If you get a business loan and the interest you are paying and/or receiving doesn't fall within the IRS's assessment of what the fair market rate is, you may owe taxes on this interest. Even if the loan has no more interest due (or any for that matter/), you may still have to pay taxes on what is known as the imputed interest rate.
So basically, the IRS assigns an interest rate to a loan that has a below market value. Even with no interest charges on a loan, the IRS will proceed to tax the amount as though it has a set interest rate; this is the imputed interest rate.
Why Imputed Interest?
Why does the IRS assign an imputed interest rate? There are a few scenarios in which this might come into play. For instance, if there is a no interest loan made from one family member to another.
Let's say, a parent loan a child 50k interest-free. The IRS would, in turn, use the federal interest rate as a benchmark here—this is the minimum rate a short term loan should carry. This rate is published every month by the IRS. Right now it is just above 2 percent annually. So in the parent loaning their child money situation, the 50k would carry with it a 2 percent annual rate—or 1000.00. Even though the parents are not charging the child this rate, they still need to declare it and thus pay taxes on the total amount which does include this imputed interest rate.
Beyond no interest loans, the imputed rate kicks in if you receive and/or make a loan that is below market value. Private companies sometimes may receive money from an owner. Especially early on in the company's lifespan, this is not an uncommon practice. The IRS needs to make sure that such transactions are actual loans.
When businesses start making money, they may be in a position to loan money to its shareholders—such loans are then listed as assets on the balance sheets. If they are below market value and are more than 10k, the IRS will require that the shareholder pays taxes on the imputed interest rate.
What is Imputed Interest for?
Imputed interest started when the government found that many companies were avoiding taxes by offering low or no interest loans. Also, some firms were avoiding taxes by showing dividends or compensation as loans and then claiming the payments on their tax returns in order to pay less than what was owed. The IRS thus determined that any loans needed to be accompanied by rates that are in line with minimum market standards. So essentially imputed interest came about to prevent organizations from funneling money through zero interest loans.
The Types of Loans Associated with Imputed Interest
Gift Loans are one such loan that is subject to imputed interest rates. Again, this is for loans made with zero interest or interest rates that fall below market value. Also, if a loan was made with the intent to reduce a person's tax liability then this is also subject to imputed interest rates. Additionally applicable: loans a company gives to shareholders, loans from an employer to an employee, or loans to continuing care facilities.
To better understand when the imputed interest rule kicks in, consider that any of the following may also have to abide by this rule:
- Gift Loan: A zero interest or below market value loan—the difference between the rate charged and the federal rate would be subject to imputed interest.
- Demand Loan: Such that the lender can demand to be paid in full at any time.
- Term loan: A loan payable at a future date with a predetermined length.
Are There Any Exceptions to the Imputed Interest Rule?
Yes, in some cases there may be exceptions to this rule. If a loan is less than 10k and is not used for income-producing assets, then it is exempt from the imputed interest rule. Also, if an employer or owner loans an employee or shareholder less than the stated 10k and with the consideration that the loan is in no way intended to evade any taxes then the imputed interest rate would not apply.
The IRS further explains:
- Loans made to the general public from a lender that is in line with normal business practices, such that include for example a no interest furniture loan or auto loan.
- Student loans and other such government-subsidized loans.
- Loans that come into play if/when an employee must relocate for a job.
Understanding How to Calculate Imputed Interest
Again, in the eyes of the IRS, a below market value loan is one that has an interest rate lower than what the current federal rate is. Monthly, the IRS will publish the imputed tax rate. The Applicable Federal Rates provide info on short, mid and long term loans. A short term loan has a duration of 36 months or less. A mid-term loan will fall between 3 and nine years, while a long term loan has a duration of greater than nine years.
So if your loan is a zero interest or below market value loan you will need to calculate the imputed interest rate. The best way to deal with this, especially come tax time when you need to report these numbers, is to enlist the aid of an accountant who understands such things. You do not want to make a mistake on your tax returns and thereby incur penalties and fees from the IRS.
At First Union, we offer many loan programs if you are in need of funding. Call today to speak to one of our agents!