Interest expense allocation related to debt-financed distributions from a passthrough entity.

• Author: Schulz, Charles P.

Facts

AB Ltd. borrowed $2,500,000 from XYZ Inc. and distributed the proceeds to its owners. The note was secured by AB's interest in Sigma Corp. AB will pay approximately $300,000 of interest expense on the note in the current year. In addition, AB had $500,000 of operating costs that were paid from current year revenues.

Issues

How is the interest expense treated by AB? By AB's owners?

Analysis

When a passthrough entity borrows funds and then distributes the funds to its owners, the debt and related interest expense must be allocated using either the general rule or the optional rule.

The general rule requires that the distribution and the related interest expense be allocated according to how the funds were used by the individual owner. This rule means that the ultimate deductibility of the interest will be determined at the owner level.

The optional allocation rule allows a passthrough entity to allocate the distributed debt proceeds and the related interest expense to one or more of its own expenditures (other than owner distributions) made during the distribution year. This rule allows for the deductibility of at least some of the interest expense at the entity level. If the amount of the distributed debt proceeds exceeds the amount of the passthrough entity's expenditures to which the debt can be allocated, die remaining debt and related interest must be allocated under the general rule (i.e., determined at the owner level).

From the information above, the interest expense would be allocated as follows: Under the general rule, all of the $300,000 interest expense would be...