Taxes and interest are two types of expenses that are hard to avoid. In the course of your business activities, you may pay various taxes and interest charges. Most taxes and interest payments are deductible; some are not.
For further information about deducting taxes and interest, see IRS Publication 535, Business Expenses.
In order to deduct taxes, they must be imposed on you. The tax must be owed by the party who pays it. If your corporation owns an office building, it is the party that owes the real property taxes. If, as part of your lease, you are obligated to pay your landlord's taxes, you can deduct your payment as an additional part of your rent; you do not claim a deduction for taxes, since you are not the owner of the property.
Taxes must be paid during the year if you are on a cash basis. If you pay taxes at year end by means of a check or even a credit card charge, the tax is deductible in the year the check is sent or delivered or the credit charge is made. This is so even though the check is not cashed until the following year or you do not pay the credit card bill until the following year. If you pay any tax by phone or through your computer, the tax is deductible on the date of payment reported on the statement issued by the financial institution through which the payment is made. If you contest a liability and do not pay it until the issue is settled, you cannot deduct the tax until it is actually paid. It may be advisable to settle a disputed liability in order to fix the amount and claim a deduction. If you pay tax after the end of the year for a liability that relates to the prior year, you deduct the tax in the year of payment.
If you receive a state or local location tax incentive in the form of an abatement, a credit, a deduction, a rate reduction, or an exemption in order to attract your company to a particular area, the incentive is not deductible. Only the amount of tax you are liable for, after reduction by any location tax incentive(s), is deductible.
In general, real property taxes are deductible. Assessments made to real property for the repair or maintenance of some local benefit (such as streets, sidewalks, or sewers) are treated as deductible taxes.
If you acquire real property for resale to customers, you may be required under uniform capitalization rules to capitalize these taxes. The uniform capitalization rules are discussed in Chapter 2.
Special rules apply when real estate is sold during the year. Real property taxes must be allocated between the buyer and seller according to the number of days in the real property tax year. The seller can deduct the taxes up to, but not including, the date of sale. The buyer can deduct the taxes from the date of sale onward.
Accrual basis taxpayers can deduct only taxes accruing on the date of sale. An accrual basis taxpayer can elect to accrue ratably real property taxes related to a definite period of time over that period of time.
The election to accrue taxes ratably applies for each separate business. If one business owns two properties, an election covers both properties. The election is binding and can be revoked only with the consent of the IRS. You make the election by attaching a statement to your return for the first year that real property taxes are due on property that includes the businesses for which the election is being made, the period of time to which the taxes relate, and a computation of the real property tax deduction for the first year of the election. The election must be filed on time with your income tax return (including extensions).
If you have already owned property for some time but want to switch to the ratable accrual method, you must obtain the consent of the IRS. To do so, file Form 3115, Change in Accounting Method, within the year for which the change is to be effective.
A corporation that pays state and local income taxes can deduct the taxes on its return. Taxes may include state corporate income taxes and any franchise tax (which is a tax for operating as a corporation and has nothing to do with being a franchise business).
A self-employed individual who pays state and local taxes with respect to business income reported on Schedule C or E can deduct them only as an itemized deduction on Schedule A. Similarly, an employee who pays state and local taxes with respect to compensation from employment usually deducts these taxes on Schedule A.
Businesses do not pay self-employment tax; individuals do. Sole proprietors, general partners (whether active or inactive), and certain LLC members pay self-employment tax on their net earnings from self-employment (amounts reported on Schedule C or as self-employment income on Schedule K-1). Limited partners do not pay self-employment tax on their share of income from the business. However, limited partners are subject to self-employment tax if they perform any services for the business or receive any guaranteed payments. LLC members who are like general partners pay self-employment tax; those who are like limited partners do not. The IRS had been precluded from issuing regulations defining a limited partner before July 1,1998. To date, the IRS still has not issued any regulations even though it has been on the IRS Priority Guidance List for a number of years.
The tax rate for the Social Security portion of self-employment tax is 12.4% and, in 2017, applies to net earnings from self-employment up to $127,200. The Medicare tax rate is 2.9%, and it applies to all net earnings from self-employment (there is no limit for the Medicare portion of self-employment tax).
Those who pay self-employment tax are entitled to deduct one-half of the self-employment tax as an adjustment to gross income on their personal income tax returns. The deduction on page 1 of Form 1040 reduces your gross income and serves to lower the threshold for certain itemized deductions.
In figuring self-employment tax, net earnings from self-employment cannot be reduced by any net operating loss carryback or carryover.
While S corporations are pass-through entities similar to partnerships and LLCs, owners of S corporations who work for their businesses are not treated the same as partners and LLC members for purposes of self-employment tax. Owners of S corporations who are also employees of their businesses do not pay self-employment tax on their compensation—they are employees of the corporation for purposes of employment tax. Their compensation is subject to FICA, not to self-employment tax. Individuals who are both self-employed and have an interest in an S corporation cannot use losses from the S corporation to reduce net earnings from self-employment.
For more on self-employment tax, see Chapter 29.
The additional 0.9% Medicare tax on earnings (wages, other taxable compensation, and self-employment income) over a threshold amount and the 3.8% Medicare tax on net investment income (which includes, for example, income from a partnership or an S corporation in which you do not materially participate and gains from the sale of an interest in a partnership or S corporation in which you do not materially participate) are not deductible. They are viewed as personal taxes even though they relate to business income.
Personal property tax on any property used in a business is deductible. Personal property tax is an ad valorem tax—a tax on the value of personal property. For example, a floor tax is a property tax levied on inventory that is sitting on the floor (or shelves) of your business. Registration fees for the right to use property within the state in your trade or business are deductible. If the fees are based on the value of the property, they are considered a personal property tax.
Sales tax to acquire a depreciable asset used in a trade or business is added to the basis of the asset and is recovered through depreciation. If sales tax is paid to acquire a nondepreciable asset, it is still treated as part of the cost of the asset and is deducted as part of the asset's expense. For example, sales tax on business stationery is part of the cost of the stationery and is deducted as part of that cost (not as a separate sales tax deduction). Sales tax paid on property acquired for resale is also treated as part of the cost of that property.
Sales tax you collect as a merchant or other business owner and turn over to the state is deductible only if you include it in your gross receipts. If the sales tax is not included, it is not deductible.
When sales tax is imposed on the seller or retailer and the seller or retailer can separately state the tax or pass it on to the consumer, then the consumer, rather than the seller or retailer, gets to deduct the tax. When the consumer is in business, the tax is treated differently depending on how the asset is acquired. (See the aforementioned details for depreciable property, nondepreciable property, and property held for sale or resale.)
A compensating use tax is treated as a sales tax. This type of tax is imposed on the use, storage, or consumption of an item brought in from another taxing jurisdiction. Typically, it is imposed at the same percentage as a sales tax.
To learn about obtaining a resale number or certificate needed for the collection of sales taxes and your sales tax obligations, contact your state tax department. You can find it through a link to your state's government from the IRS at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/State-Links-1.
Like sales tax, a luxury tax that is paid to acquire a depreciable asset is added to the basis of the asset; it is not separately deductible. For example, if you pay a luxury tax to acquire a high-priced car to use for business, the amount of the tax becomes part of the car's basis for purposes of depreciation.
Employment taxes, also called payroll taxes, are a conglomerate of a number of different taxes:
The employer share of Federal Insurance Contribution Act (FICA) tax covering Social Security and Medicare taxes
Federal Unemployment Tax Act (FUTA) tax
State unemployment tax
Employment taxes are fully deductible by an employer. This is so even if an employer claims the payroll tax credit for the employer share of Social Security tax (see Chapters 23 and 29). The employer portion of the Social Security tax is 6.2%. This tax is applied to a current wage base of up to $127,200 in 2017, which is adjusted annually for inflation. The employer portion of the Medicare tax is 1.45%. This is applied to all wages paid to an employee; there is no wage base limit. If you, as an employer, pay both the employer and employee portion of the tax, you may claim a deduction for your full payments. Your payment of the employee's share of FICA is additional compensation to the employee but does not trigger additional FICA for you or the employee.
If you are in a dispute over employment taxes with the IRS and you lose, requiring you to pay back taxes and you pay the employee share to avoid adverse employee reaction, you may deduct the employee share as well. The IRS views your payment in this instance as having a valid business reason even though you are not legally obligated to pay the employee share of FICA.
You may also be liable for federal unemployment tax (FUTA) for your employees. The FUTA tax is fully deductible. The gross federal unemployment tax rate for FUTA is 6%. This is applied to employee wages up to $7,000, for a maximum FUTA tax of $434 per employee. However, you may claim a credit of up to 5.4% for state unemployment tax that you pay, bringing the maximum FUTA tax to $56 per employee. If your state unemployment tax rate is 5.4% or more, then the net FUTA rate is 0.6%. Even if your state unemployment rate is less than 5.4%, you are permitted to claim a full reduction of 5.4%.
However, if your state has failed to repay funds borrowed from the federal government to cover state unemployment tax benefits, the federal credit for FUTA is reduced. For 2016, employers in only one state (California) were subject to FUTA tax increases when the Department of Labor named the “credit reduction states.” Employers in this state had a reduced credit for state unemployment taxes; the reduction rate was 1.8%. A 0.3% additional FUTA amount translates into $21 per employee earning $7,000 or more.
The credit reduction states for 2017 FUTA are set to be announced by the Department of Labor in November 2017. A final list of credit reduction states will be in the Supplement to this book and on Schedule A of the 2017 Form 940.
These tax payments are deductible by you as an employer. A complete discussion of employment taxes can be found in Chapter 29.
An employer who pays into a state disability or unemployment insurance fund may deduct the payments as taxes. An employee who must contribute to the following state benefit funds for disability, unemployment, or family leave benefits can deduct the payments as state income taxes on Schedule A:
Alaska—State Unemployment Fund
California—Nonoccupational Disability Benefit Fund, the State Unemployment Fund, and Paid Family Leave program
New Jersey—Nonoccupational Disability Benefit Fund, the State Unemployment Fund, and Family Leave Insurance program
New York—Nonoccupational Disability Benefit Fund
Pennsylvania—State Unemployment Fund
Rhode Island—Temporary Disability Benefit Fund
Washington—Supplemental Workmen's Compensation Trust Fund
The deduction for these taxes is not subject to a 2%-of-adjusted-gross-income floor (see Chapter 1), as is the case with other employee business expenses. However, if the option to deduct state and local sales taxes in lieu of state and local income taxes, then no deduction for these employee contributions are allowed if you opt to deduct state and local sales taxes.
Hawaii requires employers to maintain temporary disability insurance. Employers are permitted to pass on up to 50% of premium costs to employees, but employees cannot deduct their withholding; their payments are not a tax.
Corporate franchise taxes (which is another term that may be used for state corporate income taxes and has nothing to do with whether the corporation is a franchise) are a deductible business expense. Your state may or may not impose franchise taxes on S corporations, so check with your state corporate tax department.
Excise taxes paid or incurred in a trade or business are deductible as operating expenses. For example, indoor tanning salons can deduct the 10% excise tax that they pay on their services. A credit for federal excise tax on certain fuels may be claimed as explained in the following section.
Taxes on gas, diesel fuel, and other motor fuels used in your business are deductible. As a practical matter, they are included in the cost of the fuel and are not separately stated. Thus, they are deducted as a fuel cost rather than as a tax.
However, in certain instances, you may be eligible for a credit for the federal excise tax on certain fuels. The credit applies to fuel used in machinery and off-highway vehicles (such as tractors), and kerosene used for heating, lighting, and cooking on a farm.
You have a choice: Claim a tax credit for the federal excise tax or claim a refund of this tax. You can claim a quarterly refund for the first 3 quarters of the year if the refund is $750 or more. If you do not exceed $750 in a quarter, then you can carry over this refund amount to the following quarter and add it to the refund due at that time. But if, after carrying the refund forward to the fourth quarter you do not exceed $750, then you must recoup the excise tax through a tax credit.
Alternatively, if you have pesticides or fertilizers applied aerially, you may waive your right to the credit or refund, allowing the applicator to claim it (something that would reduce your application charges). If you want to waive the credit or refund, you must sign an irrevocable waiver and give a copy of it to the applicator. For further information on this credit, see Chapter 29 and IRS Publication 510, Excise Taxes.
Income taxes paid to a foreign country or U.S. possession may be claimed as a deduction or a tax credit. To claim foreign income taxes as a tax credit, you must file Form 1116, Foreign Tax Credit (unless as an individual you have foreign tax of $300 or less, or $600 or less on a joint return). Corporations claim the foreign tax credit on Form 1118. The same rules apply for foreign real property taxes paid with respect to real property owned in a foreign country or U.S. possession.
If an S corporation pays a built-in gains tax on the sale of certain property (see Chapter 4), the tax it pays is deductible. If the tax is attributable to ordinary gain, then it is deductible as a tax (on page 1 of Form 1120S). If it is attributable to short-term or long-term capital gain, then it is claimed as a short-term or long-term capital loss on Schedule D of Form 1120S.
If a corporation pays a tax imposed on a shareholder and the shareholder does not reimburse the corporation, then the corporation, and not the shareholder, is entitled to claim the deduction for the payment of the tax.
You may not deduct federal income taxes, even the amount paid with respect to your business income. These are nondeductible taxes.
Other nondeductible taxes include:
Additional 0.9% Medicare tax on earned income and 3.8% net investment income tax.
Assessments on real property for local benefits that tend to add to the value of the property. Such assessments may be made, for example, to build sidewalks, streets, sewers, or parks. These assessments are added to the basis of the property. But assessments for maintenance purposes (such as for repairs to sidewalks, streets, and sewers) are deductible. Water bills, sewage, and other service charges are not treated as taxes. They are, however, deductible as business expenses.
Employee portion of FICA and railroad retirement taxes covering Social Security and Medicare contributions.
Employee contributions to private or voluntary disability plans.
Fines imposed by a governmental authority. These are not deductible as a tax even if incurred in a trade or business. For example, if while traveling away from home on business you receive a fine for a speeding ticket, the fine is not deductible.
Penalties imposed by the federal government on taxes or for failing to file returns. These are not deductible even though they may be computed with regard to the length of time the taxpayer has failed to comply with a tax law requirement.
Occupational taxes.
Interest paid or incurred on debts related to your business is generally fully deductible as business interest. Business interest is deductible without limitation, except when such interest is required to be capitalized. (Remember, for example, that construction period interest and taxes must be capitalized, as explained earlier in this chapter.) There is one main exception to the general deductibility rule for business interest: interest on life insurance policies. (The limits on deducting interest with respect to life insurance policies are discussed in Chapter 22.)
Interest is characterized by how and for what the proceeds of the loan that generated the interest are used. Personal interest is nondeductible (except to the extent of qualified home mortgage interest and a limited amount of student loan interest). Investment interest is deductible only to the extent of net investment income. Interest characterized as incurred in a passive activity is subject to the passive loss rules. The characterization is not dependent on what type of property—business or personal—was used as collateral for the loan. For example, if you borrow against your personal life insurance policy and use the proceeds to buy equipment for your business, you can deduct the interest as business interest. On the other hand, if you take a bank loan using your corporate stock as collateral, and use the proceeds to invest in the stock market, the interest is characterized as investment interest. Interest on a tax deficiency relating to Schedules C, E, or F is nondeductible personal interest. While the Tax Court had allowed a deduction for this interest, several appellate courts have sided with the IRS in denying a deduction for this interest.
If the proceeds are used for more than one purpose, you must make an allocation based on the use of the loan's proceeds. When you repay a part of the loan, the repayments are treated as repaying the loan in this order:
Amounts allocated to personal use
Amounts allocated to investments and passive activities
Amounts allocated to passive activities in connection with rental real estate in which you actively participate
Amounts allocated to business use
The interest obligation must be yours in order for you to claim an interest deduction. If you pay off someone else's loan, you cannot deduct the interest you pay. If you are contractually obligated to make the payment, you may be able to deduct your payment as some other expense item, but not as interest.
Note: A current deduction for self-charged interest (interest you effectively charge yourself through multiple business activities) is limited under the passive activity loss rules (see Chapter 4).
If you use loan proceeds to buy an interest in a partnership, LLC, or S corporation or to make a contribution to capital, this is treated as a debt-financed acquisition. In this case, you must allocate the interest on the loan based on the assets of the pass-through business. The allocation can be based on book value, market value, or the adjusted bases of the assets.
If you, as an S corporation shareholder, LLC member, or partner, receive proceeds from a debt, you must also allocate the debt proceeds. These are called debt-financed distributions. Under a general allocation rule, debt proceeds distributed to an owner of a pass-through entity are allocated to the owner's use of the proceeds. Thus, if the owner uses the proceeds for personal purposes, the pass-through entity must treat the interest as nondeductible personal interest. Under an optional allocation rule, the pass-through entity may allocate the proceeds (and related interest) to one or more of the entity's expenditures other than distributions. The expenditures to which the debt is allocated are those made in the same year as the allocation is made (see IRS Notice 89-35 for allocations in pass-through entities).
If you borrow money to buy stock in a closely held C corporation, the Tax Court considers the interest to be investment interest. The reason: C corporation stock, like any publicly traded stock, is held for investment. This is so even if the corporation never pays out investment income (dividends) or the purchase of the stock is made to protect one's employment with the corporation.
Special care must be taken when shareholders lend money to their corporation, and vice versa, or when shareholders guarantee third-party loans made to their corporation.
If a corporation borrows from its shareholders, the corporation can deduct the interest it pays on the loan. The issue sometimes raised by the IRS in these types of loans is whether there is any real indebtedness. Sometimes loans are used in place of dividends to transform nondeductible dividend payments into deductible interest. In order for a loan to withstand IRS scrutiny, be prepared to show a written instrument bearing a fixed maturity date for the repayment of the loan. The instrument should also state a fixed rate of interest. There should be a valid business reason for this borrowing arrangement (such as evidence that the corporation could not borrow from a commercial source at a reasonable rate of interest). If the loan is subordinated to the claims of corporate creditors, this tends to show that it is not a true debt, but other factors may prove otherwise. Also, when a corporation is heavily indebted to shareholders, the debt-to-equity ratio may indicate that the loans are not true loans but are merely disguised equity.
When a corporation fails to repay a loan to a shareholder, this may give rise to a bad debt deduction for the shareholder. Bad debts are discussed in Chapter 11.
For small businesses, banks or other lenders usually require personal guarantees by the corporation's principal shareholders as a condition for making loans to the corporation. This arrangement raises one of the basic rules for deducting interest discussed earlier: The obligation must be yours in order for you to deduct the interest.
When shareholders and their corporations arrange loans between themselves, they may set interest rates at less than or more than the going market rate of interest. This may be done for a number of reasons, including to ease the financial burden on a party to the loan or to create a tax advantage. Whatever the reason, it is important to understand the consequences of the arrangement.
If you receive an interest-free or below-market-interest loan, you may still be able to claim an interest deduction. You can claim an interest deduction equal to the sum of the interest you actually pay, plus the amount of interest that the lender is required to report as income under the below-market loan rules. The amount that the lender is required to report as income is fixed according to interest rates set monthly by the IRS. Different rates apply according to the term of the loan.
Short-term loans run 3 years or less.
Mid-term loans run more than 3 but less than 9 years.
Long-term loans run more than 9 years.
Rates required to be charged in order to avoid imputed interest are called the applicable federal rates (AFRs). You can find an index of AFRs by entering “applicable federal rates” in the search box at www.irs.gov. If a loan is payable on demand, the short-term rate applies. However, if the loan is outstanding for an entire year, you can use a blended annual rate (1.09% for 2017) provided by the IRS to simplify the computation of the taxable imputed interest.
Whether you are required to report this amount as income (which would, in effect, offset the interest deduction) depends on the amount of the loan and the context in which it was made. If it was treated as compensation or a dividend, you have to include it in income. If it was considered a gift loan, you do not have additional income. Gift loans are loans up to $10,000 (as long as the loan is not made for tax avoidance purposes). The corporation (lender) must report the interest as income. If the loan is to an employee, an offsetting deduction can be taken for compensation. But if the loan is to a nonemployee, such as a shareholder who does not work for the corporation, no offsetting deduction can be taken.
Instead of borrowing from a bank, your corporation may be able to borrow from a relative of yours, such as your child or parent, to whom you want to make gifts. You can turn the arrangement into a profitable one for both your corporation and your relative (the lender). Set the interest rate at more than what would be charged by the bank. Provided that the interest is still considered “reasonable” and the loan is an arm's-length transaction, your corporation deducts the interest, and the lender receives it. If an unreasonably high rate of interest is charged and the arrangement is not at arm's length, however, the IRS will attack the arrangement and may disallow the interest as being a disguised dividend payment to you.
If you are self-employed, use a portion of your home for business, and claim a home office deduction under the actual expense method (explained in Chapter 18), you must allocate the home mortgage interest. The portion of the interest on the mortgage allocated to the business use is deducted on Form 8829, Expenses for Business Use of Your Home. The balance is treated as personal mortgage interest deductible as an itemized expense on Schedule A.
If you borrow additional funds from the same lender to pay off a first loan for business, you cannot claim an interest deduction. Once you begin paying off the new loan, you can deduct interest on both the old and new loans. Payments are treated as being applied to the old loan first and then to the new loan. All interest payments are then deductible.
As in the case of taxes, if interest is paid to acquire a capital asset for resale, you must capitalize the interest expense. The interest is recovered when the asset is sold.
Fees paid to have business funds available for drawing on a standby basis are not treated as deductible interest payments. They may, however, be deductible as business expenses. Fees paid to obtain a loan may be treated as deductible interest. However, the fees are not immediately deductible; rather, they are deductible only over the term of the loan. If the loan falls through, the fees can be deducted as a loss.
Similarly, points paid to acquire a loan on business property are treated as prepaid interest. They are not currently deductible as such. Instead, they are deductible over the term of the loan.
If you pay off the loan before the end of the term (before you have fully deducted the prepaid interest), you can deduct the remaining balance of prepaid interest in the final year of payment.
If you pay interest on a tax deficiency arising from business income from your sole proprietorship, S corporation, partnership, or LLC, you cannot deduct the interest on your individual return. This interest is treated as nondeductible personal interest even though business income generated the deficiency.
While a C corporation can deduct interest it pays on any tax deficiency, it cannot deduct tax penalties. This rule applies to both civil and criminal penalties.
For both individuals and corporations, amounts assessed for the delay of filing a return are considered penalties. Thus, estimated tax penalties, which are imposed because of a delay in payment, are not deductible even though they are calculated by application of an interest rate. Similarly, amounts owed because of the failure to deposit employment taxes are treated as penalties. Additions to tax contained in Sections 6651 through 6658 of the Internal Revenue Code are considered penalties. The shared responsibility payments for individuals and employers under the Affordable Care Act are nondeductible tax penalties.
No deduction is allowed for interest paid or incurred to buy or carry tax-exempt securities.