November 13, 2017
There are instances when you can write off interest on personal loans used for business purposes, such as injecting capital into an S corporation, multi-member LLC, partnership or C corporation. But keep in mind that interest expenses must be classified into one of four categories (see box at the bottom of this article for details).
Different tax rules apply to each type of interest. So you need to allocate your interest expenses among the four categories.
Loans to Inject Capital into an S Corp, Multi-Member LLC or Partnership
If you use loan proceeds to contribute to the capital of an S corporation, a multi-member LLC (treated as a partnership for federal tax purposes), or a partnership, the issue becomes how to treat the resulting interest expense on your tax return.
According to the IRS, you can allocate the loan proceeds using any “reasonable” method. Once the proceeds have been properly placed into the business, passive or investment categories, you allocate the interest expense in the same proportions. An acceptable method includes allocating the debt to the various types of assets owned by the entity.
For example, if all the entity’s assets are used in a trade or business in which you materially participate, you can deduct all the interest on Schedule E.
These write-offs reduce your income and self-employment tax bills. They also lower your adjusted gross income (AGI), which means you might qualify for various tax breaks that have AGI-sensitive “phase-out” rules, such as the dependent child and college tax credits.
Loans to Inject Capital into a C Corp
When you borrow to inject capital into your own C corporation (or buy shares in a closely held C corp), the related interest expense falls into the investment interest category, regardless how active you are in the business. It doesn’t matter if you use the borrowed funds to make a loan to the company, contribute additional capital, or receive additional stock in return for your cash injection.
Your ability to deduct the investment interest expense depends on how much investment income you generate. For this reason, you may be better off making a “back-to-back” loan to your C corporation and charging interest at least equal to what you pay the lender.
With this method, you are assured of being able to currently deduct the interest expense under the investment interest rules, thanks to the investment income generated by the corporation’s interest payments to you. At the corporate level, your company gets a deduction for the interest it pays you. Everyone comes out ahead.
As you can see, getting the best tax results for interest expenses can be complicated. Consult with your tax advisor about how to maximize deductions.
Tax Rules Differ by Category
The tax rules for interest deductions depend on which category the expenses are in. Here are the categories that apply to expenses that individuals can incur:
1. Business Interest is fully deductible. If you borrow money and immediately spend it to pay expenses incurred by your sole proprietorship or to purchase related supplies and equipment, you can deduct the interest as a business expense on your Schedule C, as long as you materially participate in the operation.
2. Passive Interest is a subcategory of business interest, but applies only to interest on loans to finance passive business activities in which you do not materially participate. The interest is treated as a passive expense item and is included in computing the overall taxable income or loss from the activity in question.
In general, if you have an overall taxable loss from the activity (after including the interest as an expense), you can deduct the loss only to the extent you have positive taxable income or gains from other passive activities.
If a passive activity generates overall positive taxable income, the interest expense simply offsets part of your profit from the activity.
3. Investment Interest deductions depend on how much income you have from investments. When interest expenses from investments exceeds investment income, the excess is carried forward to future years, over to the following tax year or the next year and so on until you have enough investment income to claim a write-off.
For most people, investment income consists of taxable interest income and short-term capital gains. You can also elect to treat all or part of your long-term capital gains and qualified dividends as investment income, in order to “free up” larger investment interest deductions.
However, gains and dividends treated as investment income are then taxed at your regular federal rate (which can be up to 39.6%) rather than at the preferential rate that would otherwise apply, which is no higher than 20%; and the 20% rate only affects singles with taxable income above $400,000, married joint-filing couples with income above $450,000, heads of households with income above $425,000, and married individuals who file separate returns with income above $225,000.
Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10, 15, 25, 28, 33, 35 or 39.6%.
4. Personal Interest, also called consumer interest, is nondeductible unless it meets the definition of either: