Repayments of business debt after business ceases.

• Author: Kelley, Claudia L.

EXECUTIVE SUMMARY

* Interest payments made after the cessation of business operations are deductible if the debt is allocated to business expenditures.

* A guarantor who is unable to recover from the debtor or co-guarantor is entitled to a bad debt deduction, for both principal and interest.

* Guarantors are generally denied an interest deduction under Sec. 163(a), except for interest paid and accrued after a corporate debtor's discharge in bankruptcy.

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When a small business fails, the entity or the owners are often required to pay its debts long after business operations cease. This article discusses the treatment of these payments and payments by guarantors of the entity's debts.

Seventy-two percent of the 23 million small businesses in the U.S. are sole proprietorships, according to the Small Business Administration's (SBA) Office of Advocacy. Approximately 83% of small businesses use some form of credit. (1) Lenders often extend loans to these businesses based on the principal owner's creditworthiness. The business owners may have to borrow the funds used in the business, personally guarantee the business's debt or seek a guarantee from acquaintances or family. According to the SBA, one-third of all small businesses fail after just two years; however, the entity or its owners often continue to pay debts long after business operations cease. Is the interest deductible?

Example 1: E decides to open an ice cream parlor as a sole proprietorship and borrows $100,000 to purchase the assets of an existing ice cream business. Three years later, E closes his business, sells the assets and pays a portion of the business debt. E continues to pay the remaining debt long after business ceased. Can E deduct the interest?

This article discusses the circumstances under which (1) former business owners can deduct interest on these payments and (2) guarantors can take a bad debt deduction when required to pay the outstanding debt.

Interest Tracing Rules

The Tax Reform Act of 1986 enacted Sec. 163(h)(1), which eliminated the personal interest deduction and limited the deductibility of other types of interest. This forced taxpayers to classify interest to determine its proper tax treatment. The interest tracing rules under Temp. Regs. Sec. 1.163-8T(a)(3) classify interest expense based on the taxpayer's use of the debt proceeds. Thus, taxpayers are required to maintain records of the link between expenditures and related debt. Under Temp. Regs. Sec. 1.163-8T(a)(3), disbursements of debt proceeds are traced to specific expenditures and the debt allocated accordingly. Interest on that debt is allocated in the same way. Moreover, under Temp. Regs. Sec. 1.163-8T(c)(1), the allocation is not affected by the use of property to secure the debt. For example, if a taxpayer borrows $50,000, secured by his or her personal art collection and uses the proceeds to purchase business equipment, the interest is business interest.

Reallocation Rules

Temp. Regs. Sec. 1.163-8T(c)(2) states that interest expense on debt used for business purposes remains business interest until the earlier of the date the debt is repaid or is reallocated to another expenditure. Debt recurred to acquire a capital asset (e.g., equipment) is reallocated to another expenditure when the asset's use changes or, if earlier, when proceeds from the asset disposition are used for another purpose. The reallocated debt cannot exceed the proceeds from the asset disposition. When the asset's use changes, the reallocated debt cannot exceed the asset's Fair market value (FMV) at the time of the change.

Example 2: On Jan. 1, 2002, I took a five-year, $50,000 loan to purchase equipment for use in his sole proprietorship. On May 31, 2004, I stopped operating his business, but continues to pay off the equipment loan. He does not use the equipment in another activity. The interest on this loan is business interest until I repays the loan.

Example 3: The facts are the same as in Example 2, except that I converts the equipment to personal use on Oct. 1, 2004, when the loan's principal balance is $35,000 and the equipment's FMV is $25,000. The interest on the loan is business interest from Jan. 1, 2002-Sept. 30, 2004. Beginning Oct. 1, 2004, interest on $25,000 of the principal is no longer deductible business...