I have a client who is purchasing an s-corp via a 10-year structured installment agreement. She is using owner-distributions from the business to pay the installments. These distributions are about 1/2 the amount of w-2 salary she pays herself for the work she does in the business. The business is profitable enough to support this arrangement.
She is paying approximately $16,000 interest per year on this purchase. She materially participates in the business. I've begun looking into the deductibility of this interest, and perhaps I'm looking under the wrong title, but I seem to be running into a "non-deductable" answer. I'm hoping that some of you tax pros could point me in the right direction -- is this interest deductible, what is it called and where is it deducted? Since she is being taxed on
100% of the distribution, and the individual from whom she is purchasing the business is claiming the interest paid each year, my client would surely like to deduct the interest payments to offset some of her s-corp profits (the interest is approximately 1/2 of the profits).
BTW, the CPA who prepares the 1120S includes the interest payments on an information line on the second page of the K-1, if that makes any difference.
She bought a business and is paying interest on the purchase price. That should be deductible, though I'm not sure where (it isn't passive investment interest).
When one "buys" a corporation, S or C type, he is buying stock in the corporation. So I think the main question here, is from whom is she buying the stock?
Is it: (1) from the other owner of the corporation? or (2) is she buying newly issued shares of the corporation, issued as it is paid for?
And depending on whether 1 or 2 above, who is earning interest?
Thanks Seth. After I posted the question, the client contacted the CPA who generates the 1120S (and therefore the K-1). He said to "net" it with the business profits reported on line 1 of the K-1. I wasn't too thrilled with that answer, since the IRS had a K-1 showing $16,000 more on line 1 than we were going to report on Line 28(j) of the her personal Schedule E. But after some discussion back and forth, the CPA suggested entering it on line 12R of the K-1 input screen with the statement "interest expense for stock buy-out" as an explanation for the deduction. The CPA also warned me that this interest was not deductible for PA.
She entered into an installment sale to buy 100% of the stock from the previous owner.
The previous owner, who is reporting it on her tax return (which is prepared by the same CPA who continues to prepare the 1120S and who structured the stock buyout.)
My client is considered the sole owner of this S-corp, but she is paying the installments for 10 years.
right -- she's paying (through 120 monthly installments) for the legal entity, the goodwill, the customer base, the retained earnings, the contacts and brokerage connections, the rights to future commissions (it is an insurance brokerage that was in business for about 40 years before she purchased it), etc.
Thanks! That article was very helpful (assuming that I am reading it rightly!). It seems to me that we are talking about "Active Interest Expense" (since it is "incurred in connection with a trade or business activity in which the tp materially participates and which is not a rental real estate activity.") and the article says that "Active interest expense is deductible on Schedule E along with losses from pass-through entities of trades or businesses in which the taxpayer materially participates."
Thanks again -- I printed this out and will file it with my copy of the client return.
First, was this a stock sale or an asset sale and who was really the buyer? This information will be contained in the sales contract. NOTE you (nor I nor anyone else) CANNOT rely on what we're told because most clients do NOT really understand the legal formalities of what they're doing. Most clients do NOT know how to differentiate between themselves and their companies. To get the right answer you'll need to review and scrutinize the sales contract.
Second, you say "SHE" is paying interest on this purchase, then you say the interest is being reported on the K-1. This cannot be correct. She is NOT the corporation, the corporation is issuing the K-1 so either SHE is paying or the corporation is paying, but it cannot be both.
If SHE is paying the interest it should be deductible as investment interest expense - see Form 4952.
If the company is paying the interest (assuming legitimately so) then the company gets the deduction on the face of the 1120S. NOTE - it is highly unlikely that the sale was structured to allow the company this deduction, though if done properly it can be done.
Thirdly, exactly who are the payments to? Specifically who is named as the payee on the checks? If SHE bought the shares of stock from HIM, SHE will write personal checks to HIM, SHE deducts the interest on Form 4952 and HE claims it as income on Schedule B.
However, if she bought the assets of an existing corporation (WHICH IS WHAT NORMALLY HAPPENS) then SHE should be making the payments to the old corporation and NOT to the old owner individually.
With the caveat that without this information I'm just guessing, here's my guess -
I'd bet this was supposed to be an asset sale and NOT a stock sale since that is the norm. As an asset sale, either her or her new company purchased the assets of the old business from the old company. An asset sale allows the new company to restart depreciation.
IF the deal was between her and the seller it is HER responsibility to pay. So she gets to deduct the interest as investment interest expense and her principal payments will increase her basis in the new company.
However, if the deal was between her new company and the seller than it is the company's responsibility to pay. Accordingly the company would get to deduct the interest as an operating expense.
Lastly, remember - without actually reading the sales agreement there is NO WAY to know what is supposed to happen, it is ALL conjecture and assumption. This is one of those areas where clients get fidgety because they NEVER want to pay to know what to do, they almost never ask for help and guidance up front to get it structured properly BEFORE it happens, yet they ALL want us to fix their mistakes after the fact (and usually for free).
The best recommendation I can make is for your client to pony up the sales agreement. Then either you read it, if you understand such things, or you have it read by a professional tax preparer who is experienced with such things. Then you can get the real scoop on how it should be.
I do have a question - why is there a differnent account for the business return? How come you aren't doing both?
Ahah! Now we know. You say now, that "She entered into an installment sale to buy 100% of the stock from the previous owner." This means that the transaction has nothing to do with the corporation but is a private sale between previous stockholder/owner and new one. Therefore she is paying interest to the previous owner, and not to the corporation. Therefore the interest has nothing whatsover to do with the corporation and not appropriate atall to show it on any schedule k-1.
If your practice were a corporation, and I offered to buy all your stock, I would pay you and not the corporation. The latter of course would have to transfer the shares on the books from you to me, just like any stock transaction.
Therefore, it is not right to "net" the interest with the ordinary income (line 1) on the k-1. In fact it's not a deduction on schedule e.
Gene, I got the impression it was a sale of stock between old and new owner.
(snipped....)
Yes, we would all be interested as to what actually happened. Please let us know, Elizabeth.
This is a great question, Gene. If new owner owns 100% of the stock (seems so, since she is "purchasing an s-corp via a 10-year structured installment agreement."), then she should be the one to hire and fire, and/or choose the corporate accountant.
I don't wanna . I'm getting up there in age and I realize I'm not as sharp as I once was. I do all the bookkeeping on this business and I really don't want to do the tax returns.
The owner wants continuity. This CPA firm has been doing the tax returns for a very long time (quite possibly for the entire life of the company) and are the ones that structured the buyout.
I've been an EA (my license is currently in inactive status while I decide if I even want to keep it -- like I said, I'm not as sharp as I used to be and I'm leaning toward retirement) and a QuickBooks ProAdvisor, and I work very well with other professionals. The CPA knows that I'm not trying to push him out, the client does not feel at all pressured to choose between me and the CPA, and I don't put my name on the Corp returns -- a win-win-win situation!
The owner doesn't want to pay the CPA's rates to do her own personal return. She has 2 K-1s for two different S-corps (she's the sole owner of the one in question and a partial owner of the other), one W-2 and two children. She figures it's not a tough return and was going to do it herself on Turbo Tax, till it came to trying to figure out what to do with that ,000 of interest she had paid the former owner for the stock buyout. I was helping her look into it as a courtesy (she pays me a LOT of money to be her bookkeeping department !)
Your arrangement with the client is not that unusual. I to have similar arrangements with a few of my clients. I do however prefer the label myself "consultant" or "part time controller" rather than bookkeeping department.
Since you are privy to the S-Corporation's original books of entry, can I assume the buy-out installment payments are made by the corporation and posted to the Sharholder's Distributions account?
Harlan: Then, the very next paragraph in the NYSSCPA article explains how to identify the "active interest expense" [a term that I think the author of the NYSSCPA author made up...] based on what assets the pass- through entity has, how they're used and whether or not the owner is a material participant in the activity of the pass-through entity.
Here's that next paragraph: "For example, if the debt is allocated to assets held for investment, such as stocks and bonds [held by the pass- through entity], the interest expense will generally be classified as investment interest expense. If the debt is allocated to equipment used in the conduct of an active trade or business [of the pass- through entity] in which the taxpayer materially participates, the interest expense will be classified as active interest expense. If the debt is allocated to assets used in an activity in which the taxpayer does not materially participate, it will be classified as passive interest expense."
It's clear to me that the interest expense in this instance would be "business" interest expense ["active interest expense" in the words of the author of the article.
The IRS Notice is clearer, even though it's less clear. You know how those folks write....
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