Deductible Interest

General Rules

Interest paid or incurred on debts related to your business generally is fully deductible as business interest. Business interest is deductible without limitation, except when such interest is required to be capitalized. (Remember, for example, that construction period interest and taxes must be capitalized, as explained earlier in this chapter.) There is 1 main exception to the general deductibility rule for business interest: interest on life insurance policies. (The limits on deducting interest with respect to life insurance policies are discussed in Chapter 22.)

Interest is characterized by how and for what the proceeds of the loan that generated the interest are used. Personal interest is nondeductible (except to the extent of qualified home mortgage interest and a limited amount of student loan interest). Investment interest is deductible only to the extent of net investment income. Interest characterized as incurred in a passive activity is subject to the passive loss rules. The characterization is not dependent on what type of property—business or personal—was used as collateral for the loan. For example, if you borrow against your personal life insurance policy and use the proceeds to buy equipment for your business, you can deduct the interest as business interest. On the other hand, if you take a bank loan using your corporate stock as collateral, and use the proceeds to invest in the stock market, the interest is characterized as investment interest. Interest on a tax deficiency relating to Schedules C, E, or F is nondeductible personal interest. While the Tax Court had allowed a deduction for this interest, several appellate courts have sided with the IRS in denying a deduction for this interest.

If the proceeds are used for more than 1 purpose, you must make an allocation based on the use of the loan's proceeds. When you repay a part of the loan, the repayments are treated as repaying the loan in this order:

• Amounts allocated to personal use
• Amounts allocated to investments and passive activities
• Amounts allocated to passive activities in connection with rental real estate in which you actively participate
• Amounts allocated to business use

The interest obligation must be yours in order for you to claim an interest deduction. If you pay off someone else's loan, you cannot deduct the interest you pay. If you are contractually obligated to make the payment, you may be able to deduct your payment as some other expense item, but not as interest.

Debt Incurred to Buy an Interest in a Business

If you use loan proceeds to buy an interest in a partnership, LLC, or S corporation or to make a contribution to capital, this is treated as a debt-financed acquisition. In this case, you must allocate the interest on the loan based on the assets of the pass-through business. The allocation can be based on book value, market value, or the adjusted bases of the assets.

If you, as an S corporation shareholder, LLC member, or partner, receive proceeds from a debt, you must also allocate the debt proceeds. These are called debt-financed distributions. Under a general allocation rule, debt proceeds distributed to an owner of a pass-through entity are allocated to the owner's use of the proceeds. Thus, if the owner uses the proceeds for personal purposes, the pass-through entity must treat the interest as nondeductible personal interest. Under an optional allocation rule, the pass-through entity may allocate the proceeds (and related interest) to 1 or more of the entity's expenditures other than distributions. The expenditures to which the debt is allocated are those made in the same year as the allocation is made (see IRS Notice 89-35 for allocations in pass-through entities).

If you borrow money to buy stock in a closely held C corporation, the Tax Court considers the interest to be investment interest. The reason: C corporation stock, like any publicly traded stock, is held for investment. This is so even if the corporation never pays out investment income (dividends) or the purchase of the stock is made to protect one's employment with the corporation.

Loans between Shareholders and Their Corporations

Special care must be taken when shareholders lend money to their corporation, and vice versa, or when shareholders guarantee third-party loans made to their corporation.

CORPORATION'S INDEBTEDNESS TO SHAREHOLDERS

If a corporation borrows from its shareholders, the corporation can deduct the interest it pays on the loan. The issue sometimes raised by the IRS in these types of loans is whether there is any real indebtedness. Sometimes loans are used in place of dividends to transform nondeductible dividend payments into deductible interest. In order for a loan to withstand IRS scrutiny, be prepared to show a written instrument bearing a fixed maturity date for the repayment of the loan. The instrument should also state a fixed rate of interest. There should be a valid business reason for this borrowing arrangement (such as evidence that the corporation could not borrow from a commercial source at a reasonable rate of interest). If the loan is subordinated to the claims of corporate creditors, this tends to show that it is not a true debt, but other factors may prove otherwise. Also, when a corporation is heavily indebted to shareholders, the debt-to-equity ratio may indicate that the loans are not true loans but are merely disguised equity.

When a corporation fails to repay a loan to a shareholder, this may give rise to a bad debt deduction for the shareholder. Bad debts are discussed in Chapter 11.

SHAREHOLDER GUARANTEES OF CORPORATE DEBT

Often for small businesses, banks or other lenders usually require personal guarantees by the corporation's principal shareholders as a condition for making loans to the corporation. This arrangement raises 1 of the basic rules for deducting interest discussed earlier: The obligation must be yours in order for you to deduct the interest.

Below-Market and Above-Market Loans

When shareholders and their corporations arrange loans between themselves, they may set interest rates at less than or more than the going market rate of interest. This may be done for a number of reasons, including to ease the financial burden on a party to the loan or to create tax advantage. Whatever the reason, it is important to understand the consequences of the arrangement.

BELOW-MARKET LOANS

If you receive an interest-free or below-market-interest loan, you may still be able to claim an interest deduction. You can claim an interest deduction equal to the sum of the interest you actually pay, plus the amount of interest that the lender is required to report as income under the below-market loan rules. The amount that the lender is required to report as income is fixed according to interest rates set monthly by the IRS. Different rates apply according to the term of the loan.

• Short-term loans run 3 years or less.
• Mid-term loans run more than 3 but less than 9 years.
• Long-term loans run more than 9 years.

Rates required to be charged in order to avoid imputed interest are called the applicable federal rates (AFRs). You can find an index of AFRs by entering “applicable federal rates” in the search box at www.irs.gov. If a loan is payable on demand, the short-term rate applies. However, if the loan is outstanding for an entire year, you can use a blended annual rate (0.22% for 2012) provided by the IRS to simplify the computation of the taxable imputed interest.

Whether you are required to report this amount as income (which would, in effect, offset the interest deduction) depends on the amount of the loan and the context in which it was made. If it was treated as compensation or a dividend, you have to include it in income; if it was considered a gift loan, you do not have additional income. Gift loans are loans up to $10,000 (as long as the loan is not made for tax avoidance purposes). The corporation (lender) must report the interest as income. If the loan is to an employee, an offsetting deduction can be taken for compensation. But if the loan is to a nonemployee, such as a shareholder who does not work for the corporation, no offsetting deduction can be taken.

ABOVE-MARKET LOANS

Instead of borrowing from a bank, your corporation may be able to borrow from a relative of yours, such as your child or parent, to whom you want to make gifts. You can turn the arrangement into a profitable one for both your corporation and your relative (the lender). Set the interest rate at more than what would be charged by the bank. Provided that the interest is still considered “reasonable” and the loan is an arm's-length transaction, your corporation deducts the interest and the lender receives it. If an unreasonably high rate of interest is charged and the arrangement is not at arm's length, however, the IRS will attack the arrangement and may disallow the interest as being a disguised dividend payment to you.

Home Mortgage Interest and Home Offices

If you are self-employed, use a portion of your home for business, and claim a home office deduction, you must allocate the home mortgage interest. The portion of the interest on the mortgage allocated to the business use is deducted on Form 8829, Expenses for Business Use of Your Home. The balance is treated as personal mortgage interest deductible as an itemized expense on Schedule A.