Increasing passive activity loss deductions with self-charged interest.

• Author: Ellentuck, Albert B.

GENERALLY, PORTFOLIO INCOME CANNOT be used to offset passive activity losses, but there is a special rule for self-charged interest. Under this rule, an S corporation shareholder subject to the passive activity loss rules who makes a loan to the corporation can offset the interest income received from that loan with some or all of the interest expense passed through by the S corporation (Regs. Sec. 1.469-7). (A similar rule applies to loans from the S corporation to the shareholder.)

Under the regulations, an S corporation shareholder can recharacterize all or part of the interest income from the S corporation as passive activity income if the following three conditions are present:

* The S corporation has a deduction for self-charged interest. Self-charged interest is interest charged by a person who (1) during the corporation's tax year had a direct interest in the corporation (i.e., was a shareholder) or (2) during the tax year had an indirect ownership interest in the corporation. (The taxpayer has an indirect interest in an entity if the interest is held through one or more S corporations or partnerships (Regs. Sec. 1.469-7(b)).)

* The shareholder has interest income from the S corporation in the shareholder's tax year in which the corporation's tax year ends.

* The shareholder's share of the self-charged interest includes a passive activity deduction.

The amount of interest income that can be characterized as passive income is limited to an "applicable percentage." The applicable percentage is determined by a fraction, the numerator of which is the shareholder's share of the corporation's self-charged interest deductions that are passive activity deductions. The denominator is the greater of (1) the taxpayer's share of the corporation's total self-charged interest deduction (that is, the self-charged interest deduction determined regardless of whether the deduction is passive or nonpassive) or (2) the amount of the shareholder's income for the tax year from interest charged to the corporation.

Example 1: N owns 50% of the stock of B, Inc., an S corporation. On January 1 of the current year, N loaned the corporation $100,000. The loan bears interest at 10%, payable on December 31. N relies on M, the other shareholder, for management of the corporation and does not participate in the corporate operations (which do not include any rental activities). On December 31, the corporation pays N $10,000 of interest. B experiences a $25,000 loss...