PAL rules and loan proceeds.

• Author: Ellentuck, Albert B.
• Position: Passive activity loss

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...