Deductions

ESH--Busn Interest Deductions

Since the enactment of TRA '86 attention has been focused on the deductibility of interest on loans taken out by a shareholder /employee for his or her corporation. This is not an uncommon situation since shareholders/employees frequently have more value in their assets as security for loans than their corporations.

The question is whether this interest can be treated in such a manner that it is fully deductible, assuming that it cannot be treated as home equity interest. IRC 163(h)(3)(A)(ii). The interest on such loans should be fully deductible as business interest under certain fact situations.

The law in this area is short and simple, to wit IRC sec 163(h), which prohibits the deduction of personal interest. The exceptions to the definition of personal interest include "Interest on indebtedness incurred or continued in connection with the conduct of a trade or business (other than the trade or business of performing services as an employee),..."

In the General Explanation of the Tax Reform Act of 1986 (The Blue Book) the only reference to business interest expense is basically a recital of the law and a footnote comment, "Thus, for example, interest on debt to finance an employee business expense is not deductible under this rule."

Since until the enactment of TRA '86, nearly all interest expense was deductible, commentaries, cases and rulings, interpreting sec. 163 cannot be expected to provide guidance as to the outer limits of appropriate business interest expense. Based on interpretations of sec. 162, if a loan was made to a business owner for his or her business operated as a sole proprietorship or a general partnership, the interest expense would be properly treated as business interest. It seems unlikely that Congress really intended that mere incorporation, or perhaps even the mere absence of an S-election, should be the deciding factor determining the deductibility of business interest expense.

However, based on analogy with IRC sec. 162, it is essential for deductibility as business interest that the shareholder's /employee's activities in managing the corporation must rise to the level of activities of a sole proprietor or a general partner in an active business. See Mertens (Law of Federal Income Tax, Para. 25.26, p. 94, Callaghan & Co., 1974), for a discussion of the need for such activity in the deduction of shareholder/employee expenses. For a deduction to be allowed as a business deduction for the shareholder/employee, his or her activities in managing the corporation must clearly be a separate trade or business on its own.