Self-charged interest regulations. (Federal Taxation)by Borofsky, Jeffrey M.
IRC Sec. 469 limits the use of passive activity losses and credits. A passive activity is any rental activity or any trade or business activity in which the taxpayer does not materially participate. Under Sec. 469, net aggregate passive losses may not offset other income, until such time as the taxpayer disposes of his or her entire interest in the passive activity that generated the loss. Other income includes earned income (wages, self employment income), and portfolio income (interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business). If a taxpayer borrows funds to invest in a passive activity, the interest expense incurred on that borrowing is treated as a passive activity loss (Reg. Sec. 1.163-8T). Certain lending transactions between a pass-through entity and an owner may have unintended results. For example, a partner who lends money to a partnership engaged in a passive activity will receive portfolio income from the interest charged to the entity. In addition, the partner's distributive share of the parntership's interest expense would be a passive activity deduction. The Conference Committee Report on Sec. 469 characterized this result as inappropriate to the extent the partner is in fact lending to himself, and concludes that this transaction is "self-charged" and thus lacking economic significance.
Scope of Proposed Regulation
The proposed regulations address two types of lending transactions: loans to a passthrough entity by its owners, and loans by a passthrough entity to its owners. In the proposed regulations, a passthrough entity is defined as a partnership or an S corporation and an owner of an interest in such an entity is a person holding a direct interest (regardless of size) or at least a 10 percent indirect interest.
These regulations recharacterize portfolio income and deductions only when a lending transaction as described above results in a passive deduction for an owner. Therefore, if an owner borrows from an entity and uses the proceeds for personal expenses, the owner's interest deduction will not be passive, nor will be entity's portfolio interest be recharactized.
Treatment of Self-Charged Items
The proposed regulations provide rules for determining the extent to which a taxpayer may offset interest income received from lending transactions between a passthrough entity and its owners against interest deductions from the transactions. For example, A and B each own a 50% interest in partnership AB, that is engaged in a rental activity. AB borrows $50,000 from A, and pays A $5,000 of interest for the taxable year. A and B each incur $2,500 of interest expense as their distributive share of AB's interest expense.
The amount of interest income recharacterized to A as gross passive income is $2,500 ($2,500/$5,00 x $5,000). This is based on a ratio (the "applicable percentage") whose numerator is the owner's self-charged passive activity deduction, and whose denominator is the greater of (a) taxpayer's share of the self-charged interest deductions or (b) taxpayer's income from self-charged activities. As a general rule, if the self-charged deductions are less than the related portfolio income, then an amount of interest income equal to the self-charged interest deduction would be recharacterized as passive activity gross income. If the self-charged interest deductions exceed the related interest income, all of the interest income will be recharacterized. Assume in the above example, B loans AB an additional $10,000 and receives $1,000 of interest for the taxable year. The amount of interest income recharacterized to B as gross passive income is $1,000 ($,000/$3,000 x $1,000). However, A's applicable percentage is obtained by dividing A's share of AB's self-charged interest deductions (50% x $6,000) by the greater of (a) A's share of AB's self-charged interest deduction ($3,000) or (b) A's income from interest charged to AB ($5,000). Thus A's applicable percentage is 60% ($3,000/$5,000), and $3,000 (60% x $5,000) of A's income from interest charged to AB is treated as passive activity gross income from the rental activity. Similar rules apply to an owner's interest income from a passthrough entity when the entity lends to the owner.
Example: A and B each own a 50% interest in Parnership AB. A borrows $30,000 from AB, and pays AB $3,000 for the taxable year. A uses $15,000 for personal expenditures as defined in Reg. Sec. 1.163-8T (b) (5) and uses $15,000 to invest in a passive activity. A has interest deductions of $3,000 and $1,500 of interest income from his distributive share in AB. The applicable percentage is obtained by dividing A's interest expense to the extent treated as passive activity deductions ($1,500) by the greater of (a) total interest expense paid to AB ($3,000) or (b) A's share of AB's self-charged interest income ($1,500). Thus A's applicable percentage is 50% ($1,500/3,000) and $750 (50% x $1,500) of A's self-charged interest income is recharacterized as passive activity gross income.
This section could lead to different results based on the form as opposed to the substance of the transactions. This example uses the facts above, except A and B borrow $15,000 each from AB. A purchases a passive activity for $15,000, and B loans $15,000 to A, with which A makes a personal expenditure. Under these circumstances, the applicable percentage would be determined by dividing $1,500 (the amount of interest charged to A by AB which is treated as a passive activity deduction) by either the greater of (a) A's deductions for the interest charged by AB ($1,500) or (b) A's share of AB's self-charged interest income ($1,500), and thus A's applicable percentage is 100%. This would result in 100% or $1,500 of passive activity gross income rather than $750 as in the prior example. B's net effect is unchanged as the interest income and expense is for investment purposes.
Note: Once income is recharacterized, the regulations are unclear as to which entity the passive income and expense should be allocated to. Under paragraph (d) (2), the proposed regulations can be interpreted to say that the recharacterized interest income from the lending activity would be treated as passive income from the lending activity. They can further be interpreted to say that the interest expense that would normally be allocated to the activity in which the borrowed funds were invested, under Reg. Sec. 1.163-8T, should also be allocated to the lending activity. It appears that a trade or business activity in which the taxpayer materially participates might now have a second activity, consisting of the self-charged interest income and related interest expense.
A different interpretation would allocate both interest income and expense to the activity in which the borrowed funds were invested.
This example should be clarified as to which interpretation applies. We believe that the second interpretation is more appropriate because it follows the interest tracing rules under Reg. Sec. 1.16308T and results in the proper calculation of passive activity losses for each activity.
Under the proposed regulations, a taxpayer's share of an item of income or deduction of a passthrough entity is the amount treated as income or deduction for a taxable year under Sec. 702 (partnership) and Sec. 1366 (S corporation). The amount of a taxpayer's income or deductions under Sec. 702 is determined after taking into account the application of any special allocations under Sec. 704. Therefore, if an allocation has substantial economic effect under Sec. 704 (b), then self-charged interest may be afforded this treatment. Special allocations are not permitted to S corporations due to the second class of stock issues.
Making the Election
The passthrough entity may elect out of these rules by attaching to its tax return (or amended return), a written statement that includes the name, address, and taxpayer identification number of the passthrough entity and a declaration that an election is being made under Reg. Sec. 1.469(7)(f) and is effective for the year made and all subsequent years. An entity may choose to elect out of these regulations to avoid the administrative burden of complying. An entity may also elect out when protfolio income is desirable to the owners (to avoid investment interest expense limitations). It is important that the tax return of the entity indicate whether or not the election was made, so that the partners or shareholders can record the proper items on their tax returns.
The regulations should not be limited to only self-charged interest expense, but should include all self-charged items. As noted, a transaction where in substance the partner is lending to himself, may result in self-charged interest that lacks economic significance. Equally, other transactions, where the taxpayer in substance is paying himself, are also self-charged and lack economic significance. Examples of this include fees or rents paid between the taxpayer and an entity.
As 1987 was the first year the passive activity rules went into effect, and the proposed regulations were issued only days before the three-year statute expired (for taxpayers who filed their 1987 returns by April 15, 1988) taxpayers were given an insufficient time to take the proposed regulations into account. Taxpayers should be given a reasonable period to do so. Any other approach is unfair to those taxpayers who followed the unofficial position of the IRS that self- charged treatment was not permitted until these regulations were issued. If the IRS cannot administratively extend the time for 1987 returns to be amended to conform with these proposed regulations, it should seek a legislative extension of time for amending 1987 returns.
Pursuant to Reg. Sec. 1.1469-7 (b) (1), the definition of a passthrough entity is extended only to partnerships and S corporations. Estates and trusts should also be considered passthrough entities. Furthermore, it would appear that other types of entities not typically thought of as passthrough entities, should be included for the purpose of these regulations. For example, in the situation where a sponsor of a cooperative corporation continues to own shares in the corporation, and thus pays maintenance to that corporation, and the cooperative apartments are being rented, the deduction for the maintenance would typically be considered passive. On many occasions the sponsor also holds a mortgage on the real estate owned by the cooperative corporation, and thus part of the maintenance being paid by the sponsor is being used to pay interest to himself, and is self-charged. This type of situation should be treated the same as interest paid to a partner. This section should also be applicable to loans between related parties (i.e., related partnerships, S corporations, closely held C corporations, consolidated groups, etc).
Pursuant to paragraph (b)(2), an indirect owner must own at least a 10% or greater interest in the capital and profits (S corporations--10% of stock). Therefore, partners in tiered entities would have to qualify for self-charged treatment. There does not appear to be any basis to limit a qualifying indirect interest, especially considering that a direct interest is not so limited. If the limitation on a qualifying interest remains, then entities should be required to report the appropriate percentages. This would permit taxpayers in tiered entities to determine if they hold the required percentage.
Under Reg. Sec. 1.469-7(g), if an owner and the passthrough entity have different tax years, an inequitable result could occur. The owner recognizes portfolio income in one tax year while the related self- charged interest expense occurs in a subsequent axy year. The expense item will not offset the income because the self-charged rules apply on an annual basis. The net tax effect to the taxpayer should be the same whether the taxpayer has the same year as the entity or not. The regulations should be changed to reflect this by allowing the taxpayer to report recharacterized interest income and/or expense equal to the amount calculated by using the regulations or on a cumulative basis, whichever is higher. Under this approach, a taxpayer would end up the same as if he had an interest in a calendar year entity, although the correction wouldn't occur until the final year of the loan.
Reg. Sec. 1.469-7(a)(1) should clarify the definition of a lending transaction between a taxpayer and a passthrough entity. The regulations should state that guranteed payments to partners for the use of capital, and interest paid on a deferred payment of capital, are included as lending transactions, because in substance they are the same as direct loans between a passthrough entity and a taxpayer.
For example, A is required to contribute $100,000 of capital into partnership AB, which is engaged in a passive activity. The contributions are made in five annual installments of $24,0000 each, with $20,000 representing capital and $4,000 representing interest expense. The interest expense is considered passive and would not be deductible against the partnership's distributive share of the corresponding interest income, without the application of the self- charged interest rules.
In the case of interest paid by a taxpayer to an entity, the proposed regulations require that the taxpayer own an interest in the lending entity at the end of the entity's taxable year. This contradicts the requirement that a taxpayer own an interest in the borrowing entity at any time during the entity's taxable year. This requirement causes inequities in the case of taxpayers who either (a) transfer their interests during the year, or (b) have varying interests during the year, but do not have the requisite percentage interest at the end of the entity's taxable year see Reg. Sec. 1.469-7(b)(2).
The regulations cause an unfair result in the case of the final return of a deceased taxpayer who held an interest in a passthrough entity at any time during the year of death. The final return and the estate's (or beneficiary's) return for the year of death should be allowed to utilize any reasonable method, provided the net result provided in the two returns is no more beneficial than had the taxpayer lived.
The provisions of Reg. Sec. 1.469-7 are proposed to be effective for taxable years beginning after December 31, 1986. For taxable years beginning before June 4, 1991, a taxpayer is not required to apply these provisions and may use any reasonable method to offset items of interest income and interest expense from lending transactions between the passthrough entity and its owners.
Regulations Provide Only Some
The proposed regulations for self-charged items provide some help for tax practitioners who must concern themselves with amending prior years' returns to reflect this concept. However, the proposed regulations ignore other self-charged items and enforce unfair restrictions on indirectly owned entities. Through the use of special allocations, however, taxpayers should be able to eliminate self-charged interest problems in many situations.
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