I was recently researching the tax treatment of loan origination fees for a client, and found almost all the search terms I was using returned only information on personal mortgage loans, not business loans. With a decent amount of searching, I came across a few nice articles that clearly spell out the tax treatment versus the financial accounting (GAAP) treatment of these fees, so I am sharing them here in hopes that when you go searching for the same info (as a business owner or accountant), you’ll find them all here together, in this nice little spot.
To clarify, there are different types of loan fees at closing — so, find this part out first — as that’s the key to how they’re treated.
First up, The Balance (a personal finance site that has a pretty decent “Small Business” section) discusses Deducting Interest Expenses on Your Business Taxes:
For mortgages on business property, you may end up prepaying interest from the settlement date to the closing date, as part of your closing costs.
The IRS says that when you prepay interest, you must allocate the interest over the tax years to which the interest applies. You may deduct in each year only the interest that applies to that year.
You may not deduct interest that must be capitalized, that is, interest that is added to the principal balance of a loan or mortgage. This interest expenses must be depreciated along with the other costs of the business asset.
For sole proprietors and single-member LLCs, show these expenses in the “Expenses” section of Schedule C on Line 16. Note that interest expenses are divided between mortgage interest and all other interest expenses.
For partnerships and multiple-member LLCs, show these expenses in the “Other Deductions” section of Form 1065
For corporations, show these expenses in the “Other Deductions” section of Form 1120.
Meaden & Moore’s blog does a really nice job of explaining — through an example that culminates in a journal entry — the accounting treatment (Generally Accepted Accounting Principles, or GAAP) of not only how to amortize these fees over the life of the loan, but why (the matching principle).
These costs should be recorded as an asset and the related periodic expense should be charged to amortization expense. If these costs were expensed in full at the time of payment, expense for that period would be artificially higher than normal and potentially misleading. Utilizing the matching principle will allow a Company to align this expense with the term of the loan.
However, I only found one article that discussed what I was really looking for: the comparison of tax vs. GAAP rules for period expensing or capitalization/amortization of loan origination fees.
Loan Origination: Getting Tax and Financial Accounting to Mesh, by CFO.com’s Accounting & Tax department, offers an excellent general explanation of why tax and GAAP (financial statement accounting) systems differ.
We have seen that, with respect to many items of income and expense, tax accounting differs, diametrically, from financial accounting. This divergence, of course, is not surprising in light of the fact that the fundamental goals of each system also diverge.
Financial accounting has as its underpinning the doctrine of conservatism such that, wherever possible, net income is understated through the mechanism of accelerating expenses and deferring income. The fundamental objective of the tax accounting system, as we are all aware, is revenue collection such that the system strives to enhance net (or taxable) income and, to this end, income items are accelerated while expenses, wherever possible, are deferred. With each system, however, ”matching” (of revenues with the expenses incurred to produce such revenues) is also advertised as a central tenet. But frequently, this particular objective is sacrificed on the altar of the larger objectives — conservatism and revenue enhancement.
In the case of the bank in the particular example they use, the fees were deductible as a period expense for tax purposes (as opposed to being amortized, which is the requirement for GAAP) because the bank’s loan marketing activities were a core activity of its day-to-day business.
That case stands, broadly, for the proposition that expenses must be capitalized if they provide benefits that extend beyond the year in which such expenses are incurred.
Which means that in most situations, for both financial statement and tax purposes, these fees need to be written off over the period of the loan — but there are exceptions for tax purposes if the activities are central to daily operations.