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.
Several other issues related to the imputed interest concept are:
- Installment sales. The 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.
- Original issue discount (OID). The OID 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.