Page 76 - Small Business Taxes

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The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
Interest you paid or incurred during the pro- Cash method. Under the cash method, you arm's-length transaction in which you, the bor-
duction period must be capitalized if the prop- can generally deduct only the interest you ac- rower, are considered as having received both
erty produced is designated property. Designa- tually paid during the tax year. You cannot de- of the following.
ted property is any of the following. duct a promissory note you gave as payment • A loan in exchange for a note that requires
• Real property. because it is a promise to pay and not an actual the payment of interest at the AFR.
• Tangible personal property with a class life payment. • An additional payment in an amount equal
of 20 years or more. to the forgone interest.
• Tangible personal property with an estima- Prepaid interest. You generally cannot de- The additional payment is treated as a gift, divi-
ted production period of more than 2 duct any interest paid before the year it is due. dend, contribution to capital, payment of com-
years. Interest paid in advance can be deducted only pensation, or other payment, depending on the
• Tangible personal property with an estima- in the tax year in which it is due. substance of the transaction.
ted production period of more than 1 year if Discounted loan. If interest or a discount
the estimated cost of production is more is subtracted from your loan proceeds, it is not a Forgone interest. For any period, forgone in-
than $1 million. payment of interest and you cannot deduct it terest is:
when you get the loan. For more information,
Property you produce. You produce property see Original issue discount (OID) under Interest 1. The interest that would be payable for that
if you construct, build, install, manufacture, de- You Can Deduct, earlier. period if interest accrued on the loan at the
velop, improve, create, raise, or grow it. Treat AFR and was payable annually on De-
property produced for you under a contract as Refunds of interest. If you pay interest cember 31, minus
produced by you up to the amount you pay or and then receive a refund in the same tax year 2. Any interest actually payable on the loan
incur for the property. of any part of the interest, reduce your interest for the period.
deduction by the refund. If you receive the re-
Carrying charges. Carrying charges include fund in a later tax year, include the refund in AFRs are published by the IRS each
taxes you pay to carry or develop real estate or your income to the extent the deduction for the TIP month in the Internal Revenue Bulletin
to carry, transport, or install personal property. interest reduced your tax. (I.R.B.), which is available on the IRS
You can choose to capitalize carrying charges website at IRS.gov/IRB. You can also contact
not subject to the uniform capitalization rules if Accrual method. Under an accrual method, an IRS office to get these rates.
they are otherwise deductible. For more infor- you can deduct only interest that has accrued
mation, see chapter 7. during the tax year. Loans subject to the rules. The rules for be-
Capitalized interest. Treat capitalized interest Prepaid interest. You generally cannot de- low-market loans apply to the following.
as a cost of the property produced. You recover duct any interest paid before the year it is due. 1. Gift loans (below-market loans where the
your interest when you sell or use the property. Interest paid in advance can be deducted only forgone interest is in the nature of a gift).
If the property is inventory, recover capitalized in the tax year in which it is due.
interest through cost of goods sold. If the prop- Discounted loan. If interest or a discount 2. Compensation-related loans (below-mar-
ket loans between an employer and an
erty is used in your trade or business, recover is subtracted from your loan proceeds, it is not a
capitalized interest through an adjustment to payment of interest and you cannot deduct it employee or between an independent
contractor and a person for whom the con-
basis, depreciation, amortization, or other when you get the loan. For more information,
method. see Original issue discount (OID) under Interest tractor provides services).
You Can Deduct, earlier. 3. Corporation-shareholder loans.
Partnerships and S corporations. The inter-
est capitalization rules are applied first at the Tax deficiency. If you contest a federal in- 4. Tax avoidance loans (below-market loans
partnership or S corporation level. The rules are come tax deficiency, interest does not accrue where the avoidance of federal tax is one
then applied at the partners' or shareholders' until the tax year the final determination of liabil- of the main purposes of the interest ar-
level to the extent the partnership or S corpora- ity is made. If you do not contest the deficiency, rangement).
tion has insufficient debt to support the produc- then the interest accrues in the year the tax was 5. Loans to qualified continuing care facilities
tion or construction costs. asserted and agreed to by you. under a continuing care contract (made af-
If you are a partner or a shareholder, you However, if you contest but pay the pro- ter October 11, 1985).
may have to capitalize interest you incur during posed tax deficiency and interest, and you do
the tax year for the production costs of the part- not designate the payment as a cash bond, Except as noted in (5) above, these rules
nership or S corporation. You may also have to then the interest is deductible in the year paid. apply to demand loans (loans payable in full at
capitalize interest incurred by the partnership or Related person. If you use an accrual any time upon the lender's demand) outstand-
S corporation for your own production costs. To method, you cannot deduct interest owed to a ing after June 6, 1984, and to term loans (loans
properly capitalize interest under these rules, related person who uses the cash method until that are not demand loans) made after that
you must be given the required information in payment is made and the interest is includible in date.
an attachment to the Schedule K-1 you receive the gross income of that person. The relation-
from the partnership or S corporation. ship is determined as of the end of the tax year Treatment of gift and demand loans. If you
receive a below-market gift loan or demand
Additional information. The procedures for for which the interest would otherwise be de- loan, you are treated as receiving an additional
ductible. See section 267 for more information.
applying the uniform capitalization rules are be- payment (as a gift, dividend, etc.) equal to the
yond the scope of this publication. For more in- forgone interest on the loan. You are then trea-
formation, see Regulations sections 1.263A-8 Below-Market Loans ted as transferring this amount back to the
through 1.263A-15 and Notice 88-99, which is lender as interest. These transfers are consid-
in Cumulative Bulletin 1988-2. ered to occur annually, generally on December
If you receive a below-market gift or demand 31. If you use the loan proceeds in your trade or
business, you can deduct the forgone interest
When To Deduct Interest loan and use the proceeds in your trade or busi- each year as a business interest expense. The
ness, you may be able to deduct the forgone in-
terest. See Treatment of gift and demand loans, lender must report it as interest income.
If the uniform capitalization rules, discussed un- later, in this discussion. Limit on forgone interest for gift loans of
der Capitalization of Interest, earlier, and the A “below-market loan” is a loan on which no $100,000 or less. For gift loans between indi-
business interest expense deduction limitation interest is charged or on which interest is viduals, forgone interest treated as transferred
rules discussed under Interest Expense Limita- charged at a rate below the applicable federal back to the lender is limited to the borrower's
tion, earlier, do not apply, deduct interest as fol- rate (AFR). A gift or demand loan that is a be- net investment income for the year. This limit
lows. low-market loan is generally considered an applies if the outstanding loans between the

Chapter 4 Interest Page 17