When acquiring an interest in a pass-through entity such as an interest in a partnership or an S corporation, an acquisition made by an individual using borrowed funds leads to the question of if/how you deduct the interest expense on the acquisition debt. First, yes, you can get tax benefits from the interest expense incurred by the individual on the debt. One might presume that your only option was to deduct the interest expense as investment interest on Schedule A subject to limitations such as investment income – assuming the interest on the debt otherwise qualifies as investment interest. However, IRS Notice 89-35 (see also IRS Letter Ruling 9037027) can give us a better way.
The IRS will let you treat the interest as fully deductible business interest on Schedule E if all of the following conditions are met:
- The taxpayer materially participates in the partnership’s or S Corporation’s business operations.
- The partnership’s or S Corporation’s assets are used solely in conducting an active trade or business and not for passive or portfolio activities.
- No debt-financed distributions to partners or shareholders have been made.
Such qualifying interest should be reported on Part II of Schedule E. Per IRS Notice 88-37, the interest expense should be reported on a separate line and identified as “business interest” with the name of the pass-through entity indicated. As a bonus, if the interest is related acquisition of a partnership interest, it would presumably also reduce self-employment (SE) income and therefore reduce SE tax.
By Dale F. Jensen, CPA