Interest income from S corporations.

• Author: Rowan, R. Edward

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...