Imputed Interest

Imputed interest is an interest inferred by the government for a particular set of transactions that involve payment made to someone by someone which essentially bears the nature of a loan without charging interest or charging at a much lower rate than imputed interest where such interest is used to calculate the tax to be set on such transaction.

• Imputed interest is the interest implied or considered by the government for certain transactions where interest is not explicitly charged or is charged at a lower rate. 
• Imputed interest applies in scenarios such as zero-coupon bonds, intra-family loans, gift loans, demand loans, and compensation-related loans. 
• Imputed interest is imposed if a loan is provided interest-free or at a very low rate. The IRS publishes monthly imputed tax rates to prevent tax evasion by high-bracket taxpayers. 
• Understanding imputed interest rates can help with better investment planning and avoid unpleasant surprises during tax filing.

What happens when you lend money to your family/friend/colleague? Mind you, we are not talking about 1,000 bucks for a weekend but a sizable amount that might be used by the borrower to infuse money into the business, educational loan, to buy a car, or as simple as a personal loan.

Say you lent and did not charge any interest as you lent the money in good faith. Being a perfect friend, you are only concerned about the principal, which you did get after some time as promised by your friend. Although it looks like an in-house transaction between you and your friend, there is more to the story as far as tax authorities are concerned. Even if we ignore the credit risk involved, there can be huge tax penalties that might come as a shock in your tax calculation sheets. Sounds confusing?

The concept of imputed interest refers to the calculation of interest that should have been paid for tax calculations even if there were no actual interest payments between the lender and the borrower. Hence, the name is imputed or implicit. This imputed interest serves as an instrument for tax authorities to collect tax revenues on loans and securities that pay no interest or very little interest.

Coming back to your example where you lend money to your friend. You might not have charged any interest, but the IT department assumes the interest accrued on the principal as your income. Hence, it calculates tax, eventually adding to your final tax statement.

It came to the notice of tax authorities that many high-bracket taxpayers were shifting their income to low-bracket relatives or friends. The authorities believe that these high-bracket taxpayers were evading tax. That is because there would have been taxes on this interest in an ideal scenario, in which the income tax department is losing out to the absence of a structured loan mechanism. A considerable increase in such instances led Congress to enforce new laws recognizing imputed interest as income. The first such law came through the tax act of 1984.

For example, let us say a couple provides a principal amount of $1 million to their child as a loan to buy a new house without charging any interest. Also, it has been decided that the child can pay back the amount within eight years to avoid burdening his current financial state. However, this generous situation might not be sensible for the couple as it might not bring any interest payment because they could have earned an interest income if they had lent this money to some third party.

In this scenario, the IRS would assume that the parents would have collected an annual interest payment (say 5%) added to their interest income in the tax return calculations. Hence, in this scenario, 50,000 dollars will be counted as interest income in the IT return sheet even though the child explicitly paid not a single penny.

The concept of imputed interest also applies in the following scenarios: -

• Zero-coupon bonds where the investor does not receive any fixed annual interest payments but the bond itself has been purchased at a discount to the face value. The difference between the discounted price and the maturity value represents the investor's interest during the bond's tenure. In simple terms, the tax on the imputed interest will be calculated even if the investor has not received any yearly payments.
• Corporates lend money to shareholders. So, it will be an interest income for corporates. It will be a dividend income for shareholders.
• All financial instruments such as loans may have favorable interest terms and significantly reduce the tax liability of the borrower or lender.
• Intra Family loans that generate unrealistic tax implications.
• Gift loans
• Demand loans
• The compensation-related loans from employer to employee. That shall be realized as compensation income in the employee tax returns.

When a loan has been given interest-free or very low-interest rates, the imputed interest comes into the picture. The IRS publishes these imputed tax rates monthly. Imputed interest rates remove any incentives to exploit the in-house loan transfers and evade tax exploitation by high bracket taxpayers. Therefore, knowing imputed interest rates would help you plan your investments better and avoid unpleasant surprises in your annual tax filing.

The best way to avoid any tax implications would be:

• First, we should understand that no financial loan is interest-free. There is always an imputed interest, however small it may be. A loan of $10,000 should not pose any problem for either party.

But make sure that this limit applies too when you have multiple such loans, and $10,000 is not a threshold for one such individual transaction.

• Before indulging in any such transaction, have an official contract properly documented where you and the other party agree on a loan tenure fix imputed interest rates and mode of payment. That will ensure that both the lender and the borrower know the tax implications, repayment terms, and legal proof if any issue arises with the tax authorities. In addition, that shall avoid any last-minute adverse tax consequences.

Other important factors to be considered:

• The loan principal should be reasonable considering the borrower's financial situation and not raise suspicion.
• The legal contract's intent to pay and the repayment schedule should be evident.

Borrowing from someone you know might be a better way of financing as the federal government sets the imputed interest rates at rates far below the market lending rates. However, remember that there is no free lunch, and a misunderstanding or overlooking can result in hidden tax penalties for your generous lenders.

This article is a guide to Imputed Interest. Here, we discuss imputed interest rates, work, and the reasons why imputed interest is helpful. You may learn more about corporate finance from the following articles: -

• Double Taxation
• Interest Expense Meaning
• Capital Gains vs Dividends
• Net Operating Loss