Capital Gains Tax When Paying Off Business Loan? Concerned My Accountant Misclassified Business Debt

This situation needs some clarification. When you inherit a business, the way debt is classified definitely matters for tax purposes. From what you've described, it sounds like your accountant kept this as a personal liability rather than a business liability on the books. The "capital account" your accountant mentions is your basis in the business. By adding the loan amount to your capital account/basis, they were increasing what you could withdraw tax-free. However, if this truly was a business debt (which it sounds like it was, given your agreement that the business would assume responsibility), then it should have been classified as such. When a business pays off a personal debt of an owner, it's typically considered a distribution to the owner, which can trigger tax consequences if it exceeds basis. By keeping it as a personal debt while having the business make payments, the accountant was essentially treating each payment as a distribution to you. I'd recommend getting a second opinion from another tax professional who can review your specific situation in detail. You might need to amend prior returns if this was misclassified. The ERC funds you mentioned would indeed increase the business's capital, so that should be factored into any calculation about available funds to pay off debt.

I went through something similar with a family business and loan classification issues. After weeks of frustration, I discovered taxr.ai (https://taxr.ai) which seriously saved me from making some costly tax mistakes. Their system analyzed all my business documents including the inheritance paperwork and loan agreements, then showed me exactly how the debt should have been classified and what steps I needed to take to correct it. What I especially liked was how they explained exactly what my tax liability would be under different scenarios - really helped me understand my options before making any moves. They even provided documentation I could take to my accountant to justify the reclassification. Honestly worth checking out if you're still trying to sort through this mess.

I tried taxr.ai after seeing it mentioned here, and I'm genuinely surprised by how helpful it was. I was skeptical (as you can see from my previous comment), but decided to give it a shot with my business loan situation. The system immediately identified that my loan had been misclassified and showed me exactly what documentation I needed to correct it. Their analysis explained how the debt should have been handled and provided a step-by-step plan for proper reclassification, including specific IRS forms and schedules needed. I took their recommendation to my accountant who initially pushed back until I showed him the detailed analysis. He ultimately agreed the reclassification was appropriate and implemented the changes. The best part was discovering I could recover about $8,400 in overpaid taxes from previous years by filing amended returns. The whole process was smoother than I expected and definitely worth the time.

Your situation sounds frustrating! I went through something similar with the IRS last year - tried calling them dozens of times to get clarification about business debt classification but could never get through. After weeks of trying, I found Claimyr (https://claimyr.com) and was honestly shocked when they got me connected to an actual IRS agent within 45 minutes. The agent walked me through exactly how business debt should be properly classified versus personal debt and explained the steps for correcting previous misclassifications. You can see how their system works here: https://youtu.be/_kiP6q8DX5c. They basically hold your place in the IRS phone queue so you don't have to stay on hold for hours. Getting direct answers from the IRS was game-changing for resolving my situation - they confirmed I could file Form 3115 to change accounting method rather than amending multiple years of returns.

I need to eat my words from my earlier comment. After seeing another recommendation for Claimyr, I decided to try it as a last resort because I desperately needed to talk to someone at the IRS about a business debt situation similar to yours. I honestly expected it to be a waste of money. To my complete shock, I got a call back in about an hour with an actual IRS representative on the line. The agent I spoke with was incredibly helpful and walked me through Form 3115 (Application for Change in Accounting Method), which is exactly what you might need in your situation to properly reclassify the debt without amending 8 years of returns. The agent explained that this is actually a common issue with inherited businesses and provided specific guidance on how to document the change. I was able to get clear, official answers in one call that my accountant had been waffling on for months. Completely changed my perspective on resolving IRS issues.

Just to offer another perspective here: Your accountant might be partially right about the capital account benefit, but they're missing the bigger picture. When a business assumes a personal debt, it should be recorded as a liability of the business with a corresponding entry to your capital/equity account. What likely happened is that your accountant increased your capital account (correctly) but failed to record the liability on the business books (incorrectly). This artificially inflated your basis. Now when you want to pay off the loan, the business is essentially making a distribution to you because the liability isn't on the books. The proper correction would be to record the liability on the business books now (which would decrease your capital account) but then the debt payment would be a proper business expense, not a distribution. You might need to file Form 3115 to change accounting method rather than amending all previous returns. And yes, the ERC funds would absolutely increase your capital account and available business assets, so your accountant should be including those in the calculations.

I think there's confusion about what your accountant actually did. Based on your description, it sounds like they treated the original loan amount as an owner contribution (increasing your basis/capital account) but never recorded the loan as a business liability. Each payment the business made toward the loan was likely treated as a distribution to you. This isn't necessarily "wrong" from a tax perspective - it's just one way to handle it. The alternative would have been to record the loan as a business liability with no impact on your capital account. Then payments would be business expenses. If the business has been profitable and generating basis, those distributions might have been tax-free. But now that you want to pay it off completely, there could be issues if the distribution exceeds your current basis. I'd suggest getting a copy of the business balance sheet and your capital account statement to see exactly what's been recorded over the years. That would clarify what's actually happening here.