Tax Deductions for Your Small Business Loan Payment: What’s Covered?

During the US tax season, many entrepreneurs try to minimize their income tax burden by checking every possible expense. At times, entrepreneurs get confused about the small business loan payment. Are the loan payments deductible? Does every dollar that you pay on your business loan reduce your tax burden? Knowing the IRS policy on your small business loan payment can help you minimize your income tax burden. So, let’s discuss what’s included in the loan payment and what’s not.

Is a Small Business Loan Payment Tax-Deductible?

The answer is partially yes.

A small business loan payment comprises two parts: 

• Principal: The amount of money you borrowed. 
• Interest: The cost of borrowing the money.

The IRS only allows you to claim a deduction on the interest amount. The principal amount cannot be deducted. However, if the loan amount has been used for a legitimate business purpose, then it can be deducted. This is an important concept to understand to plan taxes properly.

Reasons Why the Principal Amount Is Not Deducted

The amount borrowed from a business loan is not considered part of your income. Since it has not been taxed, it cannot be deducted. Every business loan installment paid on a small business loan only serves to reduce the outstanding balance on the loan. The business cannot claim it as an expense. This rule applies to all forms of business loans, whether it’s from a bank, an online lender, or an individual.

The Interest Portion: What You Can Deduct

The interest portion of your small business loan payment can be deducted as a business expense. This is because the interest represents the cost of borrowed funds used to operate or expand your business. You can deduct the interest on your loan payment if:

• The debt is legally liable to your business
• There is a real debtor-creditor relationship
• The borrowed funds were used for legitimate business purposes

For example, if your small business loan payment includes funds used to buy inventory, improve equipment, pay salaries, advertise, expand, etc., then the interest on the loan can be deducted as an expense.

What About Paying an SBA Loan?

You can do SBA loan payments like any other loan; the same rules apply to SBA loan payments, too. The principal amount of your loan payment is not deductible. However, the interest paid on an SBA-backed loan is usually deductible as long as the funds have been used for approved business purposes. This includes some of the most popular SBA programs, such as:

• SBA 7(a) loans
• SBA 504 loans
• SBA microloans

The longer repayment terms on an SBA loan mean that it’s especially important to keep good records of all the interest you’ve paid on your SBA loan throughout its lifetime.

Special Situations to Consider

• Loan Origination Fees: The fees associated with loans may be tax-deductible over time. They may have to be deducted over time as per the duration of the loan. They may not qualify for the full deduction of all of them at one time.
• Refinancing: If there is any refinancing of the loan with a new small business loan payment as per the new terms and conditions, then the interest may still qualify for deduction as per the same rules.
• Loan Used for Mixed Purposes: If the loan has been used for both business and personal purposes, then only the portion of the interest as per the business use may qualify for deduction. Proper segregation needs to take place.

How to Properly Classify Your Small Business Loan Payment

Improper classification of small business loan payments may result in an IRS audit. Accurate bookkeeping will enable you to claim every dollar of allowable interest expense while remaining tax compliant. To maximize tax benefits:

• Distinguish between principal and interest for every small business loan payment
• Record the interest as a business expense
• Keep all statements from the lender
• Consult with a CPA or tax professional

Recommendations for Tax Preparation for Business Owners

When small business owners can clearly understand the treatment of each small business loan repayment, they can effectively plan for taxes and maximize their overall financial strategy.

• Be sure to review your annual loan summary prior to filing your taxes.
• Match your accounting records with your lender’s records.
• Confirm the total amount of interest paid in the tax year.
• Create a cash flow plan for your future small business loan repayments.

Conclusion

The small business loan repayment deductible amount is limited. Although you cannot claim the principal amount, you may claim the interest part as a business expense. The same applies to business loan repayments and any SBA loan payment made during the year. Getting the right classification and planning will go a long way in helping you claim the most deductions and keeping you on the right side of the IRS. The knowledge of what to claim and what not to claim will enable you to handle the tax season with ease and confidence.