Making loans from business accounts

[Axecleaver]

I'm considering making a loan to my sister-in-law to buy a car. Her current ride has 200k miles and has some reliability issues. Her job is a 30 minute commute through a rural mountainous area, so she is looking at buying a modest used car for 10-12k. Her credit is poor (500's) because of problems in the past where she missed payments. She was quoted a 12% interest rate.

My plan is to offer her a loan for 100% of the car value at 6% interest. She plans to sell her hooptie for around $1000 and use this to repay principle, as soon as practical. This is a win-win as far as I'm concerned - I accept the risk of the loan, I've had discussions with her about repayment, and I'm in a position to help her out without providing a handout.

My question is, if I provide this loan from business revenues, how does this affect our tax at the end of the year? I have a single-member LLC that is taxed as a disregarded entity, so shows up on Schedule C. Do I need to recognize the loan dollars as income for this year, pay the taxes on it, and then declare the interest as it's repaid? Or is there some other mechanism to reduce or defer paying taxes on the amount loaned until future years (which would be ideal).

If there is, I can't figure it out. It looks like I can't deduct the loan principal unless the loan is "worthless" and only then in the year where it becomes so. Do I have this right? Thanks!

[DaveR]

Let's say right now you have $10k in a high yield savings account... it is "loaned" to the bank and you receive 1% interest on it this year, or $100. You report the $100 of interest income to the IRS. That's it. If the bank issues you a stack of benjamins to "repay the loan" (aka withdrawal) you don't tell the IRS.

If you decide to take that and loan it to your sister-in-law instead, you do the same. You report the $600 in interest income but don't need to worry about the principle. Only if she defaults on the loan can your write off the unpaid principle as bad debt.

Loan principle is NOT an expense, you can't magically loan out excess capital to reduce profits and avoid/defer taxation.

If you want to loan her $10k: earn profit of $12.5k, pay the $2.5k in taxes on it, make the loan, and get your $10k + 4.5% interest (net of taxes) paid back over several years. (your tax bracket may vary).

Note: I've been faced with similar situations before; when asked to play bank, I put on my banker hat. My cost of capital is invariably higher than MegaBancorp, so the numbers never work out. If money leaves my pocket, it's a handout.

[Cathy]

There are at least two elements that must be satisfied before an item is potentially deductible as a business expense: (1) the item must be an "expense", and (2) the expense must be "paid or incurred ... in carrying on any trade or business". 26 USC § 162(a). There are other conditions as well, but I do not discuss them here.

As DaveR points out above, making a loan to somebody is not generally within the plain meaning of an "expense" because it doesn't cost you anything. You are basically making a trade with the debtor. You give the debtor $10,000 and, in exchange, they give you a promissory note with a face value of $10,000. Neither of you reflects any change in your net worth.

If the loan were an expense, it still probably wouldn't be deductible under 26 USC § 162(a) because it's not being "paid or incurred ... in carrying on any trade or business", unless you are in the lending business or the car business or something like that. Even if you were in those businesses, it doesn't sound like this transaction with your sister is part of the business.