Taking out a business loan may be an ideal solution to support your business’s financial needs. That being said, it may also raise questions regarding how the loan will be repaid and how it will affect your taxes in the coming year.
The recent increase in business borrowing needs, due to the ongoing global pandemic, has raised these questions to an even more significant degree over the past year. Many businesses were, and continue to be, desperate for financial support to keep themselves afloat. With tax season upon us, they’re facing the challenges of not understanding how their loans play into their tax returns.
The good news: most loans won’t directly impact what you owe in taxes. Receiving a loan from a bank or lending institution doesn’t register as typical income the way your monthly business income does.
The main reason a business loan may affect your tax payments is based on the interest you owe. Depending on the type of loan and your business’s legal structure, you may be able to deduct your interest payments.
Is my business loan interest tax deductible?
In short, yes. The interest accumulated on a business loan can be written off as a business expense when filing your taxes. The IRS has specific loan requirements for qualification. They include the following:
- You are legally liable for that debt.
- Both you and the lender intend that the debt be repaid.
- You and the lender have a true debtor-creditor relationship.
In simpler terms, the IRS qualifications simply require a legitimate loan to be eligible for the write-off of your interest payments. For example, suppose you borrowed a sum of money from a family member or friend without official documentation of the loan terms. In that case, you are likely unable to declare the business loan’s legitimacy and therefore are probably unable to write off the interest payments as business expenses.
Interest You Cannot Deduct
While some interest types are eligible to be deducted, not all are. The following are interest types that are not eligible to be deducted.
- Interest paid with funds borrowed from the original lender: You cannot deduct interest paid with funds borrowed from the original lender through a second loan, an advance, or any other arrangement similar to a loan.
- Capitalized interest: You cannot currently deduct the interest you are required to capitalize under the uniform capitalization rules.
- Commitment fees or standby charges: Fees you incur to have business funds available on a standby basis, but not for the actual use of the funds, are not deductible as interest payments.
- Interest on income tax: Interest charged on income tax assessed on your individual income tax return is not a business deduction even though the tax due is related to income from your trade or business.
- Interest on loans with respect to life insurance policies: You generally cannot deduct interest on a debt incurred with respect to any life insurance, annuity, or endowment contract that covers any individual unless that individual is a key person.
Tax deductions for various loan types
While there are exceptions given certain circumstances, many loan types offer borrowers the ability to deduct interest payments. Claiming tax deductions for various loan types may require slight differences.
A term loan is a lump sum granted to borrowers that are paid back on a set schedule based on a pre-set interest rate.
When a borrower agrees to a term loan, they are given an initial amortization schedule. This schedule identifies how much principal is owed in addition to the interest owed at each given time period.
Since you will pay interest each year until the loan is paid off, you can expect to have multiple years of interest deductions until the loan is paid off.
SBA loans are term loans that function in this way.
Line of Credit
Business lines of credit are similar to typical credit cards but often with higher funding limits. This loan type enables borrowers to make withdrawals, repay the balance, and make withdrawals again as needed.
Since interest is only accrued on the amount withdrawn, deductions will depend on how the line of credit is utilized. This should be confirmed with your lender before the agreement is made official.
Short Term Loan
Short-term loans are often very similar to traditional term loans, as discussed above. The one significant difference is that they are typically repaid over a shorter time period, usually under one year. As such, all interest payments can typically be deducted within the same tax filing year.
Private Money Loan
Some borrowers opt to use personal loans to avoid their business’s credit history being reviewed and scrutinized by lenders.
If your personal loan is used 100% for business purposes, the entirety of your interest payments is eligible to be deducted. However, if the loan is utilized for mixed purposes, you may only be able to partially deduct interest expenses.
If your goal is to purchase an existing business to take over operations and continue using it for business purposes, borrowing capital may support your efforts to do so. If this is the case, interest payments on this loan are tax-deductible.
On the other hand, if you intend to purchase a business without running it, it’s considered an investment rather than a business purchase. In this situation, interest payments may or may not be eligible for a tax deduction. In this case, speaking to your lending partner about details of deductibility is recommended.
Cash advances consist of a lender advancing business capital in exchange for a portion of each day’s credit sales until your debt is repaid. This lending type typically includes extremely high APRs and typically includes the payment of “fees” rather than traditional interest payments. As such, they do not offer borrowers the opportunity for additional tax write-offs.
Certain types of loan options offer borrowers the opportunity to deduct interest payments from the business tax returns. The specifics of your business loan and deductibility should be discussed in the initial agreements of your loan.
Our team at Innovative Capital Corporation works with a variety of lending partners to ensure that you receive the best deal to meet your individual needs. For more information or to get started, contact our team of loan officers today.