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Interest income from S corporations.

The classification of interest income as trade or business income or as portfolio income by an S corporation has important implications to the entity's owners beyond the obvious increase in their taxable incomes. In particular, an individual shareholder's net operating loss (NOL) may be affected.

Sec. 172(c) defines an NOL as the excess of a taxpayer's deductions over gross income, with certain modifications. One important adjustment for an individual taxpayer is that nonbusiness deductions may not exceed nonbusiness income for purposes of the NOL computation under Sec. 172(d). Thus, if given the choice, an individual in an NOL situation may prefer that an income item be classified as a nonbusiness item.

Example: An S corporation has a net economic loss of $100, reported by its sole shareholder (I) under Sec. 1366 as a nonbusiness deduction of $100; an income item of $100; and an operating loss [without regard to the previous items) of $100.

If I has no other items of income, deduction or loss, classification of the S income item as business-related yields an NOL of zero. On the other hand, if the income item were nonbusiness, I would have a $100 NOL.

Under Sec. 469(e), interest income generally is portfolio income, provided it is not derived in the ordinary course of a trade or business. Temp. Regs. Sec. 1.469-2T(c)(3)(ii) provides that gross income is derived in the ordinary course of a trade or business (and therefore is not portfolio income) only in situations that include (1) interest income on loans and investments made in the ordinary course of a trade or business of lending money; (2) interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of such a trade or business, provided that credit is customarily offered to customers of the business; (3) interest derived in the ordinary course of a trade or business of trading or dealing in any property (although this provision does not apply if a dealer held the property for investment at any time before the recognition of the interest); and (4) other interest as identified by the IRS.

This limited definition of trade or business for portfolio income purposes is noteworthy. For example, if a taxpayer were to dispose of Sec. 1231 property used in a passive activity in an installment sale, the gain would be passive under Temp. Regs. Sec. 1.469-2T(c)(2)(i)(A)(2), although the interest income on the installment note would be portfolio income; see Temp. Regs. Sec. 1.469-2T(c)(3)(iv), Example (1). Of course, as a general rule, this characterization of the interest income (i.e., portfolio as opposed to passive) is disadvantageous to the taxpayer.

On the other hand, if the preceding transaction were engaged in by an S corporation, the interest income (as portfolio income) would be reported on line 4 of Schedules K and K-1 (rather than on page 1 of Form 1120S, U.S. Income Tax Return for an S Corporation), according to page 7 of the 1992 instructions. As such, each shareholder would report his pro rata share of that income on his individual Schedule B; see Schedule K-1, line 4a. Arguably, as a Schedule B item the interest income should be nonbusiness income for NOL purposes. This would be a taxpayer-advantageous result, as previously indicated. (Of course, the gain on the sale would be business income pursuant to Sec. 172(d)(4)(A).)

More precisely, since the interest income on the installment note received on the sale of the Sec. 1231 asset is portfolio income, the installment note is "property held for investment" under Sec. 163(d)(5)(A)(i). Thus, the interest income is investment income for purposes of Sec. 163(d). See Sec. 163(d)(4)(B)(i); IRS Letter Rulings 9031022 and (TAM) 9307005. Therefore, the interest income is nonbusiness income to the shareholders for NOL purposes; see Sharp, Cl. Ct., 1992: "Sections 163 and 172 deal with entirely different categories of deductions, based on entirely different theories. Investment interest income is not considered income from a trade or business and investment interest debt is not considered a tax or business expense."
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Article Details
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Author:Orbach, Kenneth N.
Publication:The Tax Adviser
Date:Sep 1, 1993
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