The Tax Consequences Of Debt Financing For Small Business Loans
Close-up of JP Morgan Chase and Co sign outside an office building in the SoMa neighborhood, San ... More Francisco, California, March 18, 2025. (Photo by Smith Collection/Gado/Getty Images)
Small business loans
Small businesses require financing, often using equity or debt. Financing decisions can significantly influence business outcomes. High-interest or unstructured loans have been linked to increased business insolvency rates over time.
Interest deduction limitations on some larger businesses
The Tax Cuts and Jobs Act of 2017 placed new limitations on how much interest certain businesses can deduct. These changes are outlined in Internal Revenue Code section 163(j). Businesses with gross receipts averaging $31 million or less over the prior three tax years are not subject to these limitations.
Loans from business owners
Many owners lend money to the business, especially in the early stages of operation:
At least the minimum applicable federal interest rate must be charged on these loans. The business will deduct the interest as an expense, and the owner will count the interest paid to them as interest income.
Documenting these loans with promissory notes and repayment schedules is necessary to comply with IRS requirements.
Related-party loans are subject to specific IRS rules.
General thoughts on business loans
If you take out a loan or get a cash advance, it is extremely important that you understand the terms:
Please read all of the fine print.
Are there penalties for early payment?
Does the interest rate change?
Are there other fees involved?
Borrowers should evaluate the consequences of missed or late payments.
Borrowers should review all loan terms thoroughly and negotiate changes as appropriate.
Different states have different regulations regarding loans and cash advances.
Traditional lenders and banks
Traditional lenders and banks frequently provide loans to businesses with sufficient credit or collateral. These loans can be term loans or lines of credit. The interest rates might be specific or might be variable over time. These loans are very common and relatively straightforward. They are heavily regulated and insured by the Federal Deposit Insurance Corporation.
Traditional lenders and banks dominate business lending. Some Americans cannot qualify for these loans due to low credit scores, high debt-to-income ratios, insufficient income, or unemployment. Further, the traditional loan process often requires a fair amount of paperwork and time to complete.
Private lenders
Private lenders are rapidly expanding their market share and are not subject to the same level of regulation as traditional lenders. 75% of all private lending in the world occurs in the United States. Currently, private lending is growing three times as quickly as traditional lending.
Private lenders typically impose higher interest rates and fees to offset higher risk.
Merchant cash advances
A Merchant Cash Advance (MCA) is business financing where a company receives a lump sum of cash in exchange for a portion of receivables or future sales. An MCA is not a loan and is not subject to as many regulations as private lenders. These loans are often riskier and typically result in higher fees. I analyzed 11 MCA advances from six lenders to four different businesses and this showed effective annual fees from 60% to 144%.
Significant marketing by private lenders and MCAs
Private lenders and MCAs market their offerings through the following strategies:
Fast approvals, often promised within 24 to 72 hours.
Streamlined approval process with minimal paperwork.
Options for borrowers rejected by traditional lenders.
What is tax deductible when your business has a loan or cash advance
From an accounting and tax standpoint, money loaned or advanced to the business is recorded as a liability on the balance sheet. Repaying the principal reduces this liability on the balance sheet and does not affect the income statement.
Anything paid to the lender that does not lower the principal is either a financing fee or interest. Both are tax deductible on the income statement for tax purposes as ordinary business expenses.
Conclusions
When and how businesses are financed and the fees associated with small business loans vary greatly and the available options are expanding.
Verify eligibility for full interest deductibility under IRC 163(j).
Understand all terms before borrowing.
Nontraditional loans often come with significantly higher costs.
Borrowers should assess the total repayment obligations before proceeding.
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