If you are a business owner, you should be careful about what you claim as deductions on your business tax returns. Claiming the wrong deductions can cause problems for you. Not all interest is deductible. Personal interest, interest paid on money borrowed to buy personal items such as clothing, gifts, artwork, furniture, and cars not used for business, is not deductible at all.
Business interest, interest paid on money borrowed to use in a trade or business, is always deductible in full. For the business owner, the goal is to separate business borrowings from investment or personal borrowings and, whenever possible, to borrow for or through the business. It is the failure to make this separation that gets businesspeople into trouble.
People who run their businesses through corporations often make the mistake of taking out a loan themselves to obtain money that is needed by their corporations. If their business needs money, they borrow the money as individuals and put it into the corporation, either because the bank won’t lend to the corporation or because they never think to have the corporation take out the loan in the first place.
Financing your business in this manner is likely to cost you interest deductions. For your corporation, the loan would be a business loan and the interest would be fully deductible. But not for you; for you, the stock you own in your own corporation is an investment for tax purposes, so when you borrow money and then put it into your corporation (either as a loan to the company or as a contribution to its capital), the loan is considered an investment loan, not a business loan, and the interest that you pay on the loan is considered investment interest, not business interest. It is deductible only to the extent that you earn investment income. This is fine if you have investment income, but if you don’t, then you have lost an interest deduction that could have been claimed very easily by the corporation. Unless there are other compelling reasons, therefore, never borrow money yourself to obtain funds needed by your corporation. You should always let the corporation borrow the money, even if you have to guarantee the loan. Limitations on deducting investment interest don’t apply to corporations. Those limitations apply only to individuals. If a corporation borrows money to invest in the stock market, therefore, all of the interest that it pays on the loan is deductible even if the corporation has no (or insufficient) investment income during the year. Consequently, if you run your business through a corporation (other than an S corporation) and you intend to borrow money to make an investment, consider doing so through your corporation so that the interest paid on the loan will be fully deductible.
S corporations are real corporations under state law and provide you with all the protection of a real corporation. They act as a shield against your business creditors (assuming you have not guaranteed the corporation’s debts). But S corporations are mostly disregarded for tax purposes. You pay tax on the corporation’s profits (or deduct the corporation’s losses) as though you were running the business as a sole proprietorship. You figure the corporation’s net profits or losses, and you carry that figure to the front of your individual income tax return, adding it to (or subtracting it from) the rest of your income. With their special status, it should come as no surprise that S corporations, in order to be recognized as such, must comply with a number of specific rules. Nor should it come as a surprise that these rules frequently get S corporation owners into trouble.