Business Interest Expense

[Snaggletooth]

Accrual based business taxpayer. Seems like I remember special rules about the deductability of interest, even though accrual accounting can accrue or prepay interest. Would like to hear from someone if the rules are different from other expenses. A link is OK, but please not a link to IRS Publication that is 90 pages long.

Thanks

[kathyc2]

Prepaid interest is an asset, not an expense.

Interest can be accrued to the closing date unless the loan is with a related party. If a related party interest can only be expensed to the same extent it is taxable to other party in same year.

[Rapid Robert]

"accrual accounting can accrue or prepay interest."

Maybe we all need a refresher on what "accrual accounting" means (or maybe just me)? I don't think we need to refer to "special rules" about interest expense deductions, at least not to begin.

Per Pub 538, "The purpose of an accrual method of accounting is to match income and expenses in the correct year." So it seems that is the first hurdle - is the accounting for the purpose of matching expense to income in the same year? I don't see how pre-paid interest (future expense) can be correctly matched to current income.

Next, we find

"Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.

• 1. The all-events test has been met. The test is met when:
  • a. All events have occurred that fix the fact of liability, and
  • b. The liability can be determined with reasonable accuracy.
• 2. Economic performance has occurred."

As for interest, "Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's money) rather than as payments are made."

So there is no current deduction for interest paid in advance.

In layman's terms, I've always understood "accrual method" accounting to be primarily about invoices and bills. "Accrual" means invoices and bills matter when they are issued under a legal contract or agreement, "Cash" means they matter when paid. After all, even a cash-based entity can have intangible non-cash assets such as pre-paid expenses (as mentioned above) and also liabilities such as retirement plan contributions payable that are still recognized in the current year.

[kathyc2]

"accrual accounting can accrue or prepay interest."



In layman's terms, I've always understood "accrual method" accounting to be primarily about invoices and bills.

That's part of it, but certainly not all.

First off, there are significant differences between financial statement accrual basis and tax basis accrual method. FS accrual requires accruing potential liabilities such as allowance for doubtful accounts, accrued warranty, etc so as not to overstate income. These items are not allowed as a tax deduction until they occur. Tax preparers that assist in financial statement preparation should protect themselves and clients by labeling such statements as tax basis rather than accrual unless they are actually using full accrual rules for FS.

Invoices and bills are a part, but not all. Interest can be deducted when liability is incurred rather than when paid. Monthly payments due on 10th of month can have 21 days of interest expense to take it to 12.31 while cash basis can not. Payroll earned but not paid can be deducted (other than for 2% shareholder) in year of work. Other items such as accrued bonuses and real estate tax can be deducted if the actual payment falls within time frame under code.

The perception that accrual makes net income higher in current year may not be true. For types of business that have little or no AR, such as retail or restaurants the income part will be essentially the same whether cash or accrual, but with accrual expense will be higher under accrual resulting in lower taxable income for current year.