Two areas of the tax law designed to prevent a corporate taxpayer from receiving a double tax benefit as a result of its deduction for interest expense are covered here. The first, under Sec. 265(a)(2), disallows a taxpayer's deduction for interest on loans that are incurred to carry obligations earning interest which is exempt from tax (e.g., obligations issued by state or local governments). The second, under Sec, 246A, limits a corporate taxpayer's deductions for dividends received on stock acquired with funds arising out of indebtedness incurred by the taxpayer. As a result of these provisions, a taxpayer is unable to enjoy a benefit of a double deduction by deducting interest on a loan and, at the same time, receiving tax-free interest or dividend income from state or local bonds or corporate stocks which have been acquired as a result of loans.

Although the origin of Sec. 265(a)(2) goes as far back as the Revenue Act of 1917, Sec. 246A, is a more recently enacted provision, having been legislated as part of TRA 84. It is designed to limit te taxpayer's dividend received deduction to the extent the underlying portfolio stock is considered debt financed. For those unfamiliar with the mechanics of Sec. 246A, an example of its application would be helpful. Assume that a corporate taxpayer owns portfolio stock with an adjusted tax basis of $1,000 and receives a $50 dividend with respect to that stock, for which it is entitled to a 70% dividend received deduction. Ordinarily speaking, the taxpayer would have a $35 dividend received deduction. Assume further that the taxpayer has $400 of portfolio indebtedness and incurs $40 of interest expense to carry that debt. As illustrated in the exhibit, under Sec. 246A, the taxpayer's dividend received deduction is $21. (See Exhibit 1.)

With regard to the application of Sec. 265(a)(2), the IRS has set forth guidelines for determining whether interest expense should be disallowed in various situations where a taxpayer holds tax exempt bonds. In other words, in a given situation, is the taxpayer's indebtedness related to his tax exempt securities? Rev. Proc. 72-18 (1972-1 CB 740) states that Sec. 265(a)(2) is only applicable where the indebtedness is incurred or continued for the purpose of purchasing or carrying tax exempt securities. Accordingly, the application of Sec. 265(a)(2) requires a determination of the taxpayer's intention in incurring or continuing the indebtedness. Whether or not the intention is to acquire or carry tax-exempt securities may be established by direct evidence or if there is none, by circumtantial evidence; but the totality of the facts and circumtances must establish a sufficiently direct relationship between the borrowing and the investment in tax exempt obligations.

At first, one may have equated the application of Sec. 246A with that of Sec. 265(a)(2), especially since there had not been any guidance under Sec. 246A either by the Service or the courts. However, comparing the Service's position under Sec. 265(a)(2), with a newly issued IRS ruling under Sec. 246A (Rev. Rul. 88-66, I.R.B. 1988-32, 7) it is now apparent that they are not similarly applicable in like situations. That is, indebtedness coupled with either tax exempt securities or portfolio stock will not necessarily bear the same result, either limiting or not limiting a taxpayer's deduction, in otherwise similar circumstances.

A corporation in need of expanding its manufacturing facilities issued corporate debt to finance plant construction, and the acquisition of new machinery and equipment. Because of the time needed to complete the construction and to obtain delivery of the equipment, the company temporarily invested the proceeds received from the financing in tax exempt securities. In this situation, the IRS (Rev. Rul 55-389 1955-1 CB 276) found that the facts and circumstances support a presumption that the debt was not incurred for the purpose of purchasing or carrying tax exempt securities, but rather for purposes of plant expansion. Accordingly, Sec. 265(a)(2) did not apply and the corporation could deduct the interest on its corporate debt as long as the funds were gradually expended over the following 21 months on plant expansion and machinery acquisitions.

The IRS has been consistent, reaching similar conclusions in two private letter rulings (LTRS 8536023 and 8350019). Both rulings deal with a corporation issuing corporate debt for purposes of business expansion and construction, temporarily investing the proceeds in tax exempt securities for up to two years while expansion and construction progress. The IRS ruled each time that the company's interest was deductible and that Sec. 265(a)(2) did not apply because the taxpayer's purpose of incurring the debt was not to acquire tax exempt securities.

Now note what the result would be in circumstances that are similar except that the taxpayer temporarily invests the debt proceeds in portfolio stock instead of tax exempt securities. Here the IRS concludes in Rev. Rul. 88-66, that the taxpayer's dividend received dedcution should be limited under Sec. 246A.

The IRS's reasoning in Rev. Rul. 88-66 is explained in General Counsel's Memorandum 39749, in terms of why there is a difference between temporarily investing debt proceeds in portfolio stock versus tax exempt securities. Under the statutory language in Sec. 246A, a taxpayer's dividend received deduction is limited if there is any indebtedness directly attributable to an investment in portfolio stock. In this regard, legislative history under Sec. 246A looks to whether an indebtedness is either directly traceable to an investment in portfolio stock or is incurred for the purpose of acquiring portfolio stock (H.R. Report No. 432 at 1181). In Rev. Rul. 88-66, the debt is directly attributable to the taxpayer's temporary investment in portfolio stock since the stock was bought with the loan proceeds. This is despite the fact that the debt was incurred for purposes of plant expansion and not for purposes of acquiring tax exempt securities. Thus, the indebtedness meets the statutory language in Sec. 246A.

On the other hand, the statutory language of Sec. 265, and the legislative history thereunder, disallows an interest deduction if the purpose of the borrowing is to purchase or carry tax-exempt obligations. Since the purpose of the borrowings is for plant expansion, Sec. 265(a)(2) does not apply even if temporarily invested in tax exempt securities. Sec. 246A, however, does not utilize a "purpose" requirement but rather uses a "directly attributable" test. Accordingly, two different tax results occur if temporarily investing in either tax exempt securities or portfolio stock.

It should be noted that Rev. Rul. 88-66, also discusses the application of Sec. 246A to a second set of circumstances, with respect to which the IRS does not rule as harshly. This ruling helps clarify the IRS's position on how to apply the "directly attributable" test. A corporation already owning portfolio stock acquired a new facility to meet the needs of its growing business. The company did not sell its portfolio stock but rather borrowed to finance the acquisition, securing the debt with the new facility. In this situation, the IRS determined that although the corporation did not sell its portfolio stock investment instead of incurring the debt, this does not constitute a direct relationship between the portfolio stock and the indebtedness (especially since the stock did not secure the loan). Accordingly, the IRS concluded that the debt was not directly attributable to the investment in portfolio stock. It is important to emphasize that although this situation achieves similar results under Secs. 246A and 265(a)(2), it is the separate application of the statutory language under each that coincidentally does not limit a taxpayer's deduction in both scenarios.

S Corporations and Fringe Benefits: Sec. 1372

With the increasing popularity of S Corporations, it is important to be familiar with the treatment of fringe benefits. Sec. 1372(a) provides "simply": "For purposes of applying the provisions of this subtitle which relate to employee fringe benefits:

1. The S corporation shall be treated as a partnership; and

2. Any 2% shareholder of the S Corporation shall be treated as a partner of such partnership."

The first question that arises is "what are employee fringe benefits?" Since there are no regulations, references must be made to the committee reports. The committee reports indicate that fringe benefits include the following:

* The $5,000 death benefit exclusion Sec. 101(b);

* The exclusion from income of amounts paid for accident and health plans Secs. 105(b), (c), and (d);

* The exclusion from income of amounts paid by an employee to an accident and health plan Sec. 106;

* The exclusion of the cost of up to $50,000 of group term life insurance on an employee's life Sec. 79; and

* The exclusion from income of meals or lodging furnished for the convenience of the employer Sec. 119. The status of other types of "fringe benefits" is unclear.

The second question that arises is "what is the import of the language' the S Corporation shall be treated as a partnership'?" The Committee Reports seem to suggest that this phrase means that certain fringe benefits are not excludable from the income of 2% or more shareholders, and furthermore that there is no allowable deduction at the corporate level. There is nothing in the Code which entirely supports both these propositions. The commentators seem to suggest that, despite the Committee Reports, a deduction should be allowable at the corporate level but the exclusion may be precluded.

Example 1: ABC Corp. has three shareholders X, Y and Z. Each shareholder has a 1/3 ownership interest in the corporation and is also an employee. The corporation expends $1,000 each for group-term life up to $50,000 for X, Y and Z respectively. In this scenario ABC Corp. has an allowable deduction of $3,000 and X, Y and Z each report an additional $1,000 as income (presumably compensation).

A related question arises as to the allocation of the deduction for fringe benefits.

Example 2: ABC Corp. provides shareholder Z with additional fringe benefits costing $6,000. It would appear that ABC Corp. may take a deduction at the corporate level for $6,000. Thus the deduction is allocated pro-rata. Yet, shareholder is reporting income of $6,000 with only a $2,000 offsetting deduction.

In Example 2, there is some question as to the availability of a special-allocation type approach. Again, clarity is not present.

Another approach is to treat the fringe benefit as non-deductible at the corporate level and as a separately stated item at the individual level. The effect of this approach can be analogous to the result in Example 2. For example, if ABC Corp. pays for medical expenses for shareholder X, but not Y and Z, the medical expense amount will be allocated pro-rata to X, Y, and Z but will only potentially be deductible by X because he is the only shareholder who actually incurred medical expense.

A third approach is to treat the payment of the fringe benefit solely as distribution (thus non-deductible at the corporate level or the individual level). The distribution would be allocable solely to the applicable shareholder, resulting in a potentially disproportionate allocation of the AAA account. This in turn could violate S Corporation status by constituting a disproportionate disposition.

Conclusion

The treatment of fringe benefits by an S Corporation is unclear. It is imperative that the IRS issue regulations which:

* Define what a fringe benefit is for purpose of Sec. 1372;

* Clarify the treatment to be accorded each fringe benefit at the corporate and/or individual level, the effect on the AAA account, and the effect on basis; and

* Provide examples. For the time being, practitioners should adopt the most suitable approach to the given clients' particular facts and circumstances, bearing in mind the potential risks. They should also be prepared to justify the approach taken.

Customer Deposits Found Not to be Income

Recently the 7th Circuit Court of Appeals examined whether customer deposits received by a utility company were to be included in its income at the time of receipt.

The facts in Indianapolis Power and Light Co. v. Commissioner, CA 7, No. 87-2438, 9/20/88, were as follows: Indianapolis Power and Light Co. ("IPL") was engaged in the business of generating and selling electricity to its customers. Approximately 5% of its customers were deemed not creditworthy and were required to deposit funds to "insure prompt payment" for electrical services. The deposits were not segregated from other assets and were used in the ordinary course of business. However, depositors were paid interest on the amounts deposited.

The deposits were available as refunds upon termination of service or when the customer established creditworthiness by timely paying his or her bill for a certain period of time. Unless a customer requested that the deposit be used to offset a bill, the deposit was refunded. IPL, under its accrual method of accounting, treated the deposits as current liabilities. Deposits were included in IPL's income only if and when they were used to offset customers' bills.

At issue was whether these deposits were prepayments of income to IPL creating current income recognition, or non-taxable payments to secure the performance of an obligation. In presenting its case, the IRS argued that the proper test for determining the character of the deposits was set forth in City Gas Co. of Florida v. Commissioner, 689 F. 2d 943 (11th Cir., 1982). That Court ruled that the proper test was to look at the underlying purpose of the deposit. If the purpose was to secure future payment for goods and services to be provided by the recipient of the deposit, the deposit should be taxable income upon receipt. If, on the other hand, the deposit was to secure the performance of a non- income provision of a contract (e.g., to cover damages to property), the deposit would not be income upon receipt. The IRS, using these categories, argued that because the deposits received by IPL were to secure payment of bills, the deposits should be included in income when received.

The Tax Court in IPL, however, declined to apply the 11th Circuit's test above. Rather it adhered to its own test of looking at the facts and circumstances to determine the purpose of the deposit. Income recognition would result if the payment was to serve as an advance payment of income. If, however, the payment served as security for future performance, a taxpayer would not recognize income upon the receipt of the payment. In holding for IPL, the Tax Court emphasized three factors that supported the treatment of the deposits as security for future performance, as opposed to advance payments of income. First, only a limited number of customers were required to make deposits. Second, customers controlled the timing and the disposition of the deposit. Third, interest was paid on the deposits.

On appeal, the 7th Circuit Court looked at the reasons for deposited funds. One was a "return factor," or interest earned on the advanced funds; the second was a "security factor," or the ability to save a portion of income lost due to customer default. The "return factor" was negated by IPL's paying interest to the customers who made the deposits. Therefore, the only benefit IPL received was the "security factor."

The court held that "this benefit alone did not constitute use of the proceeds sufficient to justify immediate taxation of the deposit." The deposit merely assured that IPL would be paid if the depositor defaulted. This is a function typically associated with non-taxable security deposits. The court further explained that "as the interest rate paid (to the depositor/customer) on the deposit begins to approximate the return that the recipient would expect to make from the use of the deposit amount, the deposit begins to serve purposes that comport more squarely with a security deposit." Therefore, IPL's deposits were held to not be income upon receipt.

Practitioners should take note of the factors outlined above when analyzing customer deposits. Proper structuring of the deposit arrangement should prevent the IRS from reclassifying the deposits as current taxable income. Tabular Data Omitted