LLc to S-corp and Equity Loan

[Mike]

A single member LLC converts to an S-Corp this year. The owner, had taken out a home-equity loan to buy the business in an asset aquisition last year. The owner was deducting the points and interest on the loan on Schedule C.

Now that there is an S-corp requirement carry a balance sheet, I'm a little confused. The owner's home equity loan does not belong on the balance sheet so I am trying to determine how to proceed. Here is what I propose:

The balance of the loan at the beginning of the year is converted to a shareholder loan so the books can remain balanced. The corporation repays the loan to the shareholder with interest. The corp deducts it and the shareholder claims it as income. The shareholder pays the mortgage herself. The interest on the mortgage is also deducted by the corp through interest tracing and she posts a capital contribution each year to offset the deductible interest on the mortgage. This way the corp books stay balanced and she can take funds out for repayment and can use them to pay the mortgage. Since the corp deducts shareholder loan interest and she claims it personally as income, there is a wash - so to get a deduction for the loan to purchase the business, it is added to corporate books with an offsetting capital contribution.

Does this sound like the correct approach?

[Jake]

Perhaps an alternative approach would be to show the balance of the loan as an equity item as opposed to a liability item on the S Corp's Balance Sheet. This would do away with all of the other entries (too complicated for me). The interest expense could still be deducted on the s/h return as follows according to IRS Notice 88-37:

Interest expense allocated to a trade or business expenditure 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.

Hope that helps

[kcjenkins]

An excellent and useful post, Jake. Thanks for the reminder.