Tax Implications of Business Loans: Interest, Forgiveness, and PPP

Business loan tax rules:

Loan proceeds:

• NOT taxable income (you created a corresponding liability)
• Do not report on Schedule C or Form 1120-S
• The loan increases the business’s liabilities on the balance sheet

Interest expense:

• Deductible as a business expense under IRC 163
• Must be for a bona fide loan (not a disguised equity contribution)
• Timing: cash-basis taxpayers deduct when paid; accrual-basis deduct when accrued
• Cannot prepay more than 12 months of interest and deduct it currently (IRC 461(g))
• Personal guarantee: interest on a loan used for business is deductible regardless of who guarantees it

Principal repayment:

• NOT deductible (it’s a return of borrowed capital)
• Common mistake: business owners sometimes confuse the full monthly payment (principal + interest) with a deductible expense. Only the interest portion is deductible.

Loan forgiveness (cancellation of debt income):

• Generally taxable as ordinary income under IRC 61(a)(11)
• Exceptions (income exclusion):
  • Bankruptcy (Title 11 proceedings)
  • Insolvency (liabilities exceed FMV of assets, excluded up to the insolvency amount)
  • Qualified real property business indebtedness
  • PPP loans (specifically excluded by statute)
• The excluded COD income may require reducing tax attributes (NOLs, credits, basis) under IRC 108(b)

S-Corp basis implications:

• Corporate loans do NOT create shareholder basis (only direct shareholder-to-corporation loans do)
• Personal guarantees of corporate debt do NOT create basis
• If the S-Corp has a loss and the shareholder has no basis, the loss is suspended even if the shareholder personally guaranteed the corporate loan
• This is the most common basis trap for S-Corp shareholders

IRC 163(j) interest limitation:

• Applies to businesses with average annual gross receipts exceeding $30 million
• Limits business interest deduction to 30% of adjusted taxable income
• Excess interest carries forward
• Most small businesses (under $30 million) are exempt