Imputed Interest
Interest income that the IRS requires to be recognized on below-market or interest-free loans, even if no actual interest was paid.
What is Imputed Interest?
Imputed interest is a notional interest amount that tax authorities require to be recognized on loans made at below-market rates, typically in transactions between related parties such as family members, a corporation and its shareholders, or affiliated companies. Under IRS rules (IRC Section 7872), if a loan carries a rate below the applicable federal rate (AFR), the difference between the AFR-based interest and the actual interest charged is treated as imputed interest—which may be classified as a gift, dividend, or compensation depending on the relationship. For accounting purposes under GAAP, long-term non-interest-bearing notes payable must also be discounted to present value, with the discount amortized as interest expense over the note's life. Imputed interest ensures that economic reality—the time value of money—is reflected in financial statements and tax returns even when formal interest payments are absent.
Example
A parent company lends $1 million to a subsidiary at 0% interest for three years. The IRS Applicable Federal Rate (AFR) for mid-term loans is 4.5%. The IRS imputes $45,000 in annual interest income to the parent and an equivalent interest deduction to the subsidiary, as if market-rate interest were being paid.
Source: IRS — IRC Section 7872: Treatment of Loans with Below-Market Interest Rates