Imputed interest expense
/What is Imputed Interest Expense?
The imputed interest rate is the interest rate that is assumed to have been paid for tax purposes, irrespective of the actual rate paid. This rate is used to maximize the taxable income reported to the Internal Revenue Service (IRS).
The IRS taxes interest income at the highest tax rate (which is classified as ordinary income). Because of the high rate, businesses may be inclined to under-report this type of income. To combat the problem, the IRS employs the imputed interest concept to ensure that the full amount of interest income is properly reported.
In essence, the concept states that interest income must be based on the current market rate of interest at the time when a loan is originated. If some other below-market rate is used, the IRS will assign a higher rate for tax purposes that is 110% of the interest rate paid on whichever Treasury debt has roughly the same amount of time to maturity as the loan in question. This imputed interest rate is known as the Applicable Federal Rate.
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Example of Imputed Interest Expense
As an example of the imputed interest expense concept, Mary lends $100,000 to her business, Mary's Boutique LLC. The loan is structured as an interest-free loan, with repayment due in 5 years. The IRS requires an interest rate to be applied to such loans to reflect the true economic cost of borrowing. Assume the IRS prescribes a minimum applicable federal rate of 4% for loans of this type and duration. The imputed annual interest expense = Loan Principal × Imputed Interest Rate, or:
$100,000 × 4% = $4,000
Mary’s Boutique must record an imputed interest expense of $4,000 annually, even though no interest is actually paid. Mary is considered to have received imputed interest income of $4,000, which must be reported on her tax return as taxable income.
Other Imputed Interest Issues
Several other issues related to the imputed interest concept are noted below.
Impact of Imputed Interest on Installment Sales
The imputed interest rate can be applied to installment sales arrangements, where there is an interest component to all payments made. The imputed rate only applies if:
The total amount of payments is greater than $3,000; and
The payment total due more than six months following the sale date is larger than the present value of the payments and the interest stated in the sale contract.
Impact of Imputed Interest on the Original Issue Discount
The original issue discount is the implicit interest rate that arises when an investor purchases a security at less than its face value (such as a zero-coupon bond). The difference between the face value and purchase price is to be recognized by the investor as taxable income as it accrues over time, irrespective of the stated interest rate on the security.