What Are the IRS Imputed Interest Rules?

Imputed interest is a concept the Internal Revenue Service (IRS) uses for loans made with a below-market interest rate or no interest at all. The IRS assumes that interest was paid, even if it was not, to prevent individuals and entities from using these loans to avoid taxes. The purpose of these rules, found in Section 7872 of the Internal Revenue Code, is to recharacterize the transaction as if a market-rate interest was charged and paid.

The rules prevent disguised transfers of value, such as a corporation giving a tax-free dividend as an interest-free loan or an employer providing tax-free compensation. By imputing interest, the IRS treats the foregone interest as a transfer from the lender to the borrower and a subsequent re-transfer of that interest payment back to the lender.

Transactions Subject to Imputed Interest Rules

The imputed interest rules target specific arrangements where the relationship between the lender and borrower creates potential for tax avoidance. Transactions are categorized by the nature of the relationship to ensure loans that might shift income or provide disguised payments are scrutinized.

Gift Loans

Gift loans occur between family members or friends where the lender’s decision to forgo interest is based on a personal relationship. A common example is a parent lending their child $75,000 for a down payment on a house with no interest charged. In this situation, the IRS views the foregone interest as a taxable gift from the parent to the child each year the loan is outstanding.

The foregone interest is treated as if it were transferred from the lender to the borrower as a gift and then immediately paid back to the lender as interest income. This ensures that both gift tax and income tax implications are considered.

Compensation-Related Loans

This category covers below-market loans between an employer and an employee or between a company and an independent contractor. These loans are viewed as a potential method for providing compensation without subjecting it to payroll and income taxes. For instance, a company might offer an executive a $200,000 interest-free loan.

The imputed interest on such a loan is treated as additional compensation paid by the employer to the employee. The employer reports this imputed amount as wage income and also recognizes the same amount as interest income, preventing companies from offering tax-free perks equivalent to a salary increase.

Corporation-Shareholder Loans

Loans between a corporation and its shareholders can be used to distribute corporate profits without classifying the payment as a taxable dividend. For example, a corporation could lend $150,000 at 0% interest to its majority shareholder.

The IRS recharacterizes this by imputing interest, which is treated as a dividend distribution to the shareholder. The shareholder must report this as dividend income, and the corporation reports the same amount as interest income.

Tax-Avoidance Loans

A final, broad category includes any other below-market loan where a principal purpose of the arrangement is the avoidance of federal tax. This serves as a catch-all provision for creative loan structures that do not fall into the other categories. The determination of a tax-avoidance purpose is based on all the facts and circumstances surrounding the loan.

Key Exceptions to the Rules

The imputed interest rules include specific exceptions that exempt certain below-market loans from these requirements. These exceptions are based on the loan amount and, in some cases, the borrower’s financial situation.

One of the most widely used exceptions is the $10,000 de minimis rule. This rule exempts any below-market loan from the imputed interest regulations as long as the total outstanding loan balance between the lender and borrower does not exceed $10,000. This exception applies to gift loans between individuals as well as to compensation-related and corporation-shareholder loans.

This $10,000 exception has a limitation. It does not apply if the loan is for the purpose of purchasing or carrying income-producing assets. For example, if a parent lends their child $9,000 interest-free to buy stocks, the imputed interest rules would still apply. This is to prevent the shifting of investment income to a lower-tax-bracket borrower.

For gift loans between individuals, a second exception exists for loans up to $100,000. Under this rule, if the total outstanding loans between the parties do not exceed $100,000, the amount of imputed interest cannot exceed the borrower’s net investment income for the year. For instance, if a parent lends a child $80,000 interest-free and the child’s net investment income is $500, the imputed interest is limited to $500.

Furthermore, this $100,000 exception has its own provision related to the borrower’s income. If the borrower’s net investment income for the tax year is $1,000 or less, the imputed interest for that year is considered to be zero. Following the previous example, if the child with the $80,000 loan had only $950 of net investment income, no interest would be imputed for that year.

Calculating Imputed Interest

The calculation of imputed interest uses benchmark rates published by the IRS known as the Applicable Federal Rates (AFRs). The AFR is the minimum interest rate the IRS considers a market rate for private loans. If a loan’s stated rate is lower than the relevant AFR, the difference between the interest that would have been charged using the AFR and the interest actually charged is the “foregone interest,” which must be reported.

The IRS publishes these rates monthly, and they are categorized based on the loan’s duration. The short-term rate applies to loans with a term of three years or less. The mid-term rate is for loans with a term of more than three years but not more than nine years. The long-term rate applies to any loan with a term exceeding nine years.

For demand loans, which are payable upon the lender’s demand, the calculation is slightly different. The short-term AFR is used, but because the rate can change, the IRS provides a “blended annual rate” each year. This rate simplifies the calculation for demand loans outstanding for the entire calendar year.

For example, a father lends his son $50,000 on January 1st to start a business, with no interest charged and a five-year repayment term. This is a mid-term loan. If the mid-term AFR for that month was 3.0%, the father must calculate the imputed interest. The foregone interest for the year is $1,500 ($50,000 x 3.0%). This $1,500 is the imputed interest, which the father is treated as gifting to his son, and the son is treated as paying back to his father as interest.

Tax Reporting Requirements

Once imputed interest is calculated, both the lender and the borrower have specific tax reporting obligations. These requirements ensure the transaction is properly reflected on their tax returns, including both the imputed interest and the underlying transfer.

The lender must report the imputed interest amount as interest income on Schedule B (Form 1040), Interest and Ordinary Dividends. The lender is taxed on this income as if it were actually received. Depending on the loan, the lender may also be required to issue a Form 1099-INT to the borrower.

The borrower’s tax treatment mirrors the lender’s, treating the imputed interest as an actual interest payment. Depending on how the loan proceeds were used, this payment may be deductible. For instance, if the loan was for investment purposes, the borrower may deduct the imputed interest on Schedule A (Form 1040), subject to limitations.

Beyond the interest, the character of the initial transfer must be reported. The lender is treated as having transferred the foregone interest amount to the borrower, and the tax nature of this transfer depends on the loan’s context. For a gift loan, the lender has made a taxable gift; for a compensation loan, the employer has paid wages; and for a corporation-shareholder loan, the corporation has paid a dividend.