What Is Unstated Interest Paid?
Unstated interest paid represents the amount of interest the Internal Revenue Service (IRS) presumes has been paid to the seller for items sold on an installment basis without specified interest. When selling an item on installments without charging adequate interest, an estimation becomes essential for determining interest income. This is crucial as interest income is treated differently for tax purposes compared to other types of income.
Gaining Clarity on Unstated Interest Paid
Unstated interest paid applies to contracts lacking explicit interest provisions or where the interest rate is below the prescribed test rate. When contracts clearly distinguish interest and principal payments, the interest included is known as stated interest. For these contracts, the stated interest must exceed the determined test rate, which typically references the applicable federal rates (AFRs) set by the IRS.
The IRS publishes three distinct applicable rates monthly: short-term, mid-term, and long-term rates. Each rate is determined based on the average interest the government pays on Treasury bond issues of corresponding maturities:
- Short-term rate: Average rates for bonds maturing within three years.
- Mid-term rate: Average rates for bonds maturing between three to nine years.
- Long-term rate: Average rates for bonds maturing over ten years.
Sellers calculating unstated interest paid for installment sales must select the appropriate rate relating to their contract length.
Inspiring Example of Unstated Interest Paid
Imagine Ernie’s Tractor Supply sells a tractor worth $10,000 via an installment plan. The buyer agrees to pay $5,000 after six months and another $5,000 at the end of a year. The contract mentions no interest charges.
For tax purposes, this scenario involves two implicit loans of $5,000 each, with maturities of six months and one year respectively. Assuming the annual applicable federal rate for the loan is 2%, the total interest earned on these loans would be approximately $150. The IRS would, therefore, consider the transaction as a tractor sale for $9,850 and two interest-earning loans amounting to $150.
Related Terms: installment sales, stated interest, applicable federal rates, interest income.
References
- Internal Revenue Service. “Topic No. 705 Installment Sales”.
- Internal Revenue Service. “Publication 537 (2018), Installment Sales”.
- Internal Revenue Service. “Section 1274.–Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property - December 2020”, Page 2.
- Internal Revenue Service. “Index of Applicable Federal Rates (AFR) Rulings”.
- Federal Register. “Determination of Adjusted Applicable Federal Rates Under Section 1288 and the Adjusted Federal Long-Term Rate Under Section 382”.
