For business owners, securing financing can be a key strategy for expansion and growth. But what many may not realize is that business financing can also provide significant tax benefits. Whether you're using a business line of credit, securing a Merchant Cash Advance (MCA), financing equipment purchases, or using invoice financing, each option comes with potential tax deductions that can lower your taxable income.
In this article, we’ll explore how different types of business financing can help you reduce your tax liability and maximize deductions, based on both federal tax codes and state-specific rules.
Business Line of Credit
A business line of credit offers flexible access to funds, making it ideal for covering operational expenses, managing cash flow, or making small purchases.
Tax Deductions for Business Line of Credit
Interest Payments: According to IRC Section 163, the interest paid on borrowed funds is generally tax-deductible. This applies to lines of credit used for legitimate business expenses, such as paying vendors, covering payroll, or purchasing supplies.
Fees: Associated fees, including annual fees or transaction costs, can also be deductible as business expenses.
Let's say you borrow $50,000 through a business line of credit, and you pay $2,500 in interest during the year. Under IRC Section 163, that $2,500 is a deductible expense, reducing your taxable income and helping you save on taxes.
State rules on the deductibility of business loan interest vary. For instance, California may impose additional restrictions on interest deductions, especially on loans for personal use or non-business expenses. Be sure to consult a local tax advisor to confirm eligibility.
Merchant Cash Advance (MCA)
A Merchant Cash Advance (MCA) allows businesses to borrow money against future sales, typically through daily payments deducted from revenue. While MCAs are often used for quick working capital, they also come with specific tax advantages.
Tax Deductions for MCA
Interest Charges: The interest or factor rate applied to the amount borrowed in an MCA is deductible under IRC Section 163 as a business expense.
Other Fees: Fees associated with securing the MCA, such as processing or administration fees, may also be deductible.
Imagine you secure an $80,000 MCA with a factor rate of 1.3, meaning you'll repay $104,000. The $24,000 in interest (the factor difference) is deductible, reducing your taxable income for the year. For a business taxed at 25%, this could lead to $6,000 in tax savings.
States like California may apply different rules to the deductibility of MCA interest, so it's essential to check local tax laws or consult a tax professional to determine how MCAs are taxed in your area.
Equipment Financing
Equipment financing allows businesses to purchase necessary machinery, vehicles, or technology without upfront costs. The financing is paid back over time, and the equipment serves as collateral.
Tax Deductions for Equipment Financing
Section 179 Deduction: Under Section 179 of the IRC, businesses can deduct the entire cost of qualifying equipment in the first year it is placed in service (up to certain limits).
Bonus Depreciation: Businesses can also take bonus depreciation under IRC Section 168(k), allowing them to write off 100% of the cost of qualifying new and used equipment in the first year.
Interest Deduction: As with other forms of financing, the interest paid on an equipment financing loan is also deductible under Section 163.
If you purchase $150,000 worth of equipment for your business, you can use Section 179 to deduct the full amount in the first year, significantly lowering your taxable income. Alternatively, if you're eligible for Bonus Depreciation, you can claim 100% of the equipment's cost in the first year, providing an immediate tax benefit.
In states like California, bonus depreciation may not apply. However, Section 179 may still offer substantial deductions, although certain limits may be imposed by the state. States like Texas, with no state income tax, make it easier for businesses to maximize these deductions.
Invoice Financing:
Invoice financing enables businesses to borrow money against outstanding invoices. It’s an excellent tool for businesses with delayed payment cycles or those needing quick access to cash.
Tax Deductions for Invoice Financing
Interest on Invoice Loans: Similar to other forms of borrowing, the interest charged on an invoice financing loan is deductible under IRC Section 163.
Factoring Fees: The fees associated with invoice factoring (e.g., service or processing fees) are also deductible as a business expense.
Say your business has $100,000 in unpaid invoices and you decide to finance them. You receive $80,000 as an advance and pay a 5% factoring fee, which amounts to $4,000. This $4,000 fee is deductible, and any interest paid on the advance is also deductible.
States such as New York may impose sales tax on invoice factoring services, affecting the overall cost of financing. Be aware of any additional taxes that may apply to financial services in your state.
How State Taxes Affect Business Financing Deductions
While federal tax codes provide clarity on many deductions, state taxes can complicate matters. State governments may impose specific rules on interest deductions, depreciation, and other expenses.
California: Known for not following federal rules in full, California may not allow bonus depreciation or may impose stricter limits on Section 179 deductions.
Texas: Being a business-friendly state, Texas typically conforms to federal tax rules, allowing businesses to take full advantage of Section 179 and bonus depreciation.
New York: Although New York generally follows federal tax laws for business expenses, there may be local taxes that apply to certain forms of financing, including invoice factoring.
Understanding how to leverage business financing for tax deductions can have a powerful impact on your business’s bottom line. By using options like a business line of credit, MCA, equipment financing, or invoice financing, businesses can lower their taxable income, resulting in significant tax savings.
However, it’s essential to consider state-specific tax regulations and ensure you're maximizing available deductions. The federal tax codes, including Section 179 and bonus depreciation, provide powerful opportunities for businesses to save, but states may impose additional rules that impact your overall savings.
At Berkman Financial, we specialize in helping businesses like yours navigate the complexities of financing and tax benefits. Our team is ready to help you explore financing options that align with your growth goals—and maximize your tax savings in the process.
Ready to optimize your business finances? Contact Berkman Financial today to discover how we can support your financing needs while maximizing your tax deductions.