It’s common for businesses to borrow money for various reasons … to start up, expand to new locations, buy equipment, launch a marketing campaign. But borrowing usually isn’t without cost: interest payments. To the extent interest payments are tax deductible, they reduce the cost of borrowing. But tax rules on deductibility can be confusing.
Business interest is broadly interpreted
Business interest is treated differently than other types of interest. For example, personal interest (other than home mortgage interest and some interest on student loan debt) is not deductible. Investment interest is only deductible to the extent of net investment income each year. But business interest may be fully deductible (exceptions follow).
The good news is that business interest encompasses interest on a variety of borrowing. Examples:
- Bank and credit union loans by the business
- Vehicles loans
- Credit card debt
- Lines of credit
The deduction for interest payments may be limited
Small businesses are exempt from a new limitation on deducting business interest, which means such interest is fully deductible. Small business for this purpose means those with those with average annual gross receipts in the three previous years less than a set amount. For 2018, it was $25 million. For 2019, it is $26 million.
More information about the interest deduction limitation may be found in the instructions to IRS Form 8990.
Guarantees aren’t deductible
As a small business owner, you may be required to give your personal guarantee on any loans made to your business. As an owner, you cannot deduct interest payments as a guarantor unless the business defaults and you are called upon to make payments.
Interest-free loans may trigger deductible interest
Generally, loans must bear a reasonable rate of interest and this makes commercial sense. But in closely held businesses, loans to or from the business to owners, employees, or other associates may be made with little or no interest. If the loan is a below-market loan — one bearing an interest rate below the IRS-set applicable federal rate — then imputed interest results. This means the lender must report this imputed interest as interest income, and the borrower may be able to deduct the imputed interest.
For example, a business owner’s parent wants to help out and lends the business $25,000 for a term of 10 years with no interest. The current AFR for this type of loan is 2.74 percent, so the imputed interest would be $685. The business would be able to deduct this amount; the parent-lender should report it as interest income.
Prepaid interest isn’t deductible upfront
When the business borrows money, it may have to pay points or other upfront fees to obtain the loan. The points or fees are a type of prepaid interest. However, on business loans, the prepaid interest cannot be deducted in the year of payment. This is so even though the business reports its income and expenses on the cash method of accounting. Instead, prepaid interest is deducted ratably over the life of the loan.
When financing your business needs, be sure to consider the cost of business borrowing and its drain on your cash flow. Also factor in the tax rules on how to treat the interest.