During growth phases, many businesses experience capital shortfalls due to unforeseen operating expenses, uneven cash flow cycles, inventory shortfalls, or when an unexpected opportunity arises. In many cases, the need for a cash infusion is only temporary, so it may not make sense to seek long-term financing with a loan. Instead, the business’ specific cash needs may best be served with a line of credit. However, business lines of credit come with certain tax implications that should be fully understood to optimize its benefits while avoiding possible IRS traps.
What exactly is a business line of credit?
A business line of credit works much the same way as a revolving credit card account. Upon qualification, the bank or online lender issues your small business a certain amount of credit that is available for your use as the need arises. You only pay interest on the amount you actually borrow, so you can better control your interest expense. With most lines of credit, you are only required to make interest payments, so, conceivably, it can be easier on your overall business cash flow.
However, the principal will eventually have to be repaid, so it may be better to build that into your cash flow expense as well. When you repay the principal, those funds can be used again when needed. Business lines of credit are ideal for covering short-term working capital needs and smoothing out cash flow during slow months.
Although the interest rate on a line of credit is typically lower than the average credit card, the actual rate charged depends on your credit rating. For a business line of credit, banks not only consider your business and personal credit rating, they factor in your business revenues, the health of your business, as well as the general trend in the market. The bank will use those factors to determine both the amount of credit it will extend and the amount of interest it will charge. If you choose to go with a platform lender, the basis of determining how much financing you’re eligible for will be more flexible as they look at sales activity as the primary criteria instead.
Tax implications of a business line of credit
Double your tax write-offs
Let’s say you use a business line of credit to purchase new equipment for your office or construction business. The equipment purchased with cash from a line of credit may be eligible for two tax write-offs – a business deduction for the interest expense and a deduction for depreciation on the equipment. Under the bonus depreciation rules in the tax code, businesses can deduct up to 50 percent of the cost of new equipment. Together, the bonus depreciation deduction and interest expense deduction can substantially reduce your equipment costs.
Interest expense deduction
Generally, the interest charges paid on a business line of credit are considered a deductible business expense as long as it is used to pay for necessary expenses in the running of your business. Purchasing equipment, inventory, supplies or other necessary items are allowable business deductions in and of themselves, and so is the interest paid on the money that is borrowed to purchase them. However, the IRS may require an itemization of items purchased with borrowed money to justify the interest expense.
Keeping personal and business lives separate
A mistake many business owners make is to use the cash from a business line of credit to pay for personal expenses. Interest paid on a personal line of credit is not tax deductible. If it is found that even a minuscule portion of the business line of credit is used to pay for a personal expense, the IRS could reclassify it as a personal line of credit and disallow all interest charges. That is why it is important to segregate your accounts and keep detailed records of business expenditures made with the line of credit.
“Using a sales account for deposits minimizes identity theft exposure because there are no checks or cards to draw money from the account. The same protection is provided for the other accounts due to their limited purposes”
You should also consider creating separate checking accounts for different categories of funds (i.e. an account for vendors, for payroll, for deposits from revenue, for operating expenses, for travel and meals, etc.). With these accounts, you’ll be able to see how you’re doing financially throughout the month.
“For example, using a sales account for deposits minimizes identity theft exposure because there are no checks or cards to draw money from the account. The same protection is provided for the other accounts due to their limited purposes,” says Paul Spizzirri, a tax attorney.
Cash from a line of credit not counted as income
Although the cash you borrow from a line of credit adds to your working capital or cash flow, it is not counted as income for tax purposes. For reporting purposes, it may be a good idea to keep a separate account for holding borrowed money, which can also make it easier to track specific expenditures for justifying interest charges.
Every small business is different
Every small business varies, especially when it comes to taxes. Depending on the type of business you own and the state you live in, your taxes won’t be the same as everyone else’s, which means your tax implications might not include all of the above.
There are different results depending upon the character of the lender and borrower, the relationship between the parties, the legal components of debt and equity of the instrument, and the purpose of the loan”
“There are different results depending upon the character of the lender and borrower (non-profit or a c corporation, s corporation, partnership or LLC), the relationship between the parties (related party transactions may lose the interest deduction), the legal components of debt and equity of the instrument (certain preferred stock can legally be classified as debt in one jurisdiction and stock in another, so interest is a dividend in one country but interest in another and interest is deductible while dividends are not), the purpose of the loan (A CERT can trigger unintended tax costs and money borrowed to pay wages to owners is a big mistake) and much more,” says Spizzirri.
Consider hiring an accountant – either full-time or part-time – to help you set up your line of credit as well as handle your taxes. Even if you can’t hire a full-time accountant, get advice on the tax implications for your business and what they mean.
A business line of credit may be the best option for quick access to cash, but business owners should have a detailed cash flow plan in place for repaying the principal to avoid lingering interest expenses. Because a line of credit does have tax implications, business owners should consult with a tax professional to determine how it impacts their particular situation.
Constantina Kokenes is a Content Specialist at Kabbage, a small business loans provider. She holds a Master’s Degree in Journalism from Northwestern University. When not in the small business world, Constantina loves cooking, baking, going on hikes and playing with her cat and chinchilla.