How Do Business Lines of Credit Work and Are They Tax Deductible?
Business lines of credit are an excellent way to access fast business funding on an ongoing basis without constantly applying for new loans. Although some lines may expire, the financing typically works like any revolving trade line. Similar to consumer credit cards, a business line lets you tap into additional capital to cover your expenses. Once you repay the outstanding balance, you regain access to those same funds up to the agreed-upon amount.
This type of funding has become increasingly popular for its flexible and convenient access to working capital. Business lines can also help lower the borrowing costs you spend on fees to originate other products like conventional term loans. If you are considering a business line of credit, you’re probably curious about how they work. You might also be wondering if the loan is tax deductible. This article addresses these two questions before discussing how to apply for this popular business loan product.
What Is a Business Line of Credit?
Business lines of credit are among the most flexible working capital solutions for organizations of all sizes. As mentioned, they work like revolving consumer trade lines, allowing companies to access a sum of money up to a certain amount. Business borrowers can access funds from their credit lines in one lump sum or in small, intermittent disbursements so long as the total amount falls below the maximum allowable balance.
Lenders offer secured and unsecured business lines of credit. Exploring both options to determine which of the two meets your needs is advisable since each lending solution has its own benefits and drawbacks. Secured and unsecured business lines of credit work the same way, and both offer an effective means for covering short-term operating costs and managing cash flows.
Secured business lines of credit are typically the more flexible of the two options, however. They almost always come with more flexibility and lower interest rates because secured loans present less risk from a lending standpoint. In the event of a default, the creditor reserves the right to foreclose on your secured assets and recover its funds.
Unsecured lines of credit can be an attractive option for upstarts that lack substantial assets. As a new business owner, you may not have accumulated enough collateral to secure the desired financing terms.
In this case, you would pursue an unsecured business line of credit until you build up the assets required for a more favorable loan. Alternatively, even if you have the assets, it may be worth your while to accept the higher rates and less flexible terms as a strategy for mitigating risk
Under most circumstances, the creditor will require a personal guarantee before approving an unsecured line. The guarantee holds the business owner personally responsible for repaying the loan if the company defaults. While rates are usually more favorable for secured loans, borrowers who stake large collateral amounts may lose substantial assets if their business fails to repay the borrowed funds.
At the same time, a secured line of credit is often valuable for companies that need access to higher credit limits. Unsecured maximum borrowing amounts tend to be lower as this reduces lender risk. Determining the most effective option of the two requires a careful analysis of both your balance sheet and your strategic growth objectives.
How Do Business Lines of Credit Work?
If you decide that a secured business line of credit offers the best solution, expect to offer up a segment of your higher-value assets as collateral for the funds to cover a potential default. The most common types of business collateral include:
- Business equipment and machinery
- Real estate
- Personal and company vehicles
- Existing inventory
The type of collateral you offer doesn’t typically matter as long as the lender believes the assets are liquid and it can fully recoup any funds you intend to borrow. The underwriting approval guidelines for secured business lines of credit generally align with other secured loan products.
The lower interest rates and higher borrower limits included with a secured business line of credit are undoubtedly beneficial. However, secured loans offer a reliable path for approval if you happen to be a borrower with a low or challenged credit profile. Since the collateral will equal the total amount borrowed, creditors are more likely to approve secured business loan products.
Regarding unsecured business lines of credit, even though they’re unsecured, you still retain some skin in the game. To put it differently, you’ll usually find ample motivation to repay the funds you borrow in the typical unsecured business lending arrangement.
In most cases, this comes in the form of a personal guarantee from the business owner. The guarantee helps assure the lender that, in the unfortunate event that your business fails, you can’t just walk away from the borrowed funds you used to finance a company that no longer exists. And while one of the benefits of unsecured loans is their lack of risk to your business assets, the guarantee implicitly stakes your personal assets as collateral.
In general, it’s easier to get approved for a secured line of credit, especially as a recent startup. Alternative and online business lenders offer more options than conventional banks for unsecured business lines of credit.
As you compare loan products, remember that, depending on your agreement, business lines of credit can expire after a specified time. In other words, this type of business line will cease revolving after you repay the borrowed funds. These terms could require you to take out a new loan under less favorable conditions and pay additional fees to access more funds.
The point above is worth reiterating because not all lines of credit revolve indefinitely. As such, they may not be the best product for meeting your short-term funding requirements on an ongoing basis.
Now that you have a general idea of how this type of financing works, let’s dive into some of the tax advantages included with a business line of credit.
Are Business Lines of Credit Tax Deductible?
While your business line of credit payments themselves aren’t tax deductible, the loans are eligible for specific deductions. For instance, if your line meets the criteria established by the IRS, the interest on your business loan is tax deductible. Moreover, you can write off any items purchased with your business line of credit as long as they qualify as business expenditures under the current tax code.
While the principle on the loan isn’t technically deductible, most companies can benefit from an additional interest deduction when they use their line of credit. This is because the purchase you typically make on the line will be deemed as business expenditures by tax authorities. In other words, you’re effectively writing off the borrowing costs on the funds used to cover your operating expenses.
However, with this mentioned, you’re not automatically receiving a one-to-one deduction on your line of credit payments. In other words, you won’t list the payments themselves as deductions. Instead, you’ll itemize the purchases made on the line of credit, just like any other business expense.
So, the tax benefits of a business line of credit are primarily discoverable in the interest deductions. In most cases, you can write off the interest you pay on your line of credit as long as it constitutes a cost against your business.
So, doing the math, let’s assume your line of credit total monthly payments are $1,800. If $1,280 of your current payment applies to the principal, then you are paying $520 in interest. You can write off the latter $520 as a business operating expense. This deduction can amount to considerable tax savings over time.
What Are the Eligibility Criteria for Taking the Deductions?
It is possible to deduct the interest on your business line of credit, but the loan must meet a specific set of qualifying criteria first. Foremost, to take the deduction, you should be prepared to supply evidence that you’re formally obligated to the loan.
You’ll have to show proof that you’re the one making the payments and that you have an exclusive debtor-creditor relationship. Likewise, prepare to demonstrate that you used the funds to cover previous business expenses. So, with that, you can’t write off the interest on funds kept in business or personal bank accounts to cover future expenses.
Unless your loan specifically prohibits it, you could theoretically use the funds from your business line of credit for purchases unrelated to your business. Of course, this is ill-advised because you are effectively “mixing funds” and you won’t be able to deduct the interest on these purchases in the same way you would on inventory or new equipment.
If the bank doesn’t expressly proscribe funds mixing, it will undoubtedly frown on this practice, and you could have issues with both your lender and the IRS. Once discovered, the bank could reclassify the loan as a personal line of credit, and you may face penalties if you write off expenses unrelated to your business.
Mixing funds in this way exposes you to additional legal consequences with customers who can potentially make claims against your company. Remember, your business line doesn’t tie to you as an individual.
Instead, the lender attaches the loan to your business. From a lending and tax standpoint alike, the expectation is that you use those funds for business expenditures only. Any exceptions to this rule would not be tax deductible. However, always check with a tax expert regarding the finer details on this subject and how they apply to your business.
Business Lines of Credit and Depreciation Deductions
Procuring new equipment to support business expansion plans is among the most common uses of a business line of credit. A qualified tax professional can confirm your eligibility for taking a bonus depreciation deduction on the business equipment purchased with your line.
Tangible business assets, with the exception of land and inventory, are depreciable. So, what qualifies as a tangible business asset? Under IRS rules, depreciable assets can include, among other things:
- Industrial machinery
- Company vehicles
- Manufacturing equipment
- Commercial buildings
- Office furniture
You can take bonus depreciation deductions on these items to cover the asset’s implied loss of value over its useful life. These deductions are effective the moment you put the asset to work. The depreciation stops after you either recover the initial cost of the item or you cease using it for business.
Any depreciation deductions you claim aren’t necessarily tied to your credit line, however. You can always take bonus depreciation deductions, regardless of the method used to finance the assets.
That said, you can still claim interest deductions on any depreciable assets you finance using your business line. Since you are not mixing funds with personal loans or credit cards, a business line of credit also makes it easier to keep a consistent paper trail of your deductible expenditures.
Ready to Apply for a Business Line of Credit?
Business lines of credit undoubtedly offer a few healthy tax advantages, but how do you qualify for one? The first step to taking out a new business line of credit is to determine how much funding your company needs and how well-qualified you are for that amount.
Next, you should check your personal and business credit by requesting your history from the main reporting bureaus. Know your score before submitting it to any lender. Too many of these inquiries can dramatically lower your score.
Finally, start compiling documentation that shows your monthly and annual revenue streams along with your time in business. After comparing the best loan offers, your preferred lender will advise on any additional required documentation, like profit and loss statements and your business plan.
Ready to begin exploring your options for a secured and unsecured line of credit? Contact American Business Credit to schedule a free consultation and learn how this flexible and comparatively affordable business lending product can put your company on the path to long-term financial success.
