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PAL rules and loan proceeds.

Facts

Janis owns all of the stock of Frames, Inc., but does not materially participate in its operations. However, Janis does have final authority over major decisions. She has decided to have the corporation make two substantial purchases: (1) a machine for use in the business and (2) stock in a publicly held corporation to be held for investment. Frames has the funds to pay cash for either the machine or the stock but will have to borrow the money for one of the purchases. Interest expense on the loan will be approximately $12,000 during the tax year. On her personal return, Janis has interest income of $15,000 and a salary of $75,000. She has itemized deductions of $13,000 before considering interest expense. Frames pays no other interest and passes through a nonseparately stated loss of approximately $10,000 in the current year.

Issue

Can the corporation structure its debt so that the interest can be deducted on Janis's personal return?

Analysis

Interest expense incurred by an S corporation is passed through to shareholders as --trade or business expense (reduces the corporation's nonseparately stated income on page 1 of Form 1120S); --investment expense (passes through as a separately stated item and is subject to limitation at the shareholder level); --rental expense or as a component of any other passive gain or loss (reduces passive activity income from rental or other activity); and --other interest expense (passes through as a separately stated item; shareholder treatment is determined by reference to how the loan proceeds were used).

The classification of the interest expense generally is determined by reference to the use of the debt proceeds. If the debt proceeds are used to buy inventory, the interest expense on the loan is a business expense. If the proceeds are used to repair a rental property, the interest is a rental expense. If the loan proceeds are used for more than one purpose, the interest expense must be allocated between the activities. The type of property pledged to secure the loan does not affect the nature of the interest deduction.

Under these rules, taxpayers evidently can manipulate the tax treatment of the interest expense by determining the best way to use the loan proceeds. (However, the IRS has the authority to determine how to allocate interest expense.)

If Frames borrowed the funds to buy the machine, the interest expense would be used in the operation of the business and would increase the passive loss passed through to Janis.

The interest expense would be investment interest expense if the borrowed funds were used to purchase the stock. Investment interest expense is deductible only to the extent of investment income (subject to certain phase-in rules). The nondeductible portion carries forward to be used in a year when there is investment income. The phase-in does not affect the S corporation's treatment of investment interest expense, i.e., the corporation passes through the full amount of investment interest and the deduction limitations are applied at the shareholder level (subject to the phase-in rules). if the loan proceeds are used to buy the machinery, Janis's adjusted gross income of $90,000 ($75,000 salary and $15,000 interest) would be reduced only by her $13,000 itemized deductions; the $22,000 passthrough from Frames ($10,000 business loss and $12,000 of business interest) would be totally disallowed. If, however, the proceeds are used to buy the stock, the $12,000 interest passthrough will be allowed as an itemized deduction (to the extent of investment income), lowering Janis's current taxable income by $12,000.

Conclusion

The best results are achieved if the borrowed funds are used to buy the stock.

The tax treatment of interest expense incurred by an S corporation is determined by reference to how the borrowed funds are used. This allows taxpayers to designate the use of specific funds. It may be wise to deposit borrowed funds in a separate account and make specific expenditures from that account. if the taxpayer purchases an asset that could be construed by the IRS as being held for business rather than for investment, the tax adviser should encourage the client to document the investment purpose of the asset.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Individuals, 2d Edition, by Elizabeth DiTommaso, Helen Gardner and Terry W. Lovelace, published by Practitioners Publishing Company, Fort Worth, Tex., 1991.
COPYRIGHT 1992 American Institute of CPA's
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Article Details
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Title Annotation:passive activity loss
Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Sep 1, 1992
Words:736
Previous Article:Successfully converting to in-house tax processing.
Next Article:Offers in compromise.
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