Increasing Passive Activity Loss Deductions with Self-Charged Interest

Editor: Albert B. Ellentuck, Esq.

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 during the year (including the interest expense) and passes through $12,500 to N.

For the year, N shows the income and losses as in Exhibit 1. Can N deduct any of his passive loss from B?

N is receiving $10,000 in interest income from B. He is also receiving passthrough of $5,000 interest expense—his share of the $10,000 interest expense the corporation paid on its indebtedness to him. He is allowed to deduct all or part of the interest expense passed through to him, even though the interest expense is part of a passive loss that would otherwise be nondeductible in the current year. N can recharacterize all or part of the interest income from B as passive activity income because the three conditions previously described are present.

N’s applicable percentage is 50%: his share of the passive activity self-charged interest deduction ($5,000) over the corporation’s entire self-charged interest expense ($10,000). The practitioner applies the percentage (50%) to the interest N received from B ($10,000) to determine that $5,000 of the interest income from B is reclassified as passive activity income. Therefore, the entire $5,000 of interest expense passed through to N as a passive loss can be offset against nonpassive (that is, active or portfolio) income.

M is not under the self-charged interest rule because all her interest expense from B is nonpassive, and she did not receive interest income from loans she made to B.

Without the self-charged interest rule, none of N’s loss from B would be deductible because of the passive activity rules. Using those rules, the entire $5,000 interest expense from B can be offset against nonpassive income. N’s adjusted gross income, assuming the self-charged interest rules do and do not apply, is shown in Exhibit 2.

N’s interest income remains reportable on his Form 1040, U.S. Individual Income Tax Return, Schedule B. However, $5,000 of the interest income from B is treated as passive income on Form 8582, Passive Activity Loss Limitations. This allows $5,000 of B’s passive loss to carry to Schedule E, where it is deductible.

Now assume that N is the sole shareholder of B, Inc. All the interest income from B would be characterized as passive income under the self-charged interest rule, and $10,000 of the passive loss from B would be deductible.

Observation: The self-charged interest rules are favorable because they allow an S shareholder to recharacterize self-charged interest income as passive (rather than portfolio) income and offset it (within limits) against passive losses. However, the self-charged interest rules apply to interest only and not to other self-charged income and deduction situations (Regs. Sec. 1.469-7; Hillman, 263 F.3d 338 (4th Cir. 2001)).

Allocating Interest Among Shareholders and Activities

Example 2: The facts are the same as in Example 1, except that B, Inc., loans $100,000 to N. He invests the entire $100,000 in a passive activity. The loan bears interest at 10%, and on December 31 N pays B $10,000 of interest expense. The $10,000 of B interest income is passed through equally ($5,000) to N and M.

Since all the money borrowed from the corporation was invested in a passive activity, N will treat his entire $5,000 share of the passthrough interest income as passive activity income (Regs. Sec. 1.469-7(d)). If he invests a portion of the $100,000 loan proceeds in a passive activity, only a portion of his passthrough interest income will be recharacterized as passive activity income. If N invests none of the $100,000 loan proceeds in a passive activity (e.g., he spends the $100,000 on personal items), none of his passthrough interest income will be recharacterized as passive activity income.

Electing Not to Apply the Self-Charged Interest Rules

An S corporation can elect not to apply the self-charged interest rules by attaching a statement to its return including the requisite information. Once made, the election is effective for that year and all subsequent years unless revoked with IRS consent (Regs. Sec. 1.469-7(g)).

Example 3: N lends B, Inc., $100,000 at 10% interest, and $5,000 of B’s interest expense is passed through to him. However, N also receives plenty of passive income from an unrelated partnership investment but needs portfolio income to deduct otherwise unusable investment interest expense. Here it would be beneficial for B to elect not to apply the self-charged interest rules.

Conclusion

Taking advantage of the self-charged interest rule (or, in some cases, electing out of it) can yield a significant tax benefit to a taxpayer. Because many clients will be unaware of this rule, practitioners should make sure they are fully informed about any loans between a client and any S corporations the client owns an interest in to ensure that the application of the rule is properly reflected on the client’s return or an election out of it is made when it would be advantageous.

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 24th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller, and Brooke Paschall, published by Practitioners Publishing Company, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com).

EditorNotes

Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.