Imputed Interest

Imputed interest is interest that is assumed to exist on a loan, note or deferred payment arrangement even though the parties have stated no interest, or a rate well below the market. Accounting standards and tax law both "impute," or assign, a reasonable rate so that the financing element of the deal is separated from the price of the goods, services or gift involved. The idea rests on the time value of money: a promise to pay $100,000 in three years is worth less than $100,000 today, and the difference is economically interest.

Imputed interest arises in two main settings. In financial reporting, US GAAP (ASC 835-30) requires notes with no stated interest or an unreasonable rate to be recorded at their present value. In US tax law, several provisions of the Internal Revenue Code require interest to be imputed on below-market loans and on certain deferred payment sales, often using the applicable federal rates (AFRs) published monthly by the IRS.

Under ASC 835-30, when a note is exchanged for property, goods or services and either no interest is stated, the stated rate is unreasonable, or the face amount differs materially from the cash price, the note is recorded at the fair value of what was exchanged or at its present value using an imputed market rate. The imputed rate should approximate what an independent borrower of similar credit standing would pay on similar terms. The difference between the face value and the present value is recorded as a discount and recognized as interest over the life of the note using the effective interest method.

A company sells a piece of land, whose cash price is not readily known, in exchange for a $100,000 non-interest-bearing note due in three years. A reasonable market rate for the buyer is 6 percent. The present value of the note is $100,000 divided by 1.06 cubed, or about $83,962. The seller therefore records:

• A note receivable of $100,000 and a discount on notes receivable of about $16,038, giving a net carrying amount of $83,962.
• A sale of land for $83,962, with any gain measured against that figure rather than against the face value.
• Interest income in the first year of about $5,038, which is 6 percent of $83,962, added to the carrying amount.

In the second year interest income is about $5,340, and by maturity the carrying amount reaches $100,000. The buyer records the land at $83,962 and the note net of a discount on notes payable, recognizing interest expense over the same period. Without imputing interest, both parties would overstate the price of the land and ignore three years of financing cost.

The tax rules aim to stop taxpayers from shifting income or disguising gifts and compensation through interest-free loans. Key provisions include:

• Section 7872 covers below-market loans, such as interest-free loans between family members, from employers to employees, or from corporations to shareholders. The forgone interest, measured using the AFR, is treated as if paid by the borrower to the lender and then returned as a gift, compensation or dividend, depending on the relationship.
• There are exceptions for small loans, such as gift loans between individuals of $10,000 or less, and limits for gift loans of up to $100,000 based on the borrower's net investment income.
• Sections 483 and 1274 impute interest on deferred payment sales of property and on certain debt instruments, treating part of the stated price as interest income to the seller.
• Bonds issued at a deep discount, such as a zero-coupon bond, generate original issue discount that holders must generally include in taxable income each year even though no cash is paid.

Lenders in intra-family loans are taxed on the imputed amount as interest income, which can surprise people who think of the loan as a favor.

Imputing interest makes transactions comparable regardless of how they are packaged. Without it, a seller could inflate reported revenue by offering long, interest-free terms, and taxpayers could move income between family members or turn taxable salary into an untaxed loan benefit. The figures that result, however, depend on the rate chosen, so companies should document how the imputed rate was set, and comparisons with the contractual interest rate and current interest rates are a normal part of an audit.