Like just about any other business loan, a payment-in-kind loan, often called a PIK loan, requires the borrower to pay interest. Unlike most business loans, though, the interest on a PIK loan isn't actually paid in cash during the loan term. Instead, the borrower supplies the interest in non-cash form. Even so, as long as the loan is used for business purposes, the value of PIK interest should be tax-deductible.
Payment-in-kind loans allow businesses to borrow money for a relatively short period of time -- five years is common -- without having to come up with cash to service that debt. Instead, it provides the lender with something else of value, often shares of stock in the company. Say a company takes out a five-year $5 million PIK loan with a 10 percent annual interest rate. After the first year, the company owes $500,000 in PIK interest.
One of the defining features of a PIK loan is that the borrower doesn't just bundle up the shares owed as interest and send them to the lender. Instead, the value of the PIK shares is added to the principal balance of the loan, which allows the interest to compound. After one year at 10 percent annual interest, in our example loan of $5 million, the balance of the loan is $5,500,000. After another year, and another 10 percent interest, it's $6,050,000, and so on. At the end of five years the balance is $8,052,550 -- the $5 million original principal plus $3,052,550 worth of stock as interest. PIK loans are due in full at maturity, so this is the first time the borrower has to come up with actual payment. Depending on the loan agreement, the lender may have the option of taking the stock -- or whatever served as PIK interest -- or demanding the cash equivalent, in which case the borrower must sell the stock.
So long as a loan is used for business activities and the loan meets the Internal Revenue Service's standards for deductible interest, then the borrower can deduct PIK interest as a business expense. When the borrower can take the deduction depends on which accounting method the borrower uses. If it does its accounting on a cash basis, the deduction comes when the interest is actually paid -- at the end of the loan term. If it uses accrual-basis accounting, the borrower deducts the interest in the year it accrues -- $500,000 in the first year, $550,000 the second year, and so on.
Businesses can deduct loan interest, including PIK interest, only if the loan meets three criteria. First, the borrower must be legally liable for the debt, meaning that PIK interest paid on someone else's loan isn't deductible. Second, the loan must be extended with the intention that the borrower will repay it in full -- in other words, that it won't be forgiven under certain circumstances. Third, the borrower and the lender must have a "true debtor-creditor relationship," a term that isn't strictly defined in tax law, but that suggests a formal loan agreement with a stated interest rate and payment schedule, rather than a "handshake deal."