When you take out personal loans to buy a business, you want to maximize the tax write-offs for the resulting interest expense. The tax law in this area is tricky. But if you play your cards right, you can get the best possible outcome.
Mortgage Interest On a Home Office
If you have a deductible home office that is used in your sole proprietorship, LLC or partnership business, you can write off part of your mortgage interest.
For example, if 20% of your home is used as a deductible office for a sole proprietorship business, 20% of your mortgage interest can be deducted on your tax return.
Claiming the interest on your tax return reduces your income and self-employment tax bills.
Unfortunately, if you are an S or C corporation shareholder-employee, a home office write-off is considered an unreimbursed employee business expense. As such, it's a miscellaneous itemized deduction. You receive no tax benefit unless your total miscellaneous itemized deductions exceed 2% of your adjusted gross income.
First, you need to trace your interest expense outlays. Under tax law, any interest expense you incur must be classified into one of four categories:
1. Business interest, which is deductible in full.
2. Passive interest applies only to interest on loans to finance business activities in which you do not "materially participate."
How is this defined? According to the IRS, a taxpayer materially participates in an activity if he or she works on a regular, continuous and substantial basis in operations.
Passive interest is deductible in the current tax year if you have enough passive income but deferred to future tax years if you do not.
3. Investment interest is also deductible in the current tax year if you have enough investment income but deferred to future tax years if you do not.
4. Personal interest, which includes currently deductible qualified residence interest (from mortgages on up to two homes), currently deductible college loan interest, and nondeductible consumer interest (usually from credit cards that are not used for business and non-business car loans).
Once you trace how you used loan proceeds in each of the four categories, the corresponding interest expense goes into the same category.
Here's how the allocation works in various situations:
Loans to Buy a Sole Proprietorship or Single-Member LLC
When you use personal loan proceeds to buy a sole proprietorship business and you materially participate in the business, you are entitled to a full write-off on Schedule C.
Schedule C interest write-offs reduce your income, self-employment tax bills and your adjusted gross income (AGI). Lower AGI means it's less likely you'll be adversely affected by AGI-sensitive "phase-out rules" for various tax breaks, such as the dependent child and college tax credits.
As an individual, if you borrow to buy a business operated as a single-member LLC (SMLLC), the IRS views this as the same as buying the assets of a sole proprietorship. So as long as you materially participate in the new business, you can deduct 100% of the interest as a business expense.
What if you borrow money to inject capital into your existing SMLLC? You can deduct 100% of the interest on Schedule C as long as you:
- Deposit the loan proceeds into the SMLLC's checking account.
- Use all the money on business expenditures.
- Materially participate in the business.
Important: Always use a separate bank account for your sole proprietorship or SMLLC's activities. When you deposit borrowed funds into that account, there will be no doubt the money was used for business purposes.
Borrowing to Buy a S Corporation Multi-Member LLC or Partnership
Here's an example to illustrate how you allocate interest if you use loan proceeds to buy an ownership interest in an S Corporation, multi-member LLC or partnership. According to the IRS, you can allocate the loan proceeds using any "reasonable" method.
Let's say you are part of a small group purchasing all the ownership interests of a multi-member LLC that distributes health products. You pay $150,000 for a 25% stake using a bank loan at 10% interest. Assume the LLC's only assets are business equipment with a fair market value (FMV) of $600,000 and an installment note receivable with FMV of $200,000. The LLC also has $200,000 of debt allocable to the equipment. You materially participate in the business.
The question is how to handle the $15,000 of annual interest on the bank loan taken to finance your ownership position. One reasonable approach would be to allocate $100,000 of your debt to the LLC's business assets and the remaining $50,000 to the note receivable. This allocation is in proportion to your share of the net-of-debt FMV of the LLC's assets.
You would treat $10,000, or two thirds, of the bank loan interest as business interest that is fully deductible on Schedule E. Treat the remaining $5,000, or one third, as investment interest (the note receivable is an investment asset), using Form 4952 to calculate your investment interest write-off, which then goes on Schedule A.
Variation No. 1: Now assume you are not active in the business. If you use the same FMV net-of-debt allocation method, $10,000 of the bank loan interest expense falls into the passive expense category. The remaining $5,000 is still classified as investment interest.
Variation No. 2: What if you materially participate in the business and the LLC has nothing but business assets? In that case, 100% of your interest is fully deductible as a business expense on Schedule E.
As you can see, properly handling interest write-offs is critical to getting the best tax results. Your tax advisor can plot the best strategy to deal with these expenses.