What is Unstated Interest Paid
Unstated interest paid is the amount of money the Internal Revenue Service assumes has been paid to the seller of an item that has been sold on an installment basis. Unstated interest must be calculated in some cases when you have sold an item on installment basis, but have charged the customer little or no interest. Because interest income must sometimes be treated differently than other types of income, it may be necessary to estimate which portion of an installment payment is actually interest income.
BREAKING DOWN Unstated Interest Paid
Unstated interest paid is only calculated for contracts in which interest payments are not included, or when the interest charged falls below the test rate of interest. If a contract or invoice describes both an interest payment and a 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, which in most cases is the 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. The IRS publishes 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 that Ernie’s Tractor Supply company sells a tractor to a customer for $10,000, and allows the customer to pay for the tractor in installments: $5,000 in six months from now, and another $5,000 one year from now. On the customer contract for this installment plan, there is no amount that is stipulated 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 percent per year, then the interest you would pay on the two $5,000 loans would end up being roughly $150 dollars. The IRS would assume that you have sold the Tractor for $9,850 and issued two loans that paid interest income of $150.