Category: Deductions & Credits; Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) owns stock in an S corporation. Historically, the taxpayer has been treated as not materially participating in the activities of the S corporation. While that characterization is suspect, the parties are not willing to upset prior filing positions. Accordingly, for purposes of this memo, it is assumed that TP is properly treated as having not materially participated in the activities of the S corporation. TP borrowed money to inject funds into the S corporation. The interest expense related to that borrowing has been treated by TP's tax preparer as passive pursuant to IRS Notice 89-35. In addition, losses flowing from the S corporation are basis limited under Section 1366(d)(1). I believe that the money borrowed and injected into the S corporation was treated as debt as between the taxpayer and the S corporation. I am not at all clear that Notice 89-35 operates to recharacterize interest expense as passive with respect to monies borrowed to make loans to a pass-through entity. Notice 89-35 operates on the theory that the purchase of interest in a pass-through entity is a de facto purchase of the underlying assets of the entity at least for purposes of the interest tracing rules. Setting aside the latter concern, the issue is as follows. Does the interest expense on the loan to carry TP's S corporation stock (or to make advances to the corporation) affect the basis of TP's stock or debt? I cannot find anything that directly addresses this point. My answer is the interest expense does not affect the basis of TP's stock or debt. IRC Section 1367 and the regulations thereunder set forth the items that affect the basis of S corporation stock and debt. The language of the statute makes it clear that the list of adjustments to basis prescribed therein is an exclusive list. Interest on debt to carry S corporation stock or shareholder loans is not a basis adjustment item enumerated in IRC Section 1367. For that reason alone, I conclude that such interest has no effect on TP's stock or debt basis. We have placed ourselves in the position of attempting to prove a negative. In other words we are trying to prove that a certain item does not affect basis as opposed to dealing with the items that do. We know what establishes basis in the first instance. The taxpayer acquires stock or debt through purchase, inheritance, gift, a carryover basis transaction such as a reorganization, or a capital contribution or loan of cash or property to the corporation. We have explicit rules on how to deal with basis in these circumstances, and we know that the type of interest expense in question does not affect the acquisition basis of stock or debt. Layer on top of the acquisition basis our knowledge of the adjustments to basis as set forth in Section 1366. There is no provision for adjustment of basis for the type of interest expense in question. To provide some further level of comfort on this matter, I have researched the commentary services and found that none addresses this matter. I would also like to briefly revisit the prior concern about the applicability of Notice 89-35 to the interest expense related to debt-financed loans to an S corporation. If such interest expense is not treated as passive under Notice 89-35, it seems to me the interest should be investment interest. As you know, unlike suspended passive activity losses, unused investment interest is not released as a result of disposing of the asset to which the interest relates. Please let me know if you wish to pursue this issue further. |
