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Limited victory for partners/S shareholders; management fees bar remains.
Let's hear a drumroll please for the IRS! After only 16 years, it has issued final regulations (T.D. 9013) under Section 469, the passive activity loss rules, concerning "self-- charged" items of income and expense. To be fair, the Service did issue proposed regs on this matter in 1991 for which it received public comments. However, given the significant period of time that had elapsed since that comment period, additional comments were solicited in Notice 2001-47.
Correcting an Inequity
Partners or S corporation shareholders who make loans to the entities in which they own an interest will receive interest income and will also be allocated a share of the interest expense incurred by the passthrough entity. Under the Code, if the loan is used in a passive activity, interest income is treated as "portfolio" income that cannot be offset by passive interest expense.
The final regs, relying on Section 469(1), recharacterize the income in these circumstances as passive income so that the partner or shareholder may offset one against the other. The regs explain that this corrects what has been an "inappropriate" result because the items of interest income and expense are "essentially self-- charged" and thus lack economic substance. In addition to those who own a direct interest in a partnership or S corporation, the regs apply to those who own an indirect interest in such entities (as illustrated in Example 5 of Reg. 1.469-7(h)) without the previously limiting 10 percent requirement that was contained in the proposed regs.
The regs also extend these self-- charged rules to lending transactions between identically owned passthrough entities. To the extent an owner shares in interest income from a loan between passthrough entities, if each owner of the borrowing entity has the same proportionate ownership interest in the lending entity, the owner is treated as having made the loan to the borrowing entity and the basic rules of the regs (Reg. 1.469-7(c)) apply to determine the correct portion of portfolio income or properly allocable interest expense that is recharacterized as passive.
It is clarified that the final regs apply to loans involving foregone interest within the meaning of Section...