1. Interest Incurred on Purchase of Stock and Interest on Tax Deficiency.
  1. Interest Incurred on the Purchase of S Corporation Stock.
  1. After TRA 1986, under § 163(d), interest paid or accrued on debt incurred to purchase or carry "property held for investment" may generally be deducted only to the extent of investment income. Initially, the policy limiting the deduction of investment interest was to prevent a taxpayer from deducting such interest against ordinary income where income or gain from the property was likely to be capital gain. Where an employee purchases stock in the employer corporation, the question arises as to whether interest on his purchase is § 163(d) interest (on the ground that the gain on the ultimate sale of the stock is likely to be capital gain) or investment interest (on the ground that the stock ownership furthers the taxpayer's trade or business). Where the stock being purchased is stock in an S corporation engaged in a trade or business in which the taxpayer materially participates within the meaning of § 469, an additional factor arguing against investment interest treatment is the fact that the taxpayer's income from the corporation will not consist of dividends, against which investment interest may be offset, but of a share of the corporation's income, against which investment interest may not be offset.
  1. Given the above, does the investment interest limitation set forth in § 163(d) apply to interest incurred to purchase S corporation stock?
  1. According to the TRA 1986 Conference Report (TRA 1986 Cong. Rept., II-153) and the TRA 1986 Senate Finance Committee Report (S.R. No. 99-313, 99th Cong., 2d Sess. 805), interest on indebtedness to purchase into a trade or business as a shareholder of an S corporation, in whose activities the taxpayer materially participates within the meaning of § 469, is not treated as investment interest (See also PLR 8235004 (May 21, 1982) where the Service ruled that interest on indebtedness incurred to purchase into a trade or business partnership as a general partner (which interest was not a limited business interest) was not treated as investment interest for purposes of § 163(d)).
  1. Interest subject to the limitation of § 163(d) includes interest paid or incurred on indebtedness to purchase into a trade or business as a shareholder of an S corporation in whose activities the taxpayer does not materially participate within the meaning of § 469.
  1. GCM 39529 (January 8, 1986) - In GCM 39529, the Service ruled that interest on an indebtedness incurred solely to purchase S corporation stock was investment interest if the facts show that stock was acquired with sufficient investment interest to result in capital gain upon disposition.
  1. According to the facts of GCM 39529, three individuals planned to acquire 18 shares of stock in an S corporation. The taxpayers would pay for the stock by issuing installment notes for an amount equal to the purchase price, which were then to be paid off in 15 equal annual installments. The corporation was in the business of designing, importing, and distributing women's accessories. All of the corporation's assets were devoted to its business activities and none of its assets, other than idle funds which were invested from time to time, were devoted to investment activities. Each of the three individuals was actively involved in the day-to-day business operations of the corporation and had an area of primary responsibility.
  1. In support of its decision, the GCM relied upon Miller v. Comm'r, 70 T.C. 448 (1978) wherein the Tax Court held that interest paid in order to acquire stock in a C corporation was investment interest despite the fact that the purchase enabled the taxpayer to become the corporation's president. The Tax Court held that the stock was investment property since the taxpayer would recognize capital gain when the stock was sold.
  1. Evidently, GCM 39529 and Miller have been overturned by § 163(d) as amended by TRA 1986. (See Notice 89-35, 1989-13 I.R.B. 8.)
  1. Tracing Interest Expense Through Pass-Through Entities.
  1. In General - As a general rule, interest is categorized by how loan proceeds are spent, and special tracing rules are provided to account for debt-financed expenditures, depending on whether loan proceeds are deposited into an account, received in cash, or paid directly to a seller or provider of services (See Reg. § 1.163-8T(c)). Reg. § 1.163-8T establishes the tracing rules that must be used to allocate interest to one of several categories: personal interest, home mortgage interest, investment interest, passive activity interest, and portfolio interest. Those regulations do not, however, discuss the treatment of partners or shareholders of S corporations (pass-through entities). To fill the gap until regulations are issued, Notice 89-35, 1989-13 I.R.B. 8 provides guidance for the proper treatment of interest for taxable years ending after 1987.
  1. Purchase of a Share in the Entity - An investor who buys a share in an S corporation is, for purposes of the interest allocation rules, treated as a proportional owner of the underlying assets. If all of the assets are business assets, then (assuming this is not a passive activity) interest on any debt used to acquire the share is considered as trade or business interest. Similarly, if all assets are investment assets, the interest would be considered as investment interest subject to § 163(d). Where there is a mix of assets, the entity may use any reasonable method to allocate the investor's debt among the entity's assets. According to the IRS, reasonable methods ordinarily include pro rata allocations based on fair market value, book value, or adjusted basis of the assets, reduced by any debts of the pass-through entity or owner allocated to the assets.
  1. See also PLR 9215013 (January 7, 1992) where an individual was entitled to an annual interest expense deduction for interest paid with respect to the installment purchase of his father's shares in a family S corporation, but only to the extent that was consistent with the principles of § 163 and Notice 89-35. The individual was considered to materially participate in the corporation's business for purposes of the passive loss rules because he had acted as vice-president for 19 years and intended to work in the business more than 2,000 hours per year after the sale. Similarly, the interest expense deduction traced to assets used in the corporation's trade or business was trade or business interest deductible to arrive at adjusted gross income and was not subject to the passive activity loss rules of § 469.
Example 1: Taxpayer has $700 in his bank account on February 1, 2003, when he borrowed an additional $1,000. He had the proceeds of the loan deposited in the account, giving him a balance of $1,700. On March 1, 2003, he withdrew $600 to purchase an existing S corporation shareholder's interest in a printing corporation where he planned to work as a typesetter. The S corporation had $10,000 of assets: $7,000 in printing equipment and $3,000 in investment securities. There is no other debt.
Under the normal allocation rules, the taxpayer's $600 investment is treated as coming entirely from the loan. The taxpayer allocates this amount in proportion to the cost basis of the assets. Therefore, $420 (70% of the $600) is allocated to trade or business expense and $180 (30% of the $600) is allocated to investment expenses. The remaining $400 of the $1,000 the taxpayer borrowed is treated as a personal loan.
  1. Contribution to Entity's Capital - Interest expense on debt proceeds allocated to a contribution to the capital of a pass-through entity may also be allocated using any reasonable method. For this purpose, the IRS considers as reasonable any method that either allocates the debt among the assets of the entity or traces debt proceeds to the entity's expenditure under the normal tracing rules as if the debt were incurred by the entity. For the purpose of this rule, a purchase of a share in a pass-through entity is treated as a contribution to the capital of the entity to the extent that the entity receives the proceeds from the purchase.
Example 2: Assume the same facts as in Example 1 above, except that the taxpayer contributes the $600 directly to the S corporation, which deposits the funds in its account. Additionally, on March 15, 2003, the S corporation buys a new paper cutter for $450 and, on April 30, 2003, the S corporation buys $800 of new investment securities. In this case, the S corporation uses the tracing method for allocating debt. The first $450 of the taxpayer's contribution is, therefore, treated as being used to purchase an item to be used in the trade or business and the remaining $150 is treated as the purchase of an investment. As before, the remaining $400 of the taxpayer's loan is treated as a personal loan.
  1. Debt Allocated to Distributions by the Entity.
  1. Where a pass-through entity itself incurs debt, the allocation of the debt is made under the normal rules that apply to taxpayers. When the debt proceeds of a pass-through entity are allocated under Reg. § 1.163-8T to distributions to owners of the entity, the debt proceeds distributed to any owner and the associated interest expense are to be allocated under Reg. § 1.163-8T in accordance with such owner's use of the debt proceeds. For example, if the owner uses the distributed debt proceeds to purchase an interest in a passive activity, the owner's share of the interest expense on such debt proceeds is allocated to a passive activity expenditure (within the meaning of Reg. § 1.163-8T(b)(4)). In addition, an owner's share of a pass-through entity's interest expense on debt proceeds allocated to distributions to owners may exceed the entity's interest expense on the portion of the debt proceeds distributed to that particular owner. In such cases, the entity may allocate the owner's excess interest expense using any reasonable method.
2) Where the entity borrows funds to make distributions to its owners, however, the entity may elect to allocate the debt to expenditures other than the distribution made during the tax year. This allocation is limited only by the difference between the amount of the other expenditures and the amount of debt already allocated to those expenditures. If, notwithstanding this election, all or part of the loan is allocated to the distribution, the loan is characterized by the owner as if he had borrowed the funds under the normal allocation rules.
  1. When an S corporation repays these types of loans, repayments are treated first as a repayment of the portion of the debt allocated to the distribution.
Example 3: On May 15, 2003, the S corporation borrowed $12,000 to make equal cash distributions to A and B, each of whom owned a 50% interest in an S corporation. On May 30, 2003, the S corporation purchased a trade or business asset for $8,000 - $5,000 cash and $3,000 financed with a purchase money loan. A used his share of the distribution to buy an entertainment center for his family. Normally, A would have to characterize his share of the interest on the S corporation's loan by the way he used the proceeds - in this case, as a personal loan. The S corporation could elect, however, to allocate part of the loan to the purchase of the trade or business asset. Since $3,000 of debt is already allocated to the trade or business asset, only $5,000 of the distribution may be allocated to it. Of the $6,000 A receives, therefore, $2,500 (5/12 of $6,000) is treated as a business loan and $3,500 (the remainder) is treated as a personal loan (determined by how the taxpayer used the loan proceeds).
  1. No Circumvention of Tracing Rules.
  1. The IRS has recognized that these flexible rules could be used to avoid or circumvent the normal interest tracing rules. Accordingly, the foregoing rules would not apply for taxable years beginning after 1988, in the case of any pass-through entity that is formed or used with the principal purpose of avoiding the normal interest tracing rules. In such a case, interest expense will be allocated in a way that reflects the way in which such interest expense would have been allocated had the pass-through entity not been involved.
  1. Modification of Single Account, Fifteen-Day Rules.
  1. Under the normal tracing rules provided in the Temporary Regulations, a borrower may treat any expenditure made from an account within fifteen days after debt proceeds are deposited as made from such proceeds. A similar rule is provided with respect to debt proceeds received in cash. Until further notice, however, the IRS is extending the fifteen day rules to thirty days. Thus, in the case of debt proceeds deposited in an account, taxpayers may treat any expenditure made from any account of the taxpayer, or from cash, within thirty days before or thirty days after the debt proceeds are deposited in any account of the taxpayer as made from such proceeds to the extent thereof. Similarly, in the case of debt proceeds received in cash, taxpayers may treat any expenditure made from any account of the taxpayer, or from cash, within thirty days before or after debt proceeds are received in cash as made from such proceeds to the extent thereof.
  1. Reporting of Interest Expense on Tax Return - Notice 88-37 and Notice 89-35.
  1. Individuals should report interest expense paid or incurred in connection with debt-financed acquisitions on either Schedule E or Schedule A of Form 1040, depending on the type of expenditure to which the interest expense is allocated. Interest expense is allocated to a particular expenditure of a pass-through entity if the interest expense is allocated to such expenditure under the rules of Reg. § 1.163-8T and Notice 89-35. In addition, any interest expense allocated under the rules of Notice 89-35 to assets used in an activity shall be treated in the same manner as interest expense allocated to an expenditure.
  1. Interest expense allocated to a trade or business expenditure of a pass-through entity should be reported in part II of Schedule E. This interest expense should be identified on a separate line in column (a) as business interest, followed by the name of the pass-through entity to which the interest expense relates, and the amount of such interest expense should be entered in column (h).
This interest expense is deductible without limitation and should not be entered on Form 8582, relating to passive activity loss limitations, or on Form 4952, relating to investment interest.
  1. Interest expense allocated to a passive activity expenditure of a pass-through entity should be entered on Form 8582 as a deduction from the activity in which such expenditure was made. The deductible amount (if any) of such interest expense should be reported in part II of Schedule E. This interest expense should be identified on a separate line in column (a) as passive interest, followed by the name of the pass-through entity to which the interest expense relates, and the amount of such interest expense should be entered in column (f).
  1. Interest expense allocated to an investment expenditure of a pass-through activity should be entered on Form 4952. The deductible amount (if any) of such interest expense should be reported on line 11 of Schedule A or on Schedule E in accordance with the instructions to Form 4952. See, however, the instructions to Form 1040 for circumstances in which deductible investment interest reportable on Schedule A may be reported on Schedule A without being entered on Form 4952. The investment interest that is reportable on Schedule E should be identified on a separate line in part II, column (a) as investment interest, followed by the name of the pass-through entity to which the interest expense relates, and the amount of such interest expense should be entered in column (h).
  1. Interest expense allocated to a personal expenditure made by a pass-through entity for or on behalf of the owner should be reported on line 12a of Schedule A.
  1. If, after the application of the rules in Notice 89-35, debt proceeds of a pass-through entity are allocated to distributions to owners of the entity, the portion of an owner's share of the pass-through entity's interest expense on debt proceeds allocated to distributions to owners that does not exceed the pass-through entity's interest expense on debt proceeds distributed to such owner should be reported on the line on Schedule K-1 for other deductions. This interest expense should be identified on an attached schedule as interest expense allocated to debt-financed distributions. The pass-through entity should allocate a ratable portion of such interest expense to each distribution of debt proceeds to such owner and, on the attached schedule, should list all distributions to the owner to which debt proceeds are allocated and the amount of debt proceeds and interest expense allocated to each distribution.
  1. If the pass-through entity uses the optional method to allocate distributed debt proceeds and associated interest expense, the entity's interest expense on debt proceeds allocated to such other expenditures should be reported on Schedule K-1 in a manner consistent with the allocation of the debt proceeds. For example, if the pass-through entity allocates distributed debt and the associated interest expense to an expenditure in connection with a rental activity, the entity should take the interest expense on the debt into account in computing the income or loss from the rental activity that is reported to the owner on Schedule K-1.
  1. The manner in which the owner should report such interest expense depends on the types of expenditures that the owner makes with the distributed debt proceeds. Thus, for example, if the owner used the debt proceeds to make a personal expenditure, the owner should report the interest expense as personal interest on Schedule A.
  1. Under Notice 89-35, if an owner's share of the pass-through entity's interest expense on debt proceeds allocated to distributions to owners exceeds the pass-through entity's interest expense on debt proceeds distributed to such owner, the pass-through entity may allocate the excess interest expense using any reasonable method. The interest expense allocated by the pass-through entity should be reported on Schedule K-1 in a manner consistent with such allocation. For example, if the pass-through entity allocates the excess interest expense to a rental activity, the expense should be taken into account by the entity in computing the income or loss from the rental activity that is reported to the owner on Schedule K-1.
  1. Interest on Debt Incurred to Purchase Stock of a C Corporation That Later Makes an S Election.
  1. Interest on debt incurred to acquire stock of a C corporation is treated as investment interest expense (Reg. § 1.163-8T(a)(4)(C); Reg. § 1.163-8T(b)(3), Reg. § 1.163-8T(b)(7); W.W. Windle Co. v. Commissioner, 65 T.C. 694 (1976) and Bell Fibre Products Corp. v. Commissioner, 36 T.C.M. 182 (1977)). The result is the same regardless of the nature of the C corporation's assets or the level of the shareholder's participation in the C corporation's trade or business.
  1. Until recently, the IRS had not provided any official guidance on the treatment of interest on debt incurred to purchase stock of a C corporation that later makes an S election. However, PLR 9040066 (July 12, 1990) clarifies the IRS' position. The ruling involves two individuals who purchased 100% of the stock of three brother sister C corporations from an unrelated trust for cash and a promissory note. Following their purchase of the stock, the two new shareholders merged two of the corporations into the third corporation. The surviving corporation then made an S election, effective as of the first day of the following taxable year.
  1. The IRS ruled that the conversion from C status to S status is, in effect, a change in the use of a debt-financed asset. Under Reg. § 1.163-8T(j)(1)(i)(B), debt allocated to an asset is re-allocated to a new asset on the date the character of the asset changes by reason of a change in the use of the asset. Accordingly, interest on the promissory note given in partial payment for the purchase of the stock is treated as investment interest expense from the date of purchase until the day before the S election becomes effective. On the first day the corporation becomes an S corporation, the debt and related interest is recharacterized under the rules of Notice 89-35.
  1. The ruling also points out one important exception to the general rule that debt and related interest are recharacterized on the date that a C corporation becomes an S corporation: Reg. § 1.163-8T(j)(1)(ii) provides that the amount of debt re-allocated cannot exceed the fair market value of the stock on the date of change from C to S status.
Example 4: Shareholder A borrows $600,000 to purchase stock of a C corporation. Subsequently, the corporation makes an S election. As of the day on which the S election takes effect, A's stock has a fair market value of at least $600,000. The entire debt is recharacterized.
Example 5: The facts are the same as in Example 4, except that on the corporation's first day as an S corporation, A's stock has declined in value to $400,000. Only $400,000 of the debt is recharacterized. The balance remains investment indebtedness. This result apparently does not change even if the value of the stock later increases to an amount in excess of $400,000.
  1. Interest on a Tax Deficiency Attributable to Owning an Interest in an S Corporation.
  1. In a case which dealt with the deductibility of interest on a tax deficiency before the effective date of the Tax Reform Act of 1986, the taxpayer was allowed to deduct the interest on a tax deficiency attributable to a partnership and an S corporation only as an itemized deduction and not as an above the line deduction in arriving at adjusted gross income (True v. United States, 93-2 USTC ¶ 50,461 (DC, Wyo 1993)), aff'd by 10th Cir. in unpublished opinion and Fitzmaurice v. U.S., 2001-1 USTC ¶ 50,198 (D.C. Tex. 2001).)
  2. In True, the taxpayer relied on Ann. 86-108, where the IRS suggested that a taxpayer may wish to pay any actual or contested deficiencies from prior years and obtain the full interest deduction on 1986 tax return since interest on most tax deficiencies would not be deductible after 1986. As a result, on December 31, 1986, the taxpayer utilized the procedure set forth in Ann. 86-108 and made payments in full on his contested tax liabilities, plus interest for ten years. The taxpayer then deducted the interest portion of these contested tax payments on Part II, Schedule E, of his 1986 individual income tax return for purposes of computing his adjusted gross income. The taxpayer reasoned that since the payment of interest on tax deficiencies was attributable directly to the activities of the business of both an S corporation and a partnership, the interest payments should constitute a business expense of the partners and shareholders as the individual taxpayer is responsible for paying the interest.
  1. The IRS disallowed the interest payments as an above the line business expense deduction, but did allow the taxpayer a deduction for such interest below the line, as an item deductible from their adjusted gross income, but only to the extent that the amount did not exceed the taxpayer's qualified net investment income. The IRS' position was that although an interest payment on tax deficiencies was generally viewed as an above the line business expense for sole proprietorships and C corporations, such payments were not business expenses for partnerships and S corporations, because these later forms of business organizations have no duty to pay income tax. The IRS further maintained that although it was the individual partners and shareholders who had the duty to pay taxes incurred through the activities of the partnership and S corporation businesses, interest payments on tax deficiencies attributable to the business interest do not constitute a business expense for the partners and shareholders as individual taxpayers.
  1. In agreeing with the IRS' position, the Court relied upon the Supreme Court's decision in United States v. Basye, 410 U.S. 441 (1973), which held that, unlike a sole proprietorship where the individual and his business are the same person for taxation purposes, partnerships and S corporations constitute separate entities, distinct from that of their partners and shareholders, in determining the character of income and the deductibility of business expenses. In applying the Basye analysis to the case at hand, the Court concluded that if the interest payments in question were to constitute a business expense at all, such deduction would have to be taken at the partnership or S corporation level, before each partner or shareholder determines his distributive share of the business's income. The Court then concluded that when the activities of a partnership or an S corporation generate an interest payment similar to that of a sole proprietor who paid interest on a federal income tax deficiency (which the Court agreed was deductible as an ordinary and necessary business expense), such payment could not attain the character of a business expense for a partner or a shareholder in an S corporation. Instead, the payment of the interest on a tax deficiency by the partner or shareholder was merely a personal deduction.
  1. It should be noted that the position taken by the IRS in True is contrary to Notice 89-35, 1989-1 C.B. 75. Notice 89-35 provides guidance concerning the treatment of debt of owners of pass-through entities (S corporations and partnerships) allocated to expenditures for purchases of interest in the pass-through entities (debt financed acquisitions). Notice 89-35 allows the taxpayer as an above the line deduction in calculating his or her adjusted gross income interest paid on borrowings where the debt proceeds are used to purchase a pass-through entity or to make a capital contribution to a pass-through entity. Notice 89-35 allows the taxpayer to deduct as an above the line deduction the interest attributable to the debt which is allocable to trade or business activities where the taxpayer materially participates on a regular, continuous and substantial basis in the business activity of the pass-through entity. (See also PLR 9040066 (July 12, 1990), which allowed the taxpayer to recharacterize interest on debt used to purchase an interest in a C corporation from investment interest to trade or business interest when the C corporation later made an S election).
  1. Interest on Loans to Purchase and Improve S Corporation Property.
  1. In Rosser v. Comm'r, T.C. Memo 2001-79, the Tax Court held that a shareholder-officer could deduct the interest he paid on loans obtained by him to buy, operate, and improve nursing homes owned by his S corporations. The interest was deductible as trade-or-business interest because he got the loans to provide a source of employment income for himself and his wife.
  1. According to the facts, in 1985 and 1986, Thomas Rosser and his wife borrowed money to buy two nursing homes. In 1987, Rosser transferred ownership of the nursing homes to two S corporations he organized, but remained liable for repaying the loans he obtained to buy the properties. Over the years he obtained a number of other loans to operate, improve, and develop his nursing homes. Rosser bought the nursing homes to earn income from managing them and to provide employment for his wife as an administrator of the homes. In 1993 and 1994, he spent 97% of his time managing them.
  1. IRS said Rosser could not deduct the interest he paid in 1993 and 1994 as trade or business interest, arguing alternatively that (a) he held the properties as investments, and (b) the interest was the S corporations' expense, not his. The Tax Court rejected both arguments and ruled in favor of Rosser.
  1. The Tax Court found that although Rosser hoped to sell the properties at a profit when he retired, his investment motive was "remote." He bought the homes to provide employment for himself and his wife, and did not have a substantial investment intent for holding them. As a result, the interest relating to the nursing home loans was trade-or-business interest.
  1. Although IRS cited several cases to support its position that the interest was an expense of Rosser's S corporations, the Tax Court said that none of them involved a taxpayer who borrowed money to buy a business to provide his livelihood. By contrast, the interest paid by Rosser related to him individually–he bought the homes primarily to provide employment for himself and his wife and remained personally liable to pay the interest. As a result, the Tax Court concluded that the interest expense was his, not that of his S corporations.