A business loan refinance can affect your tax situation in many ways. For example, you may find that after refinancing you have the ability to pay off your loan early, but you may face certain tax consequences if you do.
Before you refinance your debt, you should make sure you understand all the tax consequences. Fortunately, you won't have to handle them on your own. You can work in conjunction with the borrower, the lender and the borrower's tax advisor.
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Here are certain tax considerations when refinancing your business loan:
Deductions for Pre-Payment Penalties
The pre-payment example cited above could entail a potential tax consequence. According to IRS regulations, for the privilege of using the lender’s funds for a shorter period of time than originally intended, the funds are considered, for all intents and purposes, an additional interest expense.
Only after payments have started on the new loan can interest be deducted.
If the debt is refinanced, which includes the penalty amount, the prepayment penalty must be deducted in full in the reported tax year and cannot be amortized over the life of the new loan. Borrowers must also keep in mind that interest paid with funds borrowed from the original lender through a second loan, an advance, or any other arrangement similar to a loan cannot be deducted. Only after payments have started on the new loan can interest be deducted.
When payments are made on the new loan, the payment will be applied to interest first and then to principal. Any amounts applied to interest on the first loan are deductible, along with any interest from the new loan.
Original Issue Discount (OID) Deductions
Original Issue Discount (OID) is another type of interest. Many types of debt generally have OID when proceeds received by the borrower are less than the principal amount. The OID refers to the spread between the stated redemption price at maturity and the issue price of the loan.
The stated redemption price at maturity is the sum of all amounts (principal and interest) payable on the loan besides the qualified stated interest rates. Generally, one can deduct OID over the term of the loan. Using the constant-yield method, a certain amount can be deducted every year, unless the OID on the loan is “De Minimis." The OID is considered “De Minimis” if the loan is less than one-fourth of 1 percent (.0025) of the stated redemption price, multiplied by the number of full years from when the loan was originally issued to when the loan matures.
Remember, if the loan is refinanced with the original lender, the remaining OID in the year in which the refinancing takes place cannot be deducted. But it may be deducted over the term of the new loan.
According to the IRS, interest paid or incurred during the “production period,” or the time when a business owner intends to construct, build, install, manufacture, develop, improve, create, raise or grow anything on the land, must be capitalized. This is especially true if the produced property during this time is considered “designated property.”
Designated property is considered by the IRS to be any one of the following:
- Real property.
- Tangible personal property with a class life of 20 years or more.
- Tangible personal property with an estimated production period of more than 2 years.
- Tangible personal property with an estimated production period of more than 1 year if the estimated cost of production is more than $1 million.
The tax benefits of capitalized interest is captured as a cost of the property produced. The business owner realizes their interest when they use or sell the property. If the property is inventory, capitalized interest is realized through cost of goods sold. If the property is used in business, capitalized interest is realized through an adjustment to the initial cost basis, depreciation, amortization or any other generally accepted accounting principle.
A below-market loan is when the interest is charged at a rate below the applicable federal rate, or without interest at all. In certain instances, a gift or demand loan can also be considered a below-market loan. The IRS generally categorizes a below-market loan as being an arm's-length transaction where the borrower is considered having received the following:
- A loan in exchange for a note that requires the payment of interest at the applicable federal rate.
- An additional payment in an amount equal to the forgone interest.
In this instance, the additional payment is treated as a gift, dividend, contribution of capital or as compensation or any other type of payment, depending on the nature of the transaction. As a result, the loan may be subject to taxation at the prevailing income tax rate of the borrower, which is why borrowers must be very careful in this particular case.
Tax Consequences Can Vary
Most importantly, businesses can mitigate the potential tax consequences from refinancing by coordinating with both the lender and an accountant. That's one of the best ways a business can lessen any potential impact.