Whether you’re a small business filing as a sole proprietor, an s-corporation or a partnership, you can write off business loan interest on your annual federal income tax return. You can use Form 8990 to determine how much interest can be deducted and how much you can carry over to another tax year.
Form 8890 requires a calculation of the interest expense, which provides you with the amount you can write off now and in the future. The calculation may include the interest you paid during the filing year and the portion of interest expense disallowed from a prior year that’s now eligible for a deduction. Although the IRS allows businesses to carry forward the excess interest paid to next year’s return, you’ll need to save your receipts to show how the loan’s proceeds were spent.
Maintain Detailed Loan Records
To claim a business loan interest deduction, you must show that the loan proceeds you obtained were actually used for your business. If, for example, the loan proceeds remained idle in a savings account or if they were used for investing in securities, the IRS won’t allow the deduction.
By keeping detailed records, you can prove that the funds were used for capital expenditures or operating costs. Loan proceeds used to purchase capital assets such as computers or other business equipment generally qualify for the interest deduction. If you used the funds as working capital to maintain operations, your interest payments can also be included as a write-off.
Distinguish Loan Principal From Interest Expense
You may only write off a business loan’s interest; the amount of the payment that goes to the principal is not deductible. Monthly statements typically include an amortization schedule that breaks down how much of your payment was applied toward the loan’s principal and how much went toward interest.
If you double up on payments, you may pay off the balance faster, but it could also reduce the amount of interest paid. This would lower the tax deduction you can use to offset your business income. As part of your records keeping, you may wish to record how much of each payment went toward repaying the principal and how much was applied to interest. Late fees and other penalties, however, are not tax-deductible.
Some Loan-Associated Fees Are Not Deductible
The origination or point fees that come with real estate loans are not eligible for a business loan interest deduction. Taking out a loan to fund a retirement plan or pay past-due taxes does not provide small businesses with the ability to write off the interest.
When you refinance an existing business loan, the interest paid on your new loan will not be deductible if you have already used the funds from your original loan. You may, however, deduct interest expenses after you begin paying your new lender for the second loan when the original loan is no longer active.
Plan Ahead for Interest Expense
Small business owners may face some challenges when seeking affordable loans to work their way through an unexpected liquidity crisis. Understanding how to write off the interest from a business loan could help offset the overall costs of borrowing. With careful planning, you could have more cash available to fund your enterprise’s growth or expansion.
The application process can also proceed more smoothly when you take the time to research your financing options and choose a loan that best fits your business purpose. Lenders may agree to provide a loan to a new or challenged business, but some may do so only when charging high interest rates. When you plan ahead on how you’ll use the loan’s proceeds and deduct the interest each year, you can increase your options for managing your business’s cash flow, growth and expansion.
The Incurred Debt Must Be From a Legal Contract
A loan is an enforceable contract made between a borrower and a lender; a signed document outlines the promises made by each party. It defines the duration of the loan, its principal and the interest rate. Both parties must agree on the terms for repayment and the consequences for nonpayment. A friend or relative generally cannot enter into a lending agreement unless there’s a signed promissory note that outlines the interest rate and a repayment plan.
The IRS requires entering into a loan agreement with a bona fide lender such as a bank, credit union or other loan provider. A loan made by a business partner or shareholder may not qualify for a business loan interest deduction except when there is an “arm’s length transaction,” which is conducted between two independent parties who can prove that a legally enforceable agreement was made.
Be Mindful of Different Loan Types and Circumstances
The interest associated with most forms of business financing is tax-deductible. This includes term loans, credit lines and merchant cash advances. As long as it can be shown that the proceeds were spent on business expenses — and not on any personal expenses — you may deduct the amount of interest paid.
Some business owners apply for personal loans in their own name and with their Social Security number so a lender can perform a credit check. While the proceeds may be used for working capital or purchasing business equipment, any interest payments that may be associated with personal expenses are not deductible on a business tax return.
A lender typically requires a business to apply for a loan using its taxpayer or employer identification number. An owner’s name may also be required to serve as a personal guarantor to cover the loan in case the business defaults on payments or ceases operation. Under some circumstances, a personal guarantor taking over a loan from a business may write it off as a loss on his or her personal income tax return. It will not be possible, however, to claim the loan’s interest as a business deduction.
Be Sure Your Taxes Are Filed Properly
It’s been reported that the IRS has hired additional agents to review small business returns in response to government loans issued under the CARES Act. Consider working with an experienced professional to help you prepare your business’s return and avoid triggering a possible examination. You could also discover that there are ways your interest payments can further reduce your tax liabilities.
Sources:
https://www.irs.gov/instructions/i8990
https://www.dallasfed.org/research/swe/2020/swe2002/swe2002b.aspx
https://www.irs.gov/publications/p535#en_US_2020_publink1000208623
