Managing your business

How to Save Money With Small Business Loan Interest Deductions

By: Kate Samano November 1, 2021

Getting audited by the IRS is a headache no one walks into knowingly. That's why it's important for small business owners to do extensive homework on the different types of small business loans before taking action. Research helps you make astute decisions that can save money and mitigate risks involved with business ownership, particularly when it comes to important factors, such as financing and taxes.

Interest on business loans is usually tax-deductible as a business expense, provided your organization and the loan agreement meet the criteria defined by the IRS. But can taking out credit for your business impact your personal tax status? And are there exceptions that make you or your company liable for interest on business loans? Keep reading to learn the answers, discover the most popular tax-deductible credit options for small- to medium-sized businesses and determine which option is best for you. 

What Is the Business Loan Interest Tax Deduction?

When you take out a loan with a lender or bank, they charge a percentage of extra money on top of the repayment amount, known as interest. The borrower is responsible for paying the principal amount, plus the interest, over a predetermined period. Per IRS Publication 535, the IRS business loan deduction allows business owners to write off annual interest due on eligible business loans.

The small business loan interest tax deduction lets you deduct the amount you paid in interest from your tax liability as a business expense. However, the IRS has clear rules in place and proposes certain limitations on who can claim and how much they’re entitled to.

Eligibility for Tax-Deductible Interest Payments

There are three primary stipulations put forward by the IRS regarding who can write off interest payments on small business loans:

  1. You should be responsible by law to repay the loan.
  2. An agreement must be in place for repayment of the loan in its entirety, including all interest payments.
  3. There must be a reciprocal lender/borrower arrangement in place.

The main purpose of these rules is to make sure your loan comes from a true and reputable vendor. Loans from family and friends aren’t considered valid with regards to deductible interest because they don’t have the same legal ramifications. To calculate and deduct interest, there must be legally binding documentation in place, including a fair rate of interest and a repayment schedule.

What’s more, you need to actually spend the loan. Leaving it sitting in a business bank account is considered an investment, as opposed to an expense, and would invalidate your claim for tax-deductible interest.

Types of Small Business Loans

Some of the small business loans you might consider include:

  • Small business administration loans
  • Business line of credit 
  • Business term loan
  • Start-up loans
  • Personal loans for business
  • Business credit card
  • Equipment financing
  • Unsecured business loans

Business Structure and Tax Liability

When it comes to taking out a loan for your business, there’s a lot to think about. While the type of loan you take out doesn’t usually affect eligibility for tax deductions, your business structure can impact personal liability.

The type of organization you operate dictates whether you can be held personally accountable for business taxes. It’s crucial that you understand where you stand as a business owner before taking out a small business loan.  

Sole Proprietorship

As a sole proprietor, you and your company are indistinguishable, meaning you retain all profits and you’re responsible for all liabilities, losses and debts. Sole proprietorship income is 100% yours, which means your personal and business taxes aren’t separate. As a sole proprietor, taking out a business loan would impact your personal taxes. 

Partnership

Pros

- Lower tax rates than other structures
- Complete control over operations
- Inexpensive and easy to form
- File taxes once per year

Cons

- Difficult to get investment
- Unlimited personal liability

In a partnership, you share the burden of liability with one or more other people, in addition to profits. In this arrangement, all partners must file a joint return of business income, and each partner must file personal tax returns for their share of profit and loss. In a partnership, you’re personally liable for loans taken out by you and any partners. 

Pros

- Easier to obtain funding than an SP
- You can amend the number of partners
- Easy and cheap to form

Cons

- Personal liability for all partners' debt
- Lack of control for you as an individual
- Potential for dispute

LLC

A limited liability company is a mixture between a partnership and a corporation, in which the owners are referred to as members. Ownership can be individual or split between an unlimited number of people, and profits and losses are passed through to members. Partners are liable for filing taxes on their personal returns, with some states requiring additional taxation.

Generally speaking, members of an LLC are not liable for corporate debts, with the exception of sales and payroll taxes. However, you should consult with an expert in your local jurisdiction to make sure this applies to you personally.      

Pros

- Personal liability is in line with that of a corporation, so your financial liability is limited to a fixed sum that's usually equivalent to the value of your investment
- Has the flexibility of a partnership with fewer restrictions on sharing profits
- No tax on surplus earnings
- Relatively easy to raise capital

Cons

- The organization is liable for self-employment taxes
- Members who leave might be able to dissolve the arrangement

Cooperative, C Corps and S Corp

Cooperatives, C corporations and S corporations require the most initial investment of time and resources but deliver superior benefits when it comes to taxation. A coop is usually best placed for applying for government small business loans and grants, business loans for women and business loans for bad credit in underserved areas. Some coops are tax-exempt, but members pay personal taxes on cooperative gains.   

C corps and S corps are business structures with limited liability, although S corps allow profit and loss to pass through to personal tax returns. Speak to your accountant or financial advisor to find out the specifics of how a small business loan might affect your personal tax status in your state.  

Small Business Loans and Taxes

There’s a good chance you’ll be able to write off repayments of some or all of the interest you pay on a small business loan. This applies no matter what type of financing agreement you make, provided it meets the IRS’s requirements.

Let’s take a look at some of the most common types of business loans and how they relate to IRS tax deduction regulations.

Term Loans

A term loan is a finance agreement whereby you get a lump sum in your account, with a set period outlined for repayment. Most arrangements are set for between three and 10 years, but they can extend to 20 years or more. Once you’ve signed an agreement, the lender can provide an amortization schedule that defines monthly principal and interest repayment rates.

For example, you might take out a five-year loan for $60,000 with a 5% interest rate. The total amount of interest you would pay is $3,000, and it’s split over a five-year period, so you can expect to save $600 per year on interest repayments. 

If you’ve arranged your SBA small business loan as a term loan agreement, you can apply the above logic to it. 

Less initial expense

Short-term loans are exactly the same as term loans, except the repayment period is typically less than 18 months or within the same tax year. As such, interest payments tend to be made on a one-off basis or split into two annual tax filings. Depending on the terms of your loan, interest may be calculated on an APR (percentage) or factor rate (decimal). You’ll need to speak to your loan provider to determine which is relevant, so you can calculate annual interest rates. 

Less initial expense

Interest on a business line of credit is slightly more complicated, and it usually has more in common with a credit card than a traditional loan. This is because you borrow from a pool of funds with an allocated borrowing limit — although this limit is usually much higher than a credit card. While there are limited repayment guidelines, repayments are usually made as and when you’re able to make them.

Interest accrues when you borrow from the line of credit, so interest deductions are dependent on usage. Prior to filing annual taxes and claiming interest as a business expense, you should use statements to calculate interest paid in the way you would with a credit card. 

Personal Loans

If you’re a sole proprietor or member of a partnership or C corp, you might take out a personal loan on behalf of your business. If 100% of this loan is used for the purpose of your business, you can claim 100% of the interest on the loan. Just be aware that this might have an impact on your personal tax status, and you might be liable for debts if the business folds. 

In the case of a split arrangement, you claim for the percentage of interest that aligns with the percentage of usage applicable to the business. For example, if you get a loan for a car and use it for your business 40% of the time, you’ll claim for 40% of the interest. It’s important to note that you cannot claim interest on funds you’ve used for personal reasons.

Loan Structure and Deductions

The different types of loan structures can have different impacts on how you deduct interest payments from your tax bill. Let’s take a quick look at how:

  • Expansion loans: Expansion loans are usually used for buying another business. If you operate the business personally, you can claim interest on the loan. However, if someone else runs the business, it may be viewed as an investment and wouldn’t qualify as a business expense. We’d recommend speaking to an expert if you’re not sure whether your expansion loan qualifies for interest deductions. 
  • Credit lines: Interest is only deductible on the money you use, not the full amount outlined in the agreement, unless you use all the credit available to you.
  • Term loans: You usually pay more interest upfront on a term loan, so your tax deduction is higher at first and decreases as interest payments decrease. 

Short-term loans: Because all interest repayments are crammed into a year or two, you’ll benefit from substantial deductions, which can save your company a good chunk of capital.

Nondeductible Interest Payments

While most loans for small businesses are eligible for IRS interest payment deductibles, there are some exceptions, such as:

  • You can’t claim interest on a loan that you’ve refinanced in order to keep up with repayments.
  • Only C corps can claim interest on loans for tax penalties or overdue taxes.
  • You can’t claim capitalized interest.
  • You can’t claim for tax-exempt income if you’ve had your loan forgiven under the Paycheck Protection Program.
  • Loan origination fees and standby fees are not interest fees and don’t count as deductible expenses.

Partner With a Trustworthy Lender

As you can see, choosing the right small business loan for your organization is a complicated process. Lendzi is an experienced and trusted lender with a focus on limiting potentially harmful factors, such as hard searches and lack of upfront funding to help small businesses get ahead. We’ve helped raise more than $500 million for businesses in America, including the following financing options:

  • Business line of credit 
  • SBA small business loan
  • Business loans for bad credit
  • Government small business loans
  • Business loans for women
  • New business loans
  • Online business loan

You’ve got a bright idea, the work ethic and a mission — now all you need is financing. Let Lendzi help you find the small business loan that delivers the highest returns, so you can focus on propelling your company to stratospheric success. Call us at (877) 453-6394 to get started.

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