Unstated Interest Paid
Unstated Interest Paid
Lea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.
What Is Unstated Interest Paid?
Unstated interest paid is the money the IRS assumes has been paid to the seller of an item sold on an installment basis. Unstated interest must be calculated when you have sold an item on installment but have charged the customer little or no interest. Sometimes interest income needs to be treated differently than other types of income, so estimating the portion of an installment payment that is actually interest income may be necessary.
Understanding Unstated Interest Paid
Unstated interest paid is only calculated for contracts where interest payments are not included or when the interest charged falls below the test rate of interest. If a contract or invoice mentions both interest payment and principal payment, the interest payment is referred to as stated interest. Stated interest in an installment contract must be greater than the test rate of interest, usually based on the applicable federal rates (AFRs).
The applicable federal rate is calculated by the IRS and published monthly online and by various financial news sources. There are three different applicable rates: short-term, mid-term, and long-term rates. The short-term rate is calculated by averaging the rates the government pays on bond issues with maturities of three years or less. The mid-term rate is derived from averaging the rate paid on Treasury securities between three and nine years in maturity, while the long-term rate is based on issues of ten years or longer in maturity. To calculate unstated interest paid, sellers of goods paid for on installment should choose the applicable federal rate based on the length of the installment contract.
Example of Unstated Interest Paid
Let’s say Ernie’s Tractor Supply company sells a tractor to a customer for $10,000 and allows the customer to pay in installments: $5,000 in six months and another $5,000 one year from now. On the customer contract, there is no stipulated amount for interest paid. For tax purposes, you may need to recognize that this arrangement involves the implicit lending of the customer two $5,000 loans: one with a maturity of six months and the other for one year.
If the applicable federal rate for this loan is 2% per year, then the interest you would pay on the two $5,000 loans would be roughly $150. The IRS would assume that you have sold the tractor for $9,850 and issued two loans that paid interest income of $150.
