DEDUCTING INTEREST ON DEBT USED TO BUY S CORP STOCK

Eddie Quigg, CPA, JD

A recent Chief Counsel Advice (CCA) discussed the rules for individuals deducting interest on debt incurred to purchase stock in an S corp. Since this is a question that we get asked on a regular basis, this is a good opportunity to review the applicable rules.
The first rule is that the interest tracing rules apply, which provide that interest expense on a debt is allocated in the same way as the debt to which the interest expense relates is allocated. This mouthful from the Regulations simply means that to trace the interest, you must follow the proceeds.
In the case of debt used to purchase S corp stock, a "pass-through" rule applies which says that the debt proceeds are allocated ratably among the S corp assets, as if the proceeds were expended on the purchase of the assets.
Roughly speaking then, if all the S corp's assets are used in a trade or business, the interest is fully deductible as business interest, and is reported in Part II of Schedule E, Form 1040 on a separate line in column (a) as "business interest", with the name of the pass-through entity to which it relates. Likewise, if the S corp has portfolio assets like marketable securities, or "passive activity" assets like investments in real estate partnerships, part of the interest expense will be allocated to these assets, i.e.,  on Form 1040 on Schedule A as investment interest expense (marketable securities), or, if passive (real estate investment) on Form 8582 as a passive activity item.
It is also important to remember that these rules are separate from the rules that determine the status of the S corp shareholder under the "passive activity" rules. For example, assume that all of the interest expense is treated as "business interest" -- if the shareholder "materially participated" in the business, then the Schedule E reporting would apply, as explained above. However, if the shareholder's status was considered "passive," then the interest would be reported on Form 8582 and be governed by the passive activity rules.
The discussion above is a brief overview of the complex rules that apply in this area. Please contact us if you have any questions about how the rules apply to your situation.