylaws outline the rules and procedures for the management of a company. Not all states require a company to maintain bylaws, though many require a company to formally memorialize the bylaws.
Articles of Incorporation vs. LLC Operating Agreement
Articles of incorporation are required state filings to form a corporation, while LLC operating agreements are used exclusively for LLCs. In addition, the articles of incorporation outline the information structure of the company. Meanwhile, operating agreements often outline how internal disputes will be resolved between members or owners. An LLC operating agreement acts more of a personal protection document than the articles of incorporation.
Articles of Incorporation vs. Business License
A business license often permits a company to operate within a specific jurisdiction or industry. It gives the holder the right to start and run a business in the designed geographical location that issues the license. The rights granted by a business license are often more specific and niche than the articles of incorporation; though similar information may be required for both, the articles of incorporation simply legally form an organization and is the highest governing document for a corporation.
Articles of Incorporation vs. Business Plan
A business plan is an internal document that may be shared with major customers, investors, or lending institutions that communicates the formal operating plan of a company. Often a strategic document, a business plan is mainly used by internal management as a roadmap for decision-making. This is in stark contrast of the articles of incorporation which are information-only, non-strategic requirements for legal reasons.
A company should internally maintain a copy of its articles of incorporation request.
Importance of Articles of Incorporation
A corporation should take care when filings its articles of incorporation as these formation documents carry great significance. For starters, they are legally required to structure a new business or company. The corporation can not form and be recognized by the state as a legal business entity until the forms are registered.
Once a business is incorporated, it often has a greater ability to raise capital via stock issuances. A corporation cannot sell stock until is incorporated via the filing of its articles of incorporation. Corporations may also receive more favorable tax treatment compared to individual or personal tax rates.
In addition, there are personal liability considerations for companies being formed. Individuals are often held liable for a company’s obligations until it is incorporated. By forming a legal corporation, business owners may be shielded from some personal liability for the company’s debts. This liability protection cannot occur until the articles of incorporation have been filed.
Example of Articles of Incorporation
The image below captures the first few requirements from the Secretary of State form required by the state of Washington. This form is to be completed and returned to the government agency for review.
Articles of Incorporation, Sample (WA State).
Some sections simply require a check mark for applicability or a ‘yes/no’ mutually exclusive selection. Other areas (such as the purpose of the corporation) require written response. As designated by the top of the form, this specific article of incorporation document template is for specific use for the formation of non-profit corporations.
The Washington State Articles of Incorporation form ends with the certification section in which an incorporator must certify the information given is correct to the best of their knowledge. The incorporator is also required to provide some personal information along with their signature.
Articles of Incorporation, Certification Section (WA State).
The form above had been filed by Parrot Foundation, a Washington nonprofit organization. A snipped of Parrot Foundation’s articles of incorporation has been provided below as an example of the dates, structure, and business purpose a company may request when filing its articles of incorporation.
Parrot Foundation, Articles of Incorporation.
What Is the Purpose of the Articles of Incorporation?
The purpose of the articles of incorporation is to legally form a corporation. The filing submits information to a state agency, and the state agency officially determines whether the corporation can be recognized as a formal company. Once incorporated, the business may receive a number of different benefits (mentioned below) via its status as a corporation.
What Are the Benefits of Filing Articles of Incorporation?
By filing articles of incorporation, a company can officially become incorporated. Once incorporated, the company may receive favorable tax benefits and have the ability to raise capital by issuing stock. In addition, the owners of the corporation have different liability over company debts once a corporation is formed.
How Do You Write Articles of Incorporation?
Articles of incorporation are filed with your state’s Secretary of State office. That department provides a form that requests a variety of information about your newly forming corporation. Upon completing the required fields, the form is submit back to the Secretary of State for review. The state agency that reviews the form will contact you should they have any clarifying questions regarding your information.
Can One Person Submit Articles of Incorporation?
Yes, it is possible to incorporate a business with just one employee. That single owner will be responsible for all aspects of the company. In addition, that sole individual will be the only shareholder. However, they may be listed as the only member on the articles of incorporation.
The Bottom Line
If a company wants to become a corporation, it must file articles of incorporation with its appropriate state agency. This formation document is required as part of the incorporation process, and the articles provide the state a variety of information about the company and its incorporators. Different from other legal documents that outline how a company will operate internally, the article of incorporation is intended to help external parties evaluate and form a corporation.
