It is important to consider the tax deductibility of interest when choosing a debt-financing source for your small business. Whether or not the interest is deductible doesn’t depend on the type of debt financing, but how the financing is used by the business. Debt financing can generally be used for investment, business, or personal purposes.
In this article we will discuss how the use of debt proceeds affects the tax deductibility of interest expense in a small business (where a small business is defined as having <$25m in gross receipts) that is treated as a pass-through entity (partnership/S-corporation/schedule C).
Interest on Loans used to fund Business Expenses and Assets Purchases
If the debt proceeds are used to fund business expenses or asset purchases, the attributable interest is considered an ordinary trade or business expense that can be deducted on either Schedule C or Schedule E of the partner/shareholder/owner’s personal tax returns.
For example, if you take out a home equity loan to buy an interest in a partnership, and that partnership uses those funds for working capital or business expenses, then you can deduct the interest on that home equity loan as a business interest expense on your schedule E. Alternatively, if the partnership uses a SBA 7a loan to buy inventory and fixed assets for the business, then the interest from that loan will flow through to the partners and they can deduct it on their personal tax returns on schedule E.
There are still other limitations, such as the at-risk and passive activity loss limitations, but generally this interest expense is deductible without the partners, shareholders, or owners having to itemize their deductions.
Interest on Loans Funding Investments and Savings
If the debt proceeds are deposited to a savings account, Money Market, or Certificate of Deposit (CD) account, or used to fully or partially buy property for investment purposes (i.e. – stocks, securities, annuities, etc.), then the attributable interest is considered investment interest expense and is deductible only as an itemized deduction to the extent that it exceeds net investment income. The excess investment interest expense is carried forward to the following year.
For example, if a partnership borrows $100k, and $20k of those funds are used to buy bonds, then 20% of the interest attributable to that $100k loan will need to be treated as an investment interest expense on the personal tax returns of the partners. The partners would only be able to deduct that investment interest expense to the extent that it exceeds their personal net investment income.
Another common example of this is taking an Economic Injury Disaster Loan (EIDL) and placing the proceeds in a money market account. The interest expense on the EIDL is considered investment interest expense until those funds are spent on business purchases. This situation is extremely unfavorable and should be avoided because you will not be able to deduct the investment interest expense unless it exceeds your net investment income and you itemize (most taxpayers do not itemize).
Interest on Business Loans used for Personal Expenses
If the debt proceeds are used to fund personal expenses, then the attributable interest is considered nondeductible. For example, consider a sole proprietor takes a $100k line of credit, uses $40k to buy a boat, and $60k to buy a delivery van for their business. 40% of the interest attributable to this loan is considered nondeductible, whereas the remaining 60% is deductible on schedule C of the business owner’s personal tax return.
Interest on Loans used to Fund Owner Distributions
If the debt proceeds are used to fund a distribution to partners or shareholders, then the attributable interest is deductible based on each partner/shareholder’s use of the distribution proceeds. This type of scenario may arise if a partnership needs to distribute cash to its partners so they can pay their quarterly estimated tax payments, but the partnership doesn’t have cash because it’s waiting on a large payment from a customer or a refund from the government (this happened frequently when businesses were claiming the employee retention credit aka ERC).
For example, if a partner invests the proceeds from a debt-financed distribution into a brokerage account, then the interest attributable to that debt will be considered investment interest expense. If the partner uses those funds to make estimated tax payments, then it is considered a personal expense and it is not deductible.
You might be wondering, how does the partner track this? The schedule K-1 issued by the partnership or S-corporation is required to show the amount of interest attributable to a debt-financed distribution so the partners know how to deal with it on their personal tax returns. This scenario is not favorable because it limits the amount of the interest expense deduction.
However, there is an alternative! A pass-through entity can choose to allocate their debt proceeds to business expenses instead of their distributions thus not triggering a so called “debt-financed distribution”. This optional method of allocating interest is only available if the total debt proceeds do not exceed the amount of business expenses for the year. Any excess will be treated as a debt-financed distribution subject to the limitations above. Therefore, if you need to borrow money to issue distributions to your partners or shareholders, make sure you are allocating the funds to your business expenses first, then allocating the remainder to the distributions.
In conclusion, it is unlikely that you can deduct interest expense on your tax returns unless you use those funds on legitimate business expenses or asset acquisitions. Your accountant is responsible for tracking this information during the bookkeeping and tax preparation process, therefore it’s extremely important that they understand how you’re using your funds, and these tax implications. Please feel free to reach out to RY CPAs if you have questions about the deductibility of the interest on your loans.
About the Author
Raffi Yousefian is a CPA and the CEO of The Fork CPAs powered by RY CPAs. The Fork CPAs provides restaurant owners with modern, frictionless, streamlined bookkeeping and tax services, with friendly advice served up on the side. The Fork CPAs team believes that with the appropriate technology and accounting team, restaurants of any size can access the same detailed and impactful financial data as national restaurant chains. Contact The Fork CPAs if you're hungry for more!
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