GUIDANCE FOR REPORTING INTEREST EXPENSE INCURRED IN DEBT-FINANCED ACQUISITIONS AND DISTRIBUTIONS INVOLVING PASSTHROUGH ENTITIES.

Notice 88-37

I. BACKGROUND

In Notice 88-20, 1988-9 I.R.B. 5, the Internal Revenue Service provided temporary guidance with respect to the allocation of interest expense in connection with certain transactions involving partnerships and S corporations ("passthrough entities"). The transactions addressed in Notice 88-20 are (a) debt-financed contributions to the capital of and purchases of interests in passthrough entities ("debt-financed acquisitions") and (b) debt- financed distributions by passthrough entities to owners of such entities ("debt-financed distributions"). This notice provides guidance with respect to the reporting of interest expense in connection with such transactions.

II. EFFECTIVE DATES

This guidance applies to interest expense taken into account by owners of passthrough entities in taxable years beginning after December 31, 1986.

III. PERMISSIBLE ALTERNATIVES

Compliance with the reporting instructions set forth in this notice will facilitate the processing of returns of owners and passthrough entities. The Internal Revenue Service recognizes, however, that many taxpayers have filed their returns for taxable years beginning after December 31, 1986, and that Notice 88-20 is a recent pronouncement. Therefore, for taxable years beginning in 1987, reasonable alternative methods of reporting the interest expense described in this notice will be accepted regardless of whether the return was filed before or after this notice was issued. For example, the Service will accept a return on which interest expense properly reported on Schedule E under the rules in section IV of this notice is reported on Schedule A.

IV. INTEREST EXPENSE ON DEBT-FINANCED ACQUISITIONS

A. INDIVIDUALS

1. In general

Individuals should report interest expense paid or incurred in connection with debt-financed acquisitions on either Schedule E or Schedule A of Form 1040, depending on the type of expenditure to which the interest expense is allocated. For purposes of this section IV, interest expense is allocated to a particular expenditure of a passthrough entity if the interest expense is allocated to such expenditure under the rules of section 1.168-8T and Notice 88-20. (For purposes of this notice and Notice 88-20, the term "expenditure" has the same meaning as when used in section 1.168-8T.) In addition, any interest expense allocated under the rules of Notice 88-20 to assets used in an activity shall be treated for purposes of this section IV in the same manner as interest expense allocated to an expenditure for such assets would be treated.

2. Interest expense allocated to trade or business expenditures

Interest expense allocated to a trade or business expenditure (within the meaning of section 1.163-8T(b)(7)) of a passthrough entity should be reported in Part II of Schedule E. This interest expense should be identified on a separate line in column (a) as "business interest," followed by the name of the passthrough entity to which the interest expense relates, and the amount of such interest expense should be entered in column (h). This interest expense is deductible without limitation and should not be entered on Form 8582, relating to passive activity loss limitations, or Form 4952, relating to investment interest.

3. Interest expense allocated to passive activity expenditures

Interest expense allocated to a passive activity expenditure (within the meaning of section 1.163-8T(b)(4)) of a passthrough entity should be entered on Form 8582 as a deduction from the activity in which such expenditure was made. The deductible amount (if any) of such interest expense, as determined under section 1.469- 1T(f)(2)(ii), should be reported in Part II of Schedule E. This interest expense should be identified on a separate line in column (a) as "passive interest," followed by the name of the passthrough entity to which the interest expense relates, and the amount of such interest expense should be entered in column (f).

4. Interest expense allocated to investment expenditures

Interest expense allocated to an investment expenditure (within the meaning of section 1.163-8T(b)(8)) of a passthrough entity should be entered on Form 4952. The deductible amount (if any) of such interest expense should be reported on line 11 of Schedule A or on Schedule E in accordance with the instructions to Form 4952. See, however, the instructions to Form 1040 for circumstances in which deductible investment interest reportable on Schedule A may be reported on Schedule A without being entered on Form 4952. The investment interest that is reportable on Schedule E should be identified on a separate line in Part II, column (a), as "investment interest," followed by the name of the passthrough entity to which the interest expense relates, and the amount of such interest expense should be entered in column (h).

5. Interest expense allocated to personal expenditures

Interest expense allocated to a personal expenditure (within the meaning of section 1.163-8T(b)(5)) made by a passthrough entity for or on behalf of the owner should be reported on line 12a of Schedule A.

B. OTHER TAXPAYERS

Taxpayers other than individuals should report interest expense on debt-financed acquisitions on the line for interest expense on their returns. Although this interest expense need not be separately identified, it must be treated on the return in a manner that is consistent with the limitation (if any) that applies to such interest expense. Thus, for example, interest expense of a closely held C corporation (within the meaning of section 469(j)(1)) with respect to a debt-financed acquisition that is allocated to a portfolio expenditure (within the meaning of section 1.163-8T(b)(6)) is not taken into account in computing net active income (within the meaning of section 469(e)(2)(B) and section 1.469-1T(g)(4)(ii)).

V. INTEREST EXPENSE ON DEBT-FINANCED DISTRIBUTIONS

If, after the application of the rules in Notice 88-20, debt proceeds of a passthrough entity are allocated to distributions to owners of the entity, the portion of an owner's share of the passthrough entity's interest expense on debt proceeds allocated to distributions to owners that does not exceed the passthrough entity's interest expense on debt proceeds distributed to such owner should be included on the line on Schedule K-1 for other deductions. This interest expense should be identified on an attached schedule as "Interest expense allocated to debt-financed distributions." The passthrough entity should allocate a ratable portion of such interest expense to each distribution of debt proceeds to such owner and, on the attached schedule, should list all distributions to the owner to which debt proceeds are allocated and the amount of debt proceeds and interest expense allocated to each such distribution.

The manner in which the owner should report such interest expense depends on the types of expenditures that the owner makes with the distributed debt proceeds. Thus, for example, if the owner used the debt proceeds to make a personal expenditure (within the meaning of section 1.163-8T(b)(5)) the owner should report the interest expense as personal interest on Schedule A.

Under Notice 88-20, if an owner's share of the passthrough entity's interest expense on debt proceeds allocated to distributions to owners exceeds the passthrough entity's interest expense on debt proceeds distributed to such owner, the passthrough entity may allocate the excess interest expense using any reasonable method. The interest expense allocated by the passthrough entity should be reported on Schedule K-1 in a manner consistent with such allocation. For example, if the passthrough entity allocates the excess interest expense to a rental activity, the expense should be taken into account by the entity in computing the income or loss from the rental activity that is reported to the owner on Schedule K-1.

Subject to certain restrictions, Notice 88-20 also permits the passthrough entity to allocate debt proceeds that are distributed to owners of a passthrough entity to expenditures other than distributions. The passthrough entity's interest expense on debt proceeds allocated to such other expenditures should be reported on Schedule K-1 in a manner consistent with such allocation. Thus, for example, if the passthrough entity allocates distributed debt proceeds to an expenditure in connection with a rental activity, the entity's interest expense on the debt proceeds should be taken into account by the entity in computing the income or loss from the rental activity that is reported to the owner on Schedule K-1.

VI. DRAFTING INFORMATION

The principal author of this notice is Michael J. Grace of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the notice on matters of both substance and style. For further information regarding this notice, contact Mr. Grace on (202) 566-3288 (not a toll-free call).