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Most business owners will need to secure financing at some point. The loan application process is one that’s fraught with questions, and those questions don’t end once the funds are in your bank account. Once you’ve secured the capital you need, you may find yourself asking: is my business loan considered income—or is it an expense?
It’s an understandable question; a small business loan typically involves receiving a sudden, large influx of capital, which would normally have a significant impact on your tax filing the following year. Loans aren’t income, though, precisely because you must pay them back. In fact, you can actually use your loans to lower your tax burden—but more on that in a bit.
With that said, the answer to this question of whether you have to claim loans when you file your business income taxes is a little more complicated than a simple “no.”
Here, we’ll explain when loans are taxable and when they’re not, to help you make well-informed financial decisions for your small business. We’ll also address when you can (and can’t) expect to deduct your business loan interest on your taxes.
The following is meant to serve as a source of general information, and you should in no way construe it as tax advice planning advice. To understand how this information applies to your particular situation, you’ll need to contact an accountant.
Can Your Business Loan or Financing Be Considered Income?
Talk to a loan expert and find out if the principal and/or interest in the loan you’re looking for can be deducted as a taxable expense.
Is a business loan considered income?
Most of the time, no, they’re not. Loans aren’t earnings, so it’s usually not necessary to claim the loans you receive on your taxes.
There is an exception to this rule, which is when the lender forgives your loan. In such cases, the loan becomes taxable at the time the lender forgives the loan repayment rather than when the business received the loan.
Note: Things become a bit more complicated if you’re dealing with government small business loans, such as the (now ended) COVID-inspired Payroll Protection Program (PPP) loans offered by the Small Business Administration. This promised forgiveness for funds that businesses used for specific business purposes, such as payroll, mortgage interest, rent, etc.
Forgiven PPP loans are explicitly not considered taxable income at the federal level, but vary at the state level, so be sure to determine the rules in your state if you fall into this category.
Can I Deduct the Interest I’ve Paid on My Business Loans?
Most of the time, yes, you can claim interest payment as a business expense on your business tax return—with a couple of caveats.
For one, you cannot deduct the interest for loans that are not spent, like those that you use to accumulate interest. That’s because the IRS sees such payments as investments rather than actual loans.
According to IRS Publication 535, to be eligible for tax dedication, the following requirements must also be met for the loan in question:
- 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 essence, that means you must obtain your loan through legitimate channels, such as a loan from an online lender or a traditional bank loan.
The interest on the money you’ve borrowed from friends or family does not, therefore, count for the purposes of interest deduction. The reason for this distinction is to prevent people from getting away with tax evasion by setting up fraudulent, informal “loans” with personal acquaintances.
So, What Kinds Of Business Loans And Financing Have Tax-Deductible Interest?
There are several loan and financing options–even personal loans–that allow business owners to deduct interest. Just like loans that you take out in your business’s name, personal loans are eligible for tax deduction provided they were put toward business expenses.
Interest deduction isn’t possible, of course, for loans that you use for personal, non-business reasons. If you use your personal loans for mixed purposes (business and personal reasons), you’ll only be able to claim the interest paid on the specific amount that you put into your business.
That might mean doing some tricky math, such as when your loan contributed to the space you live and work out of or the vehicle you have for both work and personal use. For these reasons, personal loans are not ideal for small business owners who want to simultaneously take advantage of interest deduction while avoiding tax return headaches.
Other types of loans that have tax-deductible interest payments:
- Term loans, including
- Both short-term and long-term business loans
- Small Business Association (SBA) loans
- Working capital loans
Term loans are standard loans that involve a lump sum payment and a straightforward repayment plan, with pre-arranged interest rates and a clear end date. With term loans, the lender will establish the breakdown of principal versus interest at the outset, and you can use a loan calculator to receive an estimate of payment options before you take the plunge. Although the lender will communicate the interest rates to you prior to your agreement, they’ll likely vary over the course of your repayment plan, which will naturally affect your loan deductions.
With short-term loans, the repayment period is, as the name suggests, typically shorter, which means you’ll potentially be able to deduct your interest payments faster. Short-term loans are an attractive option for business owners whose credit score precludes them from obtaining a standard loan or who need cash, fast.
- Lines of credit and credit cards
Like your business credit card, a business line of credit allows you to withdraw money up to a certain limit (usually a lower limit for lines of credit than for credit cards) and pay interest only on what you withdraw.
That makes things only slightly more complicated than the interest deduction process is for term loans, as it means that you’ll have to go back and determine exactly how much interest you ended up paying at the end of each year.
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What About Merchant Cash Advances (MCAs)?
MCAs are a great financing option for many small businesses, but they’re not ideal for those who want to deduct their interest payments on their income taxes. That’s because with MCAs the lender will claim a portion of your business’s credit card sales as repayment, with the interest rate factored into these automatic payments.
Such repayments often aren’t recognized as interest, which prevents them from being deducted.
Other Exceptions To Interest Deduction Eligibility
Even if you meet the above-mentioned IRS criteria, there are some situations in which your loan interest may not be eligible for deduction. You can’t deduct:
- The interest you paid off on your original loan with a subsequent loan obtained for refinancing purposes. You can, of course, begin to claim the interest that you pay on the new loan.
- Capitalized interest (interest that has been added to the balance of the loan).
- Fees that you pay upfront for a loan, such as basis points or loan origination fees.
- Interest paid on forgiven PPPloans.
- For most businesses, interest on loans is used to pay late taxes or associated penalties.
- Standby fees.
If you need a loan for business purposes, it’s likely that the interest rates of those loans have been a source of concern. But if you’re in a position to claim this interest on your tax return, you can potentially recoup that cost and make helping your business reach its full potential a more feasible, less costly task.
Best Ways To Reduce Tax Burdens
Make the smarter choice with financing options that help you reduce your tax burden.
Talk to a loan expert and learn about flexible financing options suited for your business.
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