Welcome to Luca!globe
Main Menu
CPA Journal
Professional Libary
Professional Forums
Member Services


By Peter Barton JD, CPA, professor of accounting, and
Clayton Sager, PhD, associate professor of accounting, University of Wisconsin-Whitewater

In Russon v. Commissioner, a case of first impression, the Tax Court recently ruled that interest incurred on debt incurred by a materially participating employee to purchase C corporation stock is investment interest, which limits its deductibility. Russon applies to all taxpayers who incur debt to purchase a business as owner-managers rather than investors.

IRC section 163 allows a deduction for interest incurred in a trade or business; however, IRC section 163(d)(1) limits the deduction for investment interest to the amount of net investment income for taxpayers other than corporations. Investment interest is interest on debt "properly allocable to property held for investment." IRC section 163(d)(5) defines "property held for investment" as either property that produces IRC section 469(e)(1) income or an interest in a trade or business that is not a passive activity and in which the taxpayer does not materially participate. (This definition was added to the code under the 1986 Tax Reform Act. Under prior law, the Tax Court determined whether the taxpayer had a "substantial investment intent.")

IRC section 469(e)(1) income, known as portfolio income, includes "interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business." Deriving such IRC section 469(e)(1) income in the ordinary course of a trade or business would occur if the taxpayer were in the securities business.

In Russon, Scott Russon, his brother, and two cousins purchased all
of the stock of Russon Brothers
Mortuary, a C corporation, from
their fathers for $999,000 in 1985. The younger Russons paid 10% down and agreed to pay the balance in 180 monthly payments at nine percent interest. They were employed full-time at Russon Brothers prior to and since the purchase. Although Russon Brothers had never paid a dividend, the purchase contract contained provisions concerning the possibility of dividends.

Scott deducted the interest expense on his portion of the loan, arguing that it was incurred in a trade or business, not investment interest. He reasoned that since Russon Brothers had never paid a dividend, it had not produced any dividend income. Therefore, its stock was not property held for investment. The IRS contended that corporate stock is property held for investment whether or not dividends are actually paid.

The Tax Court ruled that the interest was investment interest expense because the statutory language and legislative history indicate that Congress did not require the actual payment of any dividends, interest, etc., for property to be property held for investment. The court also noted that the Russons' purchase agreement contained provisions about dividends.

Scott also argued that the purpose of the 1986 changes in IRC section 163 was to curb tax shelters, not to prevent taxpayers from deducting interest expense incurred in a business that they own and operate on a full-time basis. The Tax Court responded that the statutory language classifies interest expense on debt to purchase C corporation stock as investment interest regardless of the motive of the taxpayer in purchasing the stock. Also, the court pointed out that the interest would not be investment interest, and therefore could be deducted without limitation, if Russon Brothers were an S corporation or a partnership.

These entities are neither separate taxpaying entities from their owners nor do they produce IRC section 469(e)(1) income. (A limited liability company could similarly deduct the interest.)

Clearly, the best option for taxpayers who incur debt to purchase a business as owner-managers is the purchase of an entity that is not a C corporation. However, if the entity is a C corporation, there is a strategy that would allow the C corporation to deduct the interest. The buyers would purchase a small amount of the stock for cash. The corporation, which is not subject to the investment interest limitations, would then completely redeem the majority-owner sellers under IRC section 302(b)(2) or IRC section 302(b)(3). It could fully deduct any interest expense incurred and the sellers would receive capital gain treatment. In a family owned business, IRC section 302(c)(2) allows the family attribution rules on the constructive ownership of stock to be waived. Another advantage of this strategy is that, since the buyers would not be incurring the debt, they could accept lower wages and thereby reduce their FICA taxes. *

Source: Russon v. Commissioner, 107 T.C., No.15 (November 6, 1996).

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

©2009 The New York State Society of CPAs. Legal Notices

Visit the new cpajournal.com.