4 Perks and Challenges for Deducting Interest on Your Small Business Financing
They say the only certainties in life are death and taxes—but as a small business owner, your world is more defined by the yin and yang of debt and taxes.
And the yang: With your accountant chasing old expense receipts and your bookkeeping in dire need of an update, the looming tax deadline is creeping closer and will be here before you know it.
The good news? The interest you pay on your small business financing is probably tax-deductible! That is, depending on what type of financing you use to fund your business. Here are four common ways you might consider financing your business, and the pros and cons of each when the taxman comes knocking.
Loans from family and friends
PRO: Loans from people who know you and believe in your business are a popular financing option, especially if you’re just getting started and don’t have strong enough personal or business credit histories to get financing elsewhere. If you borrow from a family member or friend for exclusively business purposes, you can deduct the interest you pay on the loan as a business expense.
CON: The IRS is highly suspicious of loans between family members and friends—so you need to document these transactions very carefully. Treat the loan as officially as you would if it was from an institutional lender: sign a promissory note, follow an agreed-upon repayment schedule, and pay a fair rate of interest. (Don’t forget to keep your cancelled loan payment checks to prove you actually paid the interest!)
Credit cards and lines of credit
PRO: Revolving credit remains the most frequently used form of financing for American small businesses—and understandably so. Credit cards and lines are relatively easy to procure, and ideal for small, recurring working capital expenses that go hand-in-hand with running your business. If you open and maintain a business credit card for strictly business purposes, you can deduct the interest you pay as a business expense.
CON: At a certain point, plastic just doesn’t cut it. If you need to make big one-time or ongoing investments to expand your business (like bulk inventory purchases, expanding to an additional location, or hiring new employees), then the possible overdraft fees and variable interest rates you pay on your revolving credit may outweigh the benefits of your tax deductions.
PRO: If your business is brand-new and you need less than $25,000, a personal loan could be the right option for getting your operations off the ground (especially if you have a strong personal FICO score). Typically, personal loans offer you more flexibility in how you use your funds, and many do not require collateral. If you use at least some portion of your personal loan proceeds for legitimate business expenses, you can deduct that corresponding portion of interest you pay on the loan as a business expense.
CON: Unfortunately, you cannot deduct the interest you pay on a personal loan for any funds you use on purely personal purposes. If your loan is partly business and partly personal, split the interest between those categories. For example, let’s say you take out a $50,000 personal loan, use $30,000 of it to buy a new car for your freshly-licensed teenager, and put the other $20,000 toward office supplies and equipment for your business.
In this case, you would chalk up the $30,000 to personal use and $20,000 to your business. If you paid $1,000 of interest on the entire loan this past year, only $400 of it (or 40 percent) is deductible as a business expense. The remaining $600 would be a nondeductible personal expense. Tip: Before you move ahead with a business deduction, make sure that the interest isn’t subject to any capitalization rules. Your financial advisor or accountant can help you navigate this subject!
Business term loan
PRO: If your business is established (>2 years old) and you have good personal credit, a business term loan of $25,000 to $500,000 with a once-monthly payment may be an excellent financing option for your business. You can deduct the entirety of your interest on a business term loan, since the funds are fully dedicated to your business. For example, if you take out a business loan for $100,000 at an 8 percent interest rate to make a bulk inventory purchase, your annual interest of $8,000 is a fully deductible expense on your Schedule C, Form 1040 because you used the loan proceeds entirely for business reasons.
CON: Before you do a little happy dance, keep this in mind: business loans tend to have more stringent underwriting standards than credit cards or personal loans. If your business is under two years old, you may need to wait a couple years before graduating to this category of financing when you’re ready to take your business to the next level.
Keeping track of your funds
Hold on—we’ve got three last things you need to know! First, your deduction begins only when you spend your borrowed funds for business purposes. Long story short, you can’t claim any business deductions for interest you pay on money that you have sitting in your accounts untouched. At that point, such funds are considered an investment—not a business expense.
Second, when you borrow money for your business, make sure you deposit in an account exclusively for your business—not a personal bank account. Otherwise, you’ll have to go above and beyond to prove that the money was actually spent on legitimate business expenses. You don’t want that headache.
Lastly, if you’re still on the fence about hiring an accountant or tax advisor, consider this: tax advice is fully tax-deductible for every business type (corporations, LLCs, partnerships and even proprietorships), so now’s the time to make your business as compliant as possible.
The IRS has complicated rules which require you to connect your use of loan proceeds to legitimate business uses. To make sure you have your ducks in a row, schedule some time with your friendly tax advisor to talk about what you need to safeguard your write-offs.
Repeat after us: It’s when and how you use the money that counts, not how you get it. Happy deducting!
Think a business term loan might be the right next step for your small business? Apply for a small business loan with Funding Circle to help you grow at a rate you can afford!