Can interest paid on a loan, including seller financing, used to buy S corporation stock be deducted on my tax return?
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Yes, interest paid on a loan—including seller financing—used to acquire S corporation stock may be deductible, but the deductibility and character of the interest depend on how the loan proceeds are allocated among the S corporation’s underlying assets and how you use your S corporation interest. The rules are nuanced and require careful tracing and allocation.
1. General Rule for Interest Deduction
The Internal Revenue Code allows a deduction for all interest paid or accrued within the taxable year on indebtedness, subject to various limitations and characterizations (business, investment, passive, or personal).
2. Allocation of Interest Expense—Tracing Rules
Interest expense is generally allocated according to the use of the loan proceeds. For loans used to acquire an interest in a passthrough entity (such as an S corporation), the IRS requires that the debt and associated interest expense be allocated among all the assets of the entity using a reasonable method, such as pro rata allocation based on the fair market value, book value, or adjusted basis of the assets, reduced by any debt of the entity allocated to those assets.
- If the S corporation’s assets are used in a trade or business in which you materially participate, the interest allocated to those assets is generally treated as business interest and is not subject to the investment interest limitation.
- If the S corporation holds investment assets (such as stocks, bonds, or other property held for investment), the interest allocated to those assets is investment interest, subject to the investment interest limitation under IRC §163(d).
- If the S corporation holds passive assets and you do not materially participate, the interest allocated to those assets is passive activity interest, subject to the passive activity loss rules under IRC §469.
- If the S corporation holds personal assets, the interest allocated to those assets is personal interest, which is generally not deductible.
3. Application to Seller Financing
Seller financing is treated the same as any other loan for these purposes. The key is how the proceeds are used: if the loan is used to acquire S corporation stock, the tracing and allocation rules described above apply.
4. Practical Steps
- At the time of acquisition, allocate the debt among the S corporation’s assets using a reasonable method (e.g., based on the relative fair market value of the assets).
- Each year, as the S corporation’s asset mix changes, you may need to reallocate the debt and interest expense accordingly.
- The character of the interest deduction (business, investment, passive, or personal) is determined by the type of assets to which the debt is allocated and your level of participation in the S corporation’s business.
5. Limitations
- Investment interest is deductible only to the extent of your net investment income for the year; any excess is carried forward.
- Passive activity interest is subject to the passive activity loss rules.
- Personal interest is generally not deductible.
6. Supporting Authority
- IRC §163(a), (d), (h): General interest deduction, investment interest limitation, and disallowance of personal interest.
- Treas. Reg. §1.163-8T: Tracing rules for interest expense allocation.
- IRS Notice 89-35: Guidance on allocating debt incurred to acquire an interest in a passthrough entity.
- PLR 9037027 and PLR 9116008: Confirm that interest on debt used to acquire S corporation stock must be allocated among the S corporation’s assets, and the deductibility depends on the nature of those assets and your participation.
7. Example
Suppose you borrow $100,000 (including seller financing) to buy all the stock of an S corporation. The S corporation’s only asset is an operating business in which you materially participate. The interest on the loan is generally deductible as business interest on your tax return, subject to any applicable limitations (such as the business interest limitation under IRC §163(j)).
If, instead, the S corporation owns $60,000 of business assets and $40,000 of investment assets, then 60% of the interest is business interest and 40% is investment interest, subject to the investment interest limitation.
8. Reporting
- The S corporation does not deduct the interest; you, as the shareholder, deduct your share of the interest on your individual return, characterizing it according to the allocation described above.
Summary: Interest paid on a loan (including seller financing) used to buy S corporation stock may be deductible, but you must allocate the interest among the S corporation’s assets using a reasonable method. The deductibility and character of the interest (business, investment, passive, or personal) depend on the nature of the S corporation’s assets and your participation in its business. Investment and passive interest are subject to their respective limitations. Personal interest is not deductible.
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