Exhibit 6-4:
Self-Charged
Interest
ISSUE: Are
self-charged items
on Form 8582 line 1a
or 3a non-passive?
If so, the income
should be removed
from Form 8582,
thereby limiting
allowable passive
losses. Stated
differently, have
self-charged items
for passive
activities been
appropriately
characterized as
passive income?
Since passive losses
are deductible only
to the extent of
passive income,
removing income from
FORM 8582 generally
results in the
amount of currently
deductible passive
losses being
reduced.
LAW: To offset
interest income
which taxpayer is
required to report
(generally on
Schedule B) from
loans to related
entities, the
taxpayer may treat
self-charged
interest income as
passive income
(reflecting it on
Form 8582, thereby
triggering the same
amount of interest
expense). See Reg.
§ 1.469-7. The
recharacterization
rule for
self-charged items
applies only to
interest income.
There is no
provision in law for
any other
self-charged income
item to be entered
on Form 8582 as
passive
income.
_____ Verify that
self-charged
interest income on
Form 8582 line 1a or
3a (which has
been recharacterized
as passive income
per Reg. § 1.469-7)
has not also been
entered on Form 4952
as investment
income, erroneously
triggering
deductions for
investment interest
expense. The same
income should never
be on both Form 8582
and Form 4952. The
IRC § 163(d)(4)(D)
specifically states
that investment
income does not
include any income
taken into account
in computing passive
losses under IRC §
469. Since
investment interest
expense is
deductible only up
to investment
income, removing
self-charged
interest income from
Form 4952 will
result in automatic
adjustments to
investment interest
expense. While
the interest income
should not be
reflected on Form
4952, it is, of
course, reportable
on Schedule B.
_____ Request the
loan instrument and
verify that
self-charged
interest income is
actually interest on
a loan. Also
check balance sheet
for loans from
shareholder/partner.
Other self-charged
items such as
management fees,
guaranteed payments,
rents, royalties,
etc. should not be
on Form 8582 as
passive income.
There is no
provision in IRC or
Regulations for any
other type of income
to be treated as
passive other than
interest income as
provided for in Reg.
§ 1.469-7. To read
proposed Reg.
§1.469-7 as
providing
self-charged
treatment to
nonlending
transactions expands
the Regulations to
transactions it was
not intended to
cover.
_____ Verify that
loans are not
between two entities
which are not
tiered.
Example: Two S
Corporations owned
100 percent by one
shareholder). One S
Corporation loans
the other money.
One entity does not
own part of the
other entity;
therefore, no direct
interest. See Reg.
§ 1.469-7(b)(1).
_____ Verify that
self-charged
interest is from a
partnership or S-
Corporation.
Reg. §1.469-7(b)(1)
defines a pass
through entity as a
partnership or S-
Corporation.
_____ Verify that
interest income
has been reported
on Schedule B in the
same dollar amount
as self-charged
passive income on
Form 8582 line
1a or 3a. Passive
income must be
reported on the
return. Form 8582
is merely a
computational
schedule which
figures allowable
passive losses.
Entering income does
not report it on
return. It must be
entered on one of
return schedules to
be appropriately
reported. The
self-charged income
rules are the one
exception where
portfolio income is
recharacterized from
non-passive to
passive income.
Typically, interest
income is reported
on Schedule B –
although taxpayers
sometimes reflect it
on Schedule E in the
passive income
column.
_____ Verify that
income in the same
amount as the
self-charged
interest has NOT
been removed from
Schedule B.
Reg. § 1.469-7
merely permits
interest income
(which otherwise is
non-passive) to be
entered on FORM 8582
as passive income in
order to trigger a
like amount of loss
(representing the
related interest expense).
The allowed loss
would generally be
reflected on
Schedule E line 27
in the passive loss
column. If in doubt
as to where the loss
is reflected, refer
to worksheet 6 of
Form 8582 which
designates the
schedules allowed
passive losses are
entered on.
Reminder: Form 8582
is only a
computational
schedule. It does
not in any manner
report income. If
income is removed
from Schedule B and
reflected only on
Form 8582, it
results in
unreported income!
_____ Verify that
interest expense on
a loan which is
capitalized has
not been
recharacterized.
Reg. §
1.469-7(c)(1)(i) &
(d)(1)(ii) provide
that the loan must
give rise to an
interest deduction
for the same
year.
_____ Verify that
a passive loss
(from the same
activity as
self-charged
interest) has
also been entered on
FORM 8582. For
self-charged
interest to be on
Form 8582, it must
be from a
passive
activity (a
rental/leasing
activity OR
business in which
taxpayer does not
materially
participate). The
Reg. §
1.469-7(a)(1)(ii)
and §
1.469-7(c)(iii) and
§ 1.469-7(d)(iii)
_____ Verify that
the interest income
is not from a
non-passive
activity. If
the partnership or S
Corporation
generating the
interest is entered
as non-passive, the
interest income
cannot be on Form
8582. Similarly, if
the taxpayer
materially
participated any 5
of the prior 10
years, income in the
current year is
non-passive.
_____ Verify that
self-charged
interest has been
properly allocated
based on the portion
that is self-paid.
Fraction to compute
allocation:
Taxpayer’s ownership
percentage (i.e. his
share of entity's
self-charged
interest expense)
multiplied by
taxpayer’s Schedule
B interest income.
Obviously, this
procedure is not
necessary if
taxpayer is 100
percemt shareholder
of an S
Corporation. For
example, if the
taxpayer receives
$100 in interest
income and has a 10
percent ownership
interest, only $10
may be treated as
passive income on
Form 8582 line 1a or
3a. There are
very clear examples
of how the
applicable percent
works with multiple
investor in Reg. §
1.469-7 Example (1)
and Example (2).
Adjustment:
Remove income from
Form 8582 Line 1a or
3a and recompute.
Adjustment to
allowable passive
losses is difference
between Form 8582
Line 16 per return
and Form 8582 Line
16 as corrected.
Also, modified AGI
on Form 8582 line 7
will be increased by
the amount of
income determined to
be non-passive.
Thus, the taxpayer
may lose part of his
$25,000 offset under
IRC § 469(i), i.e.
you may have a
second computational
adjustment.
