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Some doctors understand the advantages that S corporations have over regularly taxed C corporations—and vice versa. But, an unfamiliar Tax Court decision, more than a decade ago, points up an advantage for S corporations that are sometimes overlooked.

Scenario

Suppose the owners of a family corporation are about to retire. Their children will buy their stock, giving them a note for the purchase price. The children will, of course, pay interest on the note.

Tax Difference

If the corporation is an S corporation, the younger generation will be able to write off their interest payments in full.

On the other hand, if it’s a C corporation, they may have few or no deductions.

Why the difference?

—Because interest you pay to buy S corporation stock is considered “business” interest, and that’s fully deductible. On the other hand, interest paid to purchase C corporation stock is treated as “investment” interest. And the tax rules say that investment interest is deductible only to the extent of your investment income (dividends, interest income, etc.). If you don’t have any investment income, you get no deduction for your interest payments.

Naturally, that brings up another question: Why is the ownership of a C corporation considered an investment, while the ownership of an S corporation is treated as a business? For the answer to that, let’s look at the above mentioned Tax Court case.

Case Report

Three brothers, Milton, Leo, and Dale Russon, founded Russon Brothers Mortuary as a regular C corporation. The business did well, and the Russon brothers began training their four sons, Scott, Brent, Robert, and Gary, in the mortuary business.

Eventually, the four younger Russons were trained and actively involved in the business, and the older Russons were ready to hang up their hats. The younger Russons agreed to buy all the stock in Russon Brothers for $999,000. Each of the four younger Russons agreed to pay one-fourth of the purchase price, with 10% payable up front and the remainder to be paid in 180 equal monthly payments at 9% interest.

Agreement

The agreement gave the four younger Russons their right to exercise ownership rights, including “the right to all dividends from the stock,” subject to certain limitations. One of those limitations provided that the buyers could not “declare or pay any dividends or make any distributions” without written permission from the older Russons. After the sale, the four younger Russons continued to run the mortuary business, and their fathers retired.

On his tax returns following the sale, Scott Russon deducted the interest he paid on the purchase price for the Russon Brothers stock. However, the IRS denied the deduction on the grounds that the interest was subject to the investment-interest limitation.

Scott Russon countered that his interest should be treated as fully deductible business interest. After all, he bought the stock so that he and the other younger Russons could conduct the business full time and “earn a living.” Moreover, he contended that he couldn’t have purchased the stock as an investment since Russon Brothers had never paid a dividend in its entire history.

Tax Payer Loser

The Tax Court concluded that the Russon Brothers stock was “held for investment,” and the interest paid to acquire the stock was subject to the investment-interest limitation [Russon, 107 T.C. No. 15].

The court pointed out that property “held for investment” includes any property of the type which produces interest, dividend, or royalty income. And, in the court’s view, that means property that normally produces those types of income—regardless of whether it actually produces such income.

The tax law does not require corporate stock to pay a dividend before it becomes investment property. What’s more, the court pointed out that the definition of investment property is inclusive and applies uniformly to every taxpayer; it does not depend on a taxpayer’s mind-set when buying the property.

Finally, the court pointed out that the possibility of the Russon Brothers stock actually paying dividends was clearly contemplated by all the Russons when they drew up the sales agreement. The agreement gave the younger Russons the right to “all the dividends from the stock,” subject only to the written consent of the older Russons until the purchase price was fully paid.

S Corporation Advantage

If Russon Brothers had been an S corporation; it would have been a different story. The IRS has said that interest paid to buy an S corporation is treated as interest to purchase the corporation’s assets, not its stock [Notice 89-50]. Thus, the interest the Russons paid would have been treated as fully deductible business interest to the extent the assets were used in the corporation’s business [Notice 88-20]. And since virtually all of Russon Brothers’ assets were used in the active conduct of its mortuary business, Scott Russon would have been entitled to his deductions.

Assessment

There is one bright spot for astute doctors and other buyers of C corporations. You can switch. The IRS has ruled that once a C corporation is converted to an S corporation, interest paid thereafter will be treated as paid for the assets, not the stock. So your interest will become fully deductible business interest [Ltr. Rul. 9040066].

Conclusion

Of course, switching to an S corporation has other important tax consequences. So you will want to talk things over with your tax adviser before making a final decision. And so, your thoughts and comments are appreciated.

Related Information Sources:

Practice Management: http://www.springerpub.com/prod.aspx?prod_id=23759

Physician Financial Planning: http://www.jbpub.com/catalog/0763745790

Medical Risk Management: http://www.jbpub.com/catalog/9780763733421

Healthcare Organizations: www.HealthcareFinancials.com

Health Administration Terms: www.HealthDictionarySeries.com

Physician Advisors: www.CertifiedMedicalPlanner.com

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Filed under: Accounting, Financial Planning, Investing, Taxation | Tagged: Accounting, family owned business, FOB, tax | 2 Comments »