I recently purchased shares in an S corp where I am employed. I borrowed money to pay for the shares and incurred interest expense. Where is this deductible?

[bcar1717]

The loan was made by one of the current shareholders and is not held as part of the corporation.  Can I offset income on my K1 for this interest?

[ChelsiE2]

According the the IRS: "If you use borrowed funds to buy an interest in a partnership or S corporation, then the interest on those funds must be allocated based on the assets of the entity. If you contribute to the capital of the entity, you can make the allocation using any reasonable method." (From: IRS Publication 550).

If this sounds complicated, it is.  Let me try to explain further by providing examples.

First because you are an employee of the S-Corporation, you will be considered to Materially Participate in the S-Corporation.  This is important.  Those that do not materially participate in the entity for which they borrow funds to invest in must deduct their interest in another way.

The first step is to look at the S-Corporation's Balance Sheet.  If your S-Corporation's only assets are those held for use in the regular course of business then you will be able to fully deduct your Interest Expense against your S-Corporation income.

However, if the S-Corporation is involved in it's own investing activities, it gets a little more complicated.  Let's say the S-Corporation has Cash of $10,000, Equipment of $20,000, Accounts Receivable of $5,000, and a Note Receivable of $5,000.  Let's also say that the Equipment has an outstanding loan of $10,000.

The second step is to break down these net asset values into regular line of business assets and investment assets.  

Regular business assets includes:

• $10,000 Cash
• $10,000 Equipment ($20,000 less $10,000 outstanding loan)
• $5,000 Accounts Receivable 
• $25,000 total 

Investment assets include: 

• $5,000 Note Receivable

Therefore if you have $10,000 worth of interest expense related to your loan, you would allocate the interest as $8,333 ($25,000/($25,000+$5,000) x $10,000) of deductible business interest offset against your Schedule K-1 Income and the other $1,667 as Investment Interest Expense.

Please note: if your S-Corporation's Balance Sheet is complicated, the CPA who prepares the Form 1120S should be able to provide you a breakdown of their assets and how you should allocate your Interest Expense.

To enter the deductible Business Interest Expense in TurboTax: 

1. Click the Federal Taxes tab
2. Click Wages & Income
3. Scroll down to Business Items
4. Click the blue Show More in this section
5. Click Start (or Revisit) next to Schedules K-1, Q
6. Click Yes
7. Click Start (or Update) next to S-Corporations (Form 1120S)
8. Click the blue Edit button next to the name of your S-Corporation
9. Click Continue until you get to the screen titled "Other Situations"
10. Here you'll need to check the box next to "I personally paid interest on debt....." (see first attachment for reference)
11. A drop down box will appear where you can enter the deductible Business Interest Expense associated with your loan (see first attachment for reference)

If you also have a portion that is deductible as Investment Interest Expense:

1. Click the Federal Taxes tab
2. Click Deductions & Credits
3. Scroll down to the Retirement and Investments section
4. Click the blue Show More in this section 
5. Click Start (or Revisit) next to Investment Interest Expense (see second attachment for reference)

[pingpong20]

So would this be considered an "above the line" deduction, ie you can deduct the interest you paid, but then you could also claim the full standard deduction?

[Rick19744]

Attached are the instructions for Sch E of the form 1040.  In particular review the instructions on page E-11 (line 28) for how to handle your interest expense.  If you follow the input and answer the TT questions appropriately, the software will handle this correctly.

https://www.irs.gov/pub/irs-pdf/i1040se.pdf