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Maximizing the investment interest expense deduction.


Dick is the sole shareholder of Esscorp and materially participates in its operations. Esscorp's net income is about $50,000 per year, after considering Dick's salary of $125,000. Esscorp has $65,000 of accumulated earnings and profits (AE&P) that it accumulated when it was a C corporation and $80,000 of accumulated adjustments account (AAA). On his personal return, Dick has $30,000 of interest expense on debt incurred to carry an investment in land. Dick does not expect to receive any investment income in the foreseeable future. His other itemized deductions total $15,000.

Dick wants to increase his spendable income, and he is considering either increasing his salary by $30,000 or having Esscorp distribute an additional $30,000 to him annually. His tax adviser suggests that Dick may want to distribute AE&P, which would allow the investment interest expense to become deductible.


Can an S corporation generate investment income for purposes of the investment interest limitation by distributing AE&P?


Investment interest expense is generally deductible only to the extent of investment income, which includes portfolio income. Thus, distributions of AE&P under these circumstances could permit the deduction of Dick's investment interest expense.

Generally, AE&P is distributed after all of the AAA has been distributed, but an S corporation can elect to treat all or part of a distribution as if it were from AE&P.

If Dick's spendable income is to be increased by Esscorp, there are three choices.

1. Esscorp can increase Dick's salary;

2. Esscorp can distribute AAA to Dick; or

3. Esscorp can distribute AE&P.


The results of the three choices on Dick's personal return are summarized in the chart above.

The three choices produce the same net taxable result for Dick in the current year, except that by making the election to distribute AE&P, the investment interest expense has been used, and the AE&P balance has been reduced by $30,000.

Electing to distribute AE&P before AAA can provide other advantages.

1. Distributing AE&P instead of AAA leaves the AAA undiminished, so that it can be distributed free of tax in subsequent years.

2. Distributing all of the AE&P eliminates the risk that the corporation will be subject to tax on passive income and the risk that the S election will be terminated because excess net passive income was received for three consecutive tax years.

Making the election can allow the shareholder to utilize deductions for investment interest that may otherwise have to carry over and may never be used because of a lack of investment income. To the extent dividend income can be offset with otherwise unused investment interest expense, the dividend will have no current tax effect.


In this case, the corporation could distribute $30,000 of AE&P at no tax cost because it would allow the deduction of the $30,000 investment interest expense. This would then leave $30,000 in the AAA account that could be distributed tax free at a later date. If this pattern continued, Esscorp could distribute its AE&P at the rate of $30,000 per year and thereby remove it from the corporation without causing Dick to incur additional tax at the individual level.
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Article Details
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Feb 1, 1992
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