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Do you need some money to launch your small business, tackle an existing business project or expand your marketing efforts? The Internet has no shortage of lenders offering loans to businesses. If you decide to take out a loan, confirm it is from a reputable source.
To legally write off the loan interest, the use of the money must meet the IRS requirements. Namely, a business loan must be intended only for business purposes. An executed loan agreement must define the debt, principal amount, interest rate, length of repayment, etc.
Your lender will provide a monthly statement detailing your payment amount applied to the principal and towards the interest. This statement is proof of the total amount of interest paid.
You are responsible for documenting how the loan proceeds were used for your business. Your loan statements and supporting records will then meet the requirements for the interest to be tax-deductible.
In this article, we will provide you with some examples that you may find helpful.
Are business loan payments tax deductible?
As you would expect, there are IRS requirements to qualify to claim the interest deduction. As per the IRS website: You can deduct interest on a debt only if you meet all the following criteria.
- You are legally liable for that debt.
- Both you and the lender intend that the debt be paid in full.
- You and the lender have a genuine debtor-creditor relationship.
Publication 535 (2021), Business Expenses | Internal Revenue Service (irs.gov)
You can only deduct interest payments for loans where you are legally liable. So, as an example, if you help your Son or Daughter through a tight spot by making his/her business loan payments for a few months, you cannot claim an interest deduction from his/her loan.
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How much of my business loan payment is deductible?
Each payment consists of two parts. The loan principal, in other words, the amount of money lent to you. And second, a stipulated interest rate. Some loans are fully amortized, meaning that if you choose to make each defined monthly payment, the loan account will reach zero at the end of the term.
If 100% of the loan proceeds are used for business purposes, 100% of the interest paid would be a deductible business expense. Be sure to work with your tax advisor to properly document how you used the loan proceeds to support taking the interest deduction fully.
For Illustration:
- George borrows $400.00
- 4-year term at 10% interest.
- One annual payment is required.
- The annual payment is fixed at $126.19
Since the $400 benefited the business, George would deduct each year's cumulative interest amount. You will notice that the amount paid on the principal increases each year while the interest decreases.
Read also: What Is a Business Plan?
Qualifying for a Business Loan Interest Deduction
As a taxpayer, you can take any deduction you wish. On the other hand, your responsibility as a taxpayer is to retain the documentation to support the deduction. If the IRS questions a particular deduction, you can provide the supporting documentation. IMPORTANT: When dealing with the IRS, many people find it beneficial to be represented by an authorized agent. A professional tax expert understands the law and how to respond appropriately.
Borrowing from a Verifiable Lender
A business loan that qualifies for the interest to be deductible in most cases must be originated from a bank, credit union, or other approved financial institution. These lending source loan agreements define the debtor relationship between the lender and the borrower. For that reason, the loan statements are considered an adequate authority by the IRS for claiming the interest deduction.
If a loan is acquired from your parent(s) or a friend, even though it's used entirely for business purposes, it most likely, will not qualify for the interest deduction. The IRS would consider this a biased transaction based on the personal relationship of the parties involved.
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The Money Must be Spent
The most common mistake made by small business owners is commingling personal and business funds and expenses. Earlier, we mentioned the importance of keeping good records detailing how you used the loan proceeds.
Commingling of personal and business funds may raise questions about the validity of your business and bring all deductions, including loan interest deductions, into question.
Here is a situation where a business loan interest would not be deductible. Tom has excellent credit, so he obtains a low-interest business loan. When Tom receives the money, he deposits it into the business savings account as a "just in case" fund. The interest paid would NOT qualify as an interest deduction in this scenario. Most likely, it would be considered an investment account because of its earning interest.
Types of Business Loans and Interest Options
There are almost as many different types of business loans as reasons for needing one.
- Bank loans: Either secured or unsecured.
- Small Business Administration (SBA) loans: Guarantees loans made by other lenders.
- Asset-based finance: Uses company assets to secure a loan.
- Mezzanine finance: Uses company equity to secure a loan.
- Invoice finance: Borrows against invoice balances owed by customers of the company.
- Microloans: Loans as small as $5,000 using personal credit score, not business age or income.
How the interest will be assessed varies and will determine how much is deductible on an annual basis. Be sure to refer to your loan documents and discuss them with your professional tax advisor.
The three most common interest types are.
- Simple Interest- interest due based on the underlying amount of the outstanding principal.
- Accrued Interest- accumulates unpaid until the next payment.
- Compound Interest- basically, interest on top of interest (yikes).
Term Loan Deductions
A business loan is not taxable income because you are legally obligated to pay it back. In most cases, each payment consists of two components. First, an amount applies towards the principal, and second, the interest due. Only the interest is tax-deductible.
Don't go it alone and assume you are doing things correctly. An accountant/tax advisor will pay for their fees by identifying more deductions and keeping you out of trouble.
Is SBA loan interest tax deductible?
Let's clear up a common misunderstanding. The purpose of the Small Business Administration is not to directly issue loans. Instead, the SBA has a network of approved lenders that offer loans with better terms than the open marketplace. Why the better terms, you ask? Because the SBA guarantee's up to 85% (varies per program) of the loan principal, the lender has much less risk. Hence the more attractive terms.
The answer to the question is yes. The interest is tax-deductible as per IRS requirements because the funds come from a commercial lender, not the SBA.
Working Capital Loan Deductions
Like any other business loan, as long as the money is used strictly for your business, the interest qualifies as deductible. Obtaining a personal loan and using those funds to capitalize your business might be your only choice. Your tax advisor may feel comfortable claiming the interest deduction by adequately documenting how the funds were used by your company and avoiding any comingling of funds.
Business Expansion Loan Deductions
Is the expansion loan being used to buy another business that you will manage? If so, then the loan interest should be deductible. However, if you are not involved in the expansion business but instead enjoy only the profits or a portion thereof, this would be classed as an investment, and the interest would not be deductible. This is a tricky area to navigate, so check with your tax expert to determine which tax code options are best for you.
Read more about business expansion loan
Equipment Loan Deductions
The equipment itself generally collateralizes equipment loans. The contract will stipulate the interest and length of the loan and spell out the penalties if the loan goes into default. The interest would be claimed as a tax deduction. With the plethora of equipment leasing programs, it might behoove a person to explore these to make the best decision for their situation. Most equipment leasing agreements qualify for the entire lease payment to be fully deducted as a business expense.
Read more about business equipment loan
Emergency Business Loan Deductions
A business owner usually seeks these loans to address a specific and immediate need. They are typically for smaller amounts of $50,000 and less and have a shorter payback term of 12 – 18 months. If the need results from a natural disaster or something else beyond the control of the business (think pandemic), it would be a good idea to check the SBA website or your state resources for a bridge loan or emergency capital.
Read more about business emergency loan
Business Line of Credit Deductions
Business lines of credit are different than a lump sum loan distribution. The credit line is revolving much like a credit card. The business can access much (up to the set limit) or as little of the credit line as needed. The resulting payments reduce the credit line amount owed but those paid down monies remain available should the need arise.
Accountants will have software to track the distributions and payments to determine the exact amount of interest paid on the withdrawn funds. Interest is assessed only on the monies withdrawn, not on the total amount of the credit line.
Read more about business line of credit
Understanding Business Loan Interest Tax Deductions
Has this article got your head spinning? Good, because deciding what type of business loan is best for your unique situation requires a well-trained guide. One uniformed misstep can cost you thousands in lost deductions or disallowed deductions.
Ask other small business owners in your area who they would recommend as a small business tax advisor? Then whittle it down to a shortlist and set up an appointment to visit with each one. It won't take long before you find the tax advisor that is the best fit.
Article Topics
Business Loans
For over 17 years, Dave has been a financial business coach, teaching owners how to succeed in the digital economy. He is also an in-demand speaker for webinars and live events covering various business topics dealing with Internet marketing. Dave is also the author of a course on using LinkedIn to find your ideal prospects. He is an avid outdoor photographer and hiking enthusiast living in the desert southwest.
