A common question regarding the tax treatment of business loan interest is whether it is taxable income. The answer to this question primarily depends on the taxpayer's status as a small business owner, whether they are actively using the funds advanced, and other relevant circumstances. It is important for all business owners to understand that the terms “taxable” and “net profit” refer not just to the amount of the advance paid but also to the manner in which it is being used, i.e., is it being used to make purchases or do other things that are specifically excluded from normal income? In short, before determining if a business loan interest is taxable income, you must determine the gross proceeds advanced and the manner in which they will be used.
A business loan is, in many respects, a conventional loan. This means that the lender is assuming a risk in lending money to a small business. He or she has to assume that the borrower will succeed in a specific course of action. That means that the lender must commit both financial and non-financial assets to the enterprise. All of these assets are subject to UBIT, which can be described as the portion of the business loan interest that is business-related or is tangible personal property of the borrower.
The purpose of UBIT is to provide the lender with a reasonable assurance that the capital advanced will be repaid. Otherwise, there is a risk that the small business will fail. UBIT can be defined as any interest paid or credit extended to a small business, including interest paid by the business itself and any payments made by the small business to its suppliers.
It is important for all borrowers to understand that the total cost of a business loan does not reduce over time. As a matter of fact, new business loans carry higher interest rates and loan fees than older loans. Moreover, most new businesses are required to secure their loan with collateral, such as real estate. This is done because the small business is at greater risk of not being able to repay the loan. As a result, the property is seized and sold to pay the outstanding balance of the loan.
When we speak of the Internal Revenue Code, we are typically talking about income and profits of a business that is being used as collateral for a loan. This type of collateral is referred to as “equity”. It is important for you to realize that the use of equity as collateral is only for special tax purposes. In general, equity will not be taxable, but you could be required to report the value of your “equity”.
Another way to look at equity is that it is the “revenue product” of your business. Equity will increase over time and will eventually produce surplus income. You should keep in mind that when a business receives a loan, most of their money is already earmarked for future growth and . . . . . . expansion. When a loan is issued, future payments are based on the amount of equity already remaining in the company.
The last way to define equity is by using the tax law term, “interest”. We generally divide interest between capital and profits. Interest is considered to be an expense for the benefit of the borrower. Because the lender is always making a profit, the interest is taxable. This means that if you receive a loan for a percentage of your capital and that amount is interest paid over time, then the loan will be taxable.
It may not seem obvious, but in order to claim your interest on a loan for your business, you must claim the interest as an itemized deduction on your personal income tax return. However, the loan will always have interest as its primary component. The IRS has established the terms and guidelines for calculating interest and you need to abide by these rules. If you fail to do so, you could be subjected to harsh penalties. However, if you do claim your interest on your business loan, you need to pay taxes at the normal tax rate regardless of what the tax bracket you are in. In short, when it comes to business loans and interest, the answer is “yes.”