When someone uses debt to acquire an interest in an S corporation, or any other pass-through entity including a partnership, the interest on the debt must be classified to determine its deductibility. Depending on several factors, the interest expense for an S corp you own and also work for would likely be classified as either investment interest, which, subject to certain limitations, is deductible on Schedule A, or as active interest expense, which is deductible on Schedule E.
The IRS defines investment interest as interest that is incurred on indebtedness allocated to property held for investment. However, investment interest expense is deductible only to the extent of net investment income. So if your S corp investments already show a loss, the allocated interest is not deductible. Investment expenses are deductions directly connected to the production of investment income and traditionally include margin interest, investment consulting fees, and the like. In performing this calculation, the investment expenses are reduced by 2 percent of adjusted gross income (AGI) as a miscellaneous itemized deduction on Schedule A.
Alternatively, active interest expense is interest incurred in connection with a trade or business in which the taxpayer materially participates (except rental real estate). Active interest expense is not subject to the same investment interest limitations discussed above. Notably, active interest incurred in connection with performing services strictly as an employee (not an S corp owner) is nondeductible personal interest. However, other than that, allocated active interest will generally be deductible without limitation.
Allocation of Interest Expense
The IRS provides specific guidance on how to allocate interest expense in connection with debt-financed acquisitions of S corporations. When the debt is allocated to the S corp, the debt and its related interest expense are allocated among the various assets of the company using a reasonable method. For instance, if some of the debt is allocated to assets held for investment, such as stocks, bonds or mutual funds, that interest expense generally will be classified as investment interest expense. However, if some of the debt is allocated to computer equipment or office furniture used in an active trade or business in which the taxpayer materially participates, the allocated interest expense will be classified as active interest expense and, therefore, again will be deductible without limitation.
Reporting Interest Expense
Depending on how the interest expense is classified, individuals report deductible interest expense incurred related to their debt-financed acquisitions of S corps on either Schedule A (if it is investment interest) or Schedule E (if it is active interest). Investment interest expense is first reported on Form 4952, Investment Interest Expense. Then, to the extent that investment interest expense is deductible, it is reported on Schedule A as an itemized deduction. Active interest expense is deductible on Schedule E, along with losses from S corporations or other pass-through entities of businesses in which the taxpayer materially participates.