Accounting for a Non-Interest Bearing Note and Tax Rules

A non-interest bearing note is a formal agreement to pay a specific amount of money on a future date, but it does not include a stated interest rate. These financial instruments are often used in transactions like the sale of property or equipment, or in lending arrangements between related companies or individuals. The note is typically issued for an amount less than its face value, which is the full amount to be repaid at maturity. This difference between the initial cash received and the total repayment amount represents the implied interest over the life of the note. For accounting and tax purposes, this unstated interest must be recognized to accurately reflect the transaction’s economic reality.

The Principle of Imputed Interest

The reason for recognizing interest on a non-interest bearing note is the time value of money. This financial principle states that money available today is more valuable than the same amount in the future because it can be invested to earn a return. A promise to receive $1,000 in three years is inherently less valuable than having that $1,000 today.

Because of this principle, accounting standards and tax authorities mandate the “imputation” of interest. Imputing interest means assigning a reasonable interest rate to the transaction, even though one isn’t explicitly stated. This imputed interest is treated as income for the lender and an expense for the borrower over the term of the note, ensuring that income and expenses are recognized in the periods they are economically earned or incurred.

Valuation and Initial Recording

The accounting treatment for a non-interest bearing note depends on its term. For short-term notes, those due within one year, the interest component is often considered immaterial and they are recorded at their face value without calculating imputed interest.

Long-term notes require a more detailed approach. The initial recording is based on the note’s present value, which is the current worth of the future payment. To calculate this, you must discount the note’s face value using a market interest rate—the rate that would be applied to a similar instrument with a similar risk profile.

Consider a company that receives a three-year, $20,000 non-interest bearing note when the market interest rate for similar notes is 6%. The present value is calculated by discounting the $20,000 face value back three years at this 6% rate. Using a present value formula, the calculation would be $20,000 / (1 + 0.06)^3, which equals approximately $16,792. This amount is the cash or fair value of the asset received.

The difference between the face value ($20,000) and the present value ($16,792) is $3,208. This amount is recorded in a contra-account called “Discount on Notes Payable” for the borrower or “Discount on Notes Receivable” for the lender. This structure ensures the note’s initial carrying value on the balance sheet is its present value, not the full face value.

Amortization of the Discount

After the initial recording, the discount on the note must be systematically reduced over its life through a process called amortization. Amortizing the discount gradually increases the carrying value of the note on the balance sheet, so that by the maturity date, its value equals the face amount to be paid. This process also ensures that interest expense for the borrower, or interest income for the lender, is recognized each accounting period.

Continuing with the $20,000, three-year note with a 6% market rate, an amortization schedule would be created. At the end of the first year, interest is calculated by multiplying the carrying value of the note ($16,792) by the market interest rate (6%), resulting in $1,007.52 of interest. The borrower records this as interest expense, which reduces the discount balance and increases the note’s carrying value to $17,799.52.

This process repeats for the remaining years. In the second year, the interest is calculated on the new, higher carrying value ($17,799.52 6% = $1,067.97). By the end of the third year, the entire discount of $3,208 will have been amortized to interest, and the carrying value of the note will be $20,000. The lender follows a parallel process, recognizing interest income each period.

Tax Implications and Compliance

The Internal Revenue Service (IRS) has specific rules regarding loans that do not carry an adequate stated interest rate. To prevent tax avoidance, the IRS publishes minimum interest rates known as the Applicable Federal Rates (AFRs). These rates are updated monthly and are categorized into short-term (up to three years), mid-term (over three to nine years), and long-term (over nine years) to align with the duration of the loan.

If a loan is made at a zero or below-market interest rate that is less than the relevant AFR, the IRS will impute interest for tax purposes. This means the transaction is re-characterized as if the lender charged the AFR. The lender must report this imputed interest as taxable income, even though they never actually received the cash. For the borrower, this imputed interest may be deductible as an interest expense, subject to standard deduction limitations.

The lender also has a compliance obligation to report this imputed interest. For tax purposes, the imputed interest on a non-interest-bearing note is treated as Original Issue Discount (OID). Lenders must report this OID to the recipient and the IRS, usually on Form 1099-OID, “Original Issue Discount.”