interest expense

[natiro]

Taxpayer is a shareholder in a new s-corp. He does not materially participate. The corp needs additional funds to get up and running. Taxpayer has the following options to infuse more funds into the corp.

Source of funds:

1) Borrow additonal funds from HELOC which will cause HELOC balance to exceed 100,000.
2) Sell stock at a gain and use those proceeds.

Use of funds:

1) Use funds as additional equity contribution
2) Loan funds to the corp

Questions:

1. If taxpayer uses the HELOC option, would the interest be deductible? Would the answer be different if funds are used as additional equity contribution vs. loaning funds to the corp? (It might be useful to note that there will be no portfolio assets in the corp.)

2. What would be the best combination of choices above and why?

I really appreciate any help on this. I'm on vacation and don' t have access to my usual research library.

Many thanks.

And aloha!

[Corduroy Frog]

Purpose Interest

Natiro, I believe we're dealing with a general rule and an exception to the general rule.

Maybe I'm oversimplifying the situation, but I believe the "general" rule for all interest is that it should be treated as deductible in the same theatre as the principle was used. The taxpayer does not have the choice as to where to deduct it. If the funds were used to make repairs on a rental house, then the taxpayer must deduct on Schedule E where the rental operation is reported. I don't believe he has the option of deducting on Schedule F or Schedule C or any other part of his tax return. Another less appealing example is the borrowing of principle to buy a strictly personal item. This is non-deductible, even though the taxpayer may have a business, farm, or other operation.

The exception is mortgage interest, where the personal residence is given as collateral for principle funds. The taxpayer may then use the interest on schedule A as deductible interest expense. He therefore may use HELOC interest as an "Ace of Trumps" and deduct, subject to limits, as mortgage interest regardless where the principle was used.
I believe the taxpayer has the choice of using this interest on either the purpose of the funds or as mortgage interest, wherever the greatest benefit may occur. Others may post and take me to task, but unless I see evidence to the contrary, I will believe I am correct.

Let's apply this to your example. The obvious use of the principle is investment interest, as in Form 4952. However, deductibility may be impaired because investment interest is limited by investment income, so it may be more advantageous for this interest to be used as mortgage interest deduction. If your client is running into a limit problem for mortgage interest, then he may use the mortgage interest up to its limit, and then the remainder of the interest on the 4952.

There is yet another subtlety involved with your example. In the above paragraph, we assumed that mortgage interest is superior to investment interest. This may or may not be true. At high income levels, Schedule A erodes because of high income phaseout. Investment interest (Form 4952) does not phase out.

Classic question, Natiro, and a great opportunity for you to use your skill to maximize the tax benefit for your customer.

[natiro]

Investment interest

Thanks for the reply.

Since any addtitional funding from the HELOC would cause the HELOC to exceed 100,000, I don't believe there is the option to deduct as mortgage interest. What I'm not clear about is whether using the HELOC funds would qualify for the investment interest deduction if used for either additional paid in capital or to loan funds to the corp. As I mentioned, the s-corp does not have any portfolio income which I believe may impact the situation (especially if the funds are used for additional paid in capital), although I'm not sure about that.

If the taxpayer makes a loan to the s-corp, he will receive a rate of interest that exceeds the interest he's paying on the HELOC. So he would have enough interest income to make the interest expense deductible. Would using the HELOC funds to make an interest bearing investment in an s-corp of which you're a shareholder allow the interest to be deductible as investment interest?

Thanks again for any insight.

[Corduroy Frog]

"Silent Partner"

Good discussion Natiro, and I'm hoping others will add to it, as I do not consider myself the summum bonum on this subject.

I believe since the stockholder is not active, he qualifies as an investor and not an operator. Same theory as a "limited partnership" where the income/loss is passive.

I would try deducting the interest whichever way is best. If the $100,000 is being eclipsed, I would still consider using the interest as "Mortgage Interest" to the extent of the $100,000. I would prorate the interest and take the HELOC as far as I could, then use the rest as a 4952 deduction.

Profits from a "limited partnership" should be considered investment income, and provide income enough (hopefully) to free up the interest deduction on 4952. If there is not enough income, the interest not deducted by virtue of the limitation can be rolled forward.

[jainen]

Why is that?

>>The corp needs additional funds to get up and running.<<

Why is that? Will risking his personal home ensure the success of the business? What else is going on here -- why did they decide to start while still under-capitalized, which is the most common reason that 85% of new companies fail?

Would it really be a bona-fide loan -- I don't mean with a legally enforceable promissory note, of course he will have that. I mean is there any realistic expectation (as opposed to a mere hope) of getting repaid? If not, he would do slightly better with an equity investment, assuming he actually gets extra shares of stock.

This is a great idea that this new corporation has--irresistable product or service, right? Definitely worth the risk of ending up in a homeless shelter?

Whatever. Yes, he can deduct his HELOC as investment interest expense. For the portion within the $100,000 limit, he must make a formal, irrevocable election to not treat it as qualified home mortgage debt.

[Gretel]

I followed this thread with great interest since I have one S-Corp. owner who always runs faster than his money.

Of course, you are right Jainen, but the reality we deal with all the time, are those undercapitalized corps. It’s a pain and frustration for all of us.

How does the law effect these corps if audited? Lets say IRS finds it was rather a capital investment and not a loan, then investment interest could only be taken if no material participation, right?

What about being the only shareholder, making major decisions but having employees for all the work? Would that qualify as non-material? And, if not, then no investment interest possible only S/H loan if bonafied?

Don’t bark at me, Jainen.

[Corduroy Frog]

Gabriele

Having decision-making powers means that a shareholder is "active" and not "passive." This opens an entire new discussion not applicable to the original post, so I won't go further.

Corduroy Frog