Imputed interest is an estimated interest rate used by the Internal Revenue Service (IRS) or tax authorities when a loan does not have a rate that meets the minimum interest rules set by the IRS.
The IRS requires that a certain rate of interest, known as the applicable federal rate (AFR), be charged on loans, especially those between related parties (like family members or corporations and their shareholders). If the interest charged in the loan is less than the AFR, the IRS will deem that there is imputed interest. This means that the lender must report and pay taxes on the amount of interest that should have been charged according to the AFR, even though they did not actually receive that interest.
Imputed interest can apply to various loans including:
- Below-market loans: These are loans where no interest or interest below the AFR is charged.
- Gift loans: These are loans made between family members or other individuals that are interest-free or have a below-market interest rate.
- Corporation-shareholder loans: These are loans made from a corporation to a shareholder without a proper interest rate.
Imputed interest ensures that the IRS can collect tax revenue from loans that are made below the standard interest rate. It’s important for those entering into a loan agreement with a related party to understand the rules around imputed interest to avoid unexpected tax liabilities.
Example of Imputed Interest
Suppose a father lends his daughter $100,000 interest-free to help her start a business. The daughter plans to pay back the loan in 5 years.
Let’s say the applicable federal rate (AFR) set by the IRS for long-term loans like this one is 2% per year. According to the IRS rules, the father should charge his daughter at least this rate of interest, so the interest income for the father over the 5-year period should be $10,000 ($100,000 x 2% x 5 years).
However, since the father charged no interest, the IRS will impute interest on this loan. Even though the father did not actually receive $10,000 in interest, he would be required to report this $10,000 as interest income on his tax return over the 5-year period, and pay tax on it.
The IRS would also consider this $10,000 as a gift from the father to his daughter. If this amount, combined with any other gifts from the father to his daughter in a year, exceeds the annual gift tax exclusion ($15,000), the father may also have to pay gift tax on the excess.
This example illustrates how imputed interest works and why it’s important to consider the tax implications when making a loan that doesn’t charge interest or charges interest below the AFR.