Handling Interest Expense on Loans to Inject Capital

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.