Legal Definitions - imputed interest

Imputed interest refers to interest that a legal authority, typically the tax agency, presumes to exist in a transaction, even if the parties involved did not explicitly state, charge, or pay it. This concept is often applied when a loan or sale is made at no interest, or at an interest rate significantly below the prevailing market rate, especially between related parties. The purpose is usually to prevent individuals or entities from avoiding taxes by structuring transactions in a way that disguises what would otherwise be taxable interest income.

• Example 1: Family Loan

  Imagine a parent lends their adult child $100,000 to help them purchase a home, with an agreement that the child will repay the principal over five years, but without any interest charged. From a legal and tax perspective, the Internal Revenue Service (IRS) might "impute" interest on this loan. This means that even though no interest was explicitly agreed upon or paid, the IRS could treat a portion of the loan as if interest *had* been paid at a reasonable market rate. The parent might then be required to report this imputed interest as taxable income, and the child might be treated as having received a taxable gift of the interest amount, depending on the specific rules and amounts involved.

• Example 2: Below-Market Installment Sale

  Consider a small business owner who sells a piece of valuable machinery to a friend for $50,000, allowing the friend to pay in monthly installments over three years with no stated interest rate. While the contract explicitly says "no interest," the law might impute interest on this transaction. A portion of each monthly payment would be reclassified as interest income for the seller, and the remaining portion as principal repayment. This ensures that the seller pays taxes on the economic benefit of providing financing, even if it wasn't explicitly labeled as interest in the sales agreement.

• Example 3: Employer-Employee Loan

  A company provides a low-interest loan to one of its executives, allowing them to borrow $200,000 at a 1% annual interest rate, while the prevailing market rate for a similar loan is 5%. The difference between the market rate (5%) and the actual rate charged (1%) would be considered imputed interest. The IRS would treat the 4% difference as additional taxable compensation for the executive. This ensures that the executive is taxed on the full economic benefit received from the employer, which includes not just the principal but also the savings from the below-market interest rate.