DBTC Law Firm

Charging Too Much Interest? Your Goose Is Cooked. Charging Too Little Interest? The Goose Cooks You.

Over the past ten years, the maximum constitutionally allowed rate of interest in Arkansas has been a moving target, leaving businesses and financial institutions with little sense of certainty in regard to how much interest they are legally allowed to charge. Failure to abide by the Arkansas Constitution’s usury requirements has resulted in debts being declared void and creditors being held liable to repay debtors twice as much interest as the debtors paid on the usurious loans. This issue has been further complicated by the Internal Revenue Service’s policies regarding taxing interest on no interest loans. While banks and sophisticated lenders are usually informed on these complex rules, privately negotiated loans involving individuals and small businesses regularly run afoul of the rules, leading to unexpected and unhappy results.

Prior to the 1980’s, an interest rate greater than 10% per annum was considered void in Arkansas as to both principal and interest. In the 1980’s, Arkansas voters approved Amendment 60 to the Arkansas Constitution (identified as Article 19, §13), which specified that the maximum legal rate of interest would be set at 5% per annum above the Federal Reserve Discount Rate at the time of the contract, with an additional cap for consumer loans and credit sales being set at 17% per annum. Under Article 19, §13, a usurious contract could result in interest, principal or both being declared void as well as entitling a debtor to damages of double the interest already paid.

The variable maximum lawful rate of interest, which was set forth in Article 19, §13 of the Arkansas Constitution, caused tremendous confusion for persons wishing to charge lawful interest rates. First, the Federal Reserve Discount Rate, which served as the starting point for determining the lawful rate of interest, was abolished by the Federal Reserve in January of 2003. See 12 CFR §201.4. This left Arkansas’s maximum lawful rate of interest in limbo until 2006, when the Arkansas Supreme Court clarified that the Primary Credit Rate was the natural successor to the Federal Reserve Discount Rate and, therefore, should replace the Federal Reserve Discount rate for purposes of calculating the maximum lawful rate of interest. See Pakay v. Davis, 367 Ark. 421, 241 S.W.3d 257 (2006).

Second, Arkansas Constitution Art. 19, §13(d)(i) provided for an assumed 6% interest rate in all contracts in which no interest rate was previously agreed to by the parties. Such a provision seemed viable, so long as the Federal Reserve Discount Rate/Primary Credit Rate was greater than 1%. However, once the Primary Credit Rate dropped below 1%, in 2008, the Arkansas Constitution appeared to be internally contradictory. The 6% assumed interest rate, which was required by Art. 19, §13(d)(i), was considered unlawful because it exceeded 5% per annum above the Primary Credit Rate. Perhaps no one conceived of the possibility of interest rates dropping as low as 0.75%.

In light of these shortcomings, in 2010, Arkansas voters approved Amendment 89, which repealed Arkansas Constitution Art. 19, §13 in its entirety. Amendment 89, which became effective on January 1, 2011, establishes that the maximum interest rate allowed in Arkansas is 17%. This is a departure from the fluctuating interest rates that were calculated as part of now repealed usury provisions of the Arkansas Constitution. Amendment 89’s streamlined approach establishes a general maximum lawful interest rate to apply to the vast majority of loans and contracts. Only government bond transactions (under Ark. Const. Amendment 89, §§2 and 4), national banking association loans (under 12 U.S.C., §85), and loans from federally insured depository institution banks with their primary office in Arkansas (under Ark. Const. Amendment 89, §2; 12 U.S.C., §1831u) fall outside the limits of the 17% maximum rate. The fixed 17% maximum interest rate affords lenders, businesses and individuals greater certainty in their efforts to avoid charging unlawful interest rates. This ease of compliance is particularly important due to the harsh penalty for failing to comply with the usury requirements of Amendment 89. Under Amendment 89, loans that exceed the maximum lawful rate of interest are void as to both principal and interest. In essence, the creditor loses the ability to collect from the debtor.

While Amendment 89 removed some of the more complicated aspects of the previous usury provisions of the Arkansas Constitution, it left a vacuum in relation to one key issue. Unlike the previous usury provision, Amendment 89 does not address the rate of interest a party can collect on a contract in which no rate of interest was agreed upon by the parties. The previous usury provisions of the Arkansas Constitution accounted for such a situation by allowing for an assumed rate of 6% interest, but those provisions have been repealed and there are currently no Arkansas statutes to fill the gap. With this omission, lenders, businesses and individuals who have relied upon the assumed 6% interest rate for decades may be left to the discretion of the courts with respect to the collection of interest on contracts that fail to include a specified rate of interest. It is thus exceedingly important for anyone who enters into a contract to ensure that the contract specifically states the exact interest rate to be charged and that the rate is not in excess of the maximum lawful interest rate allowed under Amendment 89.

Even though it is now much easier to make sure one steers clear of charging more than the lawful rate of interest, it is also important to note that not charging enough interest is also an issue. Generally a below market loan, especially those payable over a period greater than six months, are subject to re-characterization by the Internal Revenue Service to impute interest. That means that some number of past years’ tax returns have to be amended from both sides of the transaction – taking time, money and effort, and drawing additional IRS scrutiny. The IRS is aware that some individuals in an attempt to avoid paying ordinary income on interest earned will instead charge little or no interest but have a higher principal on the loan. This is often done in an attempt to convert ordinary interest income to capital gains which is often taxed at a preferential rate. In order to prevent this from happening, the IRS can re-characterize the loan to either include imputed interest or to require an original loan discount be taken on the principal amount. One needs to be especially careful in intra-family loans to make sure the appropriate interest rate is charged or there might be gift tax implications to such loan. Before entering into a below-market or interest free loan be sure to check with a tax adviser to review the possible implications of such loans or one could be very surprised by the changes the IRS makes to the loans and the corresponding tax returns, even if the taxpayer had no ill intentions when the loan was originally made.

 

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