It’s not uncommon for an incoming partner in a professional firm to take out a personal loan to finance all or part of the cost of acquiring an ownership interest. If some of your firm’s partners have done this, they need to know the proper federal income tax treatment of the resulting interest expense. Such partner-level interest expense is sometimes called “outside interest” because it comes from a personal loan that is outside of the partnership.
IRS guidelines say outside interest expense that is traceable to a personal loan is generally fully deductible in the same way as other ordinary business expenses when the proceeds are used to finance the acquisition of an ownership interest in a pass-through business entity such as a partnership, LLC or S corporation. This assumes the borrower — the firm partner in this case — is not limited by the passive activity rules. In most cases, he or she is probably not. This also assumes that essentially all of the firm’s assets are used to conduct the law practice business, which is most likely the case. (Source: IRS Notice 89-35)
So far, so good. But exactly how does the partner claim his or her rightful deduction for the outside business interest expense?
- First, the IRS says the write-off should be reported as a negative amount on Part II of Schedule E. This is the same form that is used to report the partner’s share of taxable income from the firm each year. (This is the amount reported to the partner on his or her Schedule K-1 from the partnership.) More specifically, the outside interest expense amount should be entered on a separate line below the partnership income amount and described as “business interest” followed by the name of the partnership and the partnership’s taxpayer ID number. (Source: IRS Notice 88-37)
- Second, the interest expense should also be claimed as a deduction in figuring the partner’s self-employment (SE) income for SE tax purposes. That way, the partner will receive both an income tax and SE tax benefit from the expenditure.
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Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
