Tax Treatment of Interest Incurred to Purchase S Corporation Stock

Stuart Freeland
May 8, 2008 — 2,454 views  
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Section 163(d) of the Internal Revenue Code of 1986 as amended limits the deduction of interest incurred to purchase property held for investment to an amount not to exceed the investment income of the taxpayer for the year in which the interest is paid.  This provision can provide an unpleasant result in connection with the acquisition of the business of an S corporation by means of a stock purchase.  If the purchaser does not materially participate in the trade or business of the acquired corporation as defined in Treas. Reg. 1.469-5T, the limitation will clearly apply.  However if the purchaser materially participates in the business, the applicability of the limitation has been held to depend on the primary purpose for which the stock is purchased and held.  If the primary purpose is to acquire a business in order to obtain or protect the employment of the purchaser, there is authority that the limitation will not apply with respect to interest allocable to the business assets of the acquired corporation.  Schanhofer v. Commissioner, T.C. Memo 1986-166, 51  TCM 924 (1986); Notice 89-35, 1989-1 C.B. 675; Ltr. 9215013; Ltr. 9037027; Cf., Russon v. Commissioner, 107 T.C. 263 (1996).  If the primary purpose is to acquire and hold the stock for investment, the limitation will apply.  Miller v. Commissioner, 70 T.C. 448 (1978); GCM 39529 (July 16, 1986).

The problem with the foregoing authorities is that, notwithstanding the different outcomes, the facts under consideration were not greatly different.  For example, Mr. Miller was a partner in a partnership that purchased stock in a bank of which he served as president.   The court acknowledged that one of the purposes for which the partnership acquired the stock was to enable Mr. Miller to obtain a salary as an employee of the bank; however it determined that the primary purpose of the partnership was to acquire the stock with the intent to obtain a profit when it was sold (which had occurred fourteen months after the stock was purchased).  Similarly, GCM 39529 found that the purchase of S corporation stock by three taxpayers, all of whom held executive positions in the acquired company, was primarily motivated by an investment purpose.

Even if the purchase is found to have a primary business purpose, the interest must be allocated among the assets of the acquired business in accordance with Rev. Rul. 89-35, 1989-1, C.B. 675.  See Ltr. 9037027, supra, which allowed the purchaser to deduct interest incurred to purchase shares of an S corporation by which he was employed but only to the extent allocable to assets actually used in the conduct of the acquired business.

Happily, as a pass through entity, which enables the seller to avoid the double level of tax imposed in connection with the sale of the assets of a C corporation, most S corporations are acquired by means of an asset purchase.  This should avoid the limitation problem with respect to interest allocable to assets used in the trade or business of the acquired corporation.  If it is necessary to purchase stock in order to preserve contract rights or other non transferable rights of the acquired corporation, it should be possible to structure the transaction as a deemed asset purchase by making a 338(h)(10) election.

Stuart Freeland

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Mr. Freeland represents businesses and institutions both as outside general counsel and in a broad range of transactions, particularly real estate related activities. His clients include a major Boston area university, real estate development firms and organizations involved in a variety of business activities. Mr. Freeland assists clients to organize and operate their businesses in a tax efficient manner.