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PDtax
PDtax, CPA firm owner
Category: Tax
Satisfied Customers: 1970
Experience:  32 years tax experience, including four years at a Big 4 firm.
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I am reporting interest on a loan used to purchase shares in

Customer Question

I am reporting interest on a loan used to purchase shares in an S-Corporation as 'business interest expense' on federal form Schedule E (2012) as a Non-Passive loss, as described by the IRS here:

"How to report. If the proceeds were used in a nonpassive trade or business activity, report the interest on Schedule E (Form 1040), line 28; enter “interest expense” and the name of the partnership or S corporation in column (a) and the amount in column (h)." http://www.irs.gov/publications/p535/ch04.html

I am not a California resident, but the S-Corp does some business there and so I am filing form 540NR, but am unclear on how/where to record the 'business interest expense' in the California state forms.

Can I offset this interest expense against the S-Corp's ordinary business income in California?

If so, can I calculate the amount of interest expense to include according to percentage of the S-Corp's total ordinary income vs it's California source amounts? That is, the company's CA source amount income was 25% of it's total income, should I include 25% of my interest expense in the California Return?

Where do I record this? My best guess at this point (assuming a yes answer to #1) is to adjust the amount shown for the company's CA Sources and Credits on CA Schedule K-1(100S) by the portion of the interest determined using the method from #2 and put the result in box 17e of Schedule CA (540NR): 'CA Amounts' from 'Rental...S Corporations, etc..'

This approach seems strange to me though because the amount of that adjustment won't be recorded anywhere (except on Schedule E of my federal return, and even there, in a larger amount not showing the adjustment for the "CA portion" of the interest expense.
Submitted: 11 months ago.
Category: Tax
Expert:  PDtax replied 11 months ago.

Customer:

Welcome to the site. I'mCustomer and will be helping you today.

Customer:

Hi from Just Answer. There are specific rules for the purchase of an interest in a pass through entity. Can you tell me about the s corp business you purchased?

Customer:

If the business held investment assets, such as stocks or bonds, your interest would be investment interest. If you purchased an active trade or business, your reporting on Schedule E would be correct.

Customer :

Hi - thanks. Sure - what about it are you looking for?

Customer :

Ah

Customer:

Type of assets in the s corp, type of business

Customer :

The business's CPA has already indicated he feels there is justification for considering 95% of the business interest expense, and the other 5% interest expense.

Customer :

I feel confident in reporting on schedule E. My question, however, is how to handle the CA state return.

Customer:

I would be ok allocating the interest expense to each state's allocation in a reasonable manner. If total s corp income is $2,000, and $1,400 of the income is CA source, 70% of the interest cost you can allocate is reasonable to me.

Customer:

Now, how to report it:

Customer :

Ok - that makes sense. Yes..how to report.

Customer:

Report your state allocable income on the 540NR, line 13 is Federal AGI, which would include the s corp income and deduction for interest.

Customer:

Line 14 is the adjustment schedule, and you can remove the income items not allocable to CA.

Customer:

Section B, column E, of the income adjustment schedule will leave the S corp income and your allocation of interest to report.

Customer :

Thanks, XXXXX XXXXX make sure I follow you correctly:

Customer:

The schedule allows for reporting of the amount you allocate, and since you will choose a reasonable method to allocate, the 540NR, line 15 will have the net CA allocated income.

Customer :

I am looking at the adjustment schedule CA (540NR)

Customer:

yes.

Customer :

On line 17, rental, s-corp, etc..., column a would show the same amount as my federal schedule e)

Customer :

then

Customer:

yes

Customer :

I currently have some values in columns b and c that are from my CA Schedule K (indicating differences between CA and Federal law). are you suggesting I add use either of those columns?

Customer :

or that I just use column E to show the portion of CA income from the s-corp (as shown on my CA k-1) minus a the interest expense (proportional to the state's percentage of total s-corp income)

Customer:

yes, use column b and/or c as appropriate to report the allocation.

Customer :

I'm not totally sure if I follow that -- would you walking me through a brief example. Appreciate your time on this.

Customer:

let's say your S corp income is 1,000, 700 CA allocation.

Customer :

k

Customer:

Let's say you reported $80 as interest expense, Schedule E.

Customer :

yes

Customer:

You should allocate 700-56, or 644, total to CA.

Customer :

and record that 644 where?

Customer:

Schedule CA(540NR), part II, column A, line 17, is the federal net of 920.

Customer :

yes

Customer:

column B, line 17, is 276. (that's the net non-CA allocation).

Customer:

column E, line 17, is 644.

Customer:

There will be a supporting schedule for line 17 of the CA 540NR in most software. Use it to explain the non-CA allocations.

Customer:

You may be able to do the allocations in the data entry off your CA K-1, depending on how your software works. The test is to determine what the income should be, and use either method to allocate.

Customer :

Ah, maybe that's why I'm having some issues - I am not using software, doing things by hand. And it seemed like I should articulate what I'm doing here somewhere.

Customer:

No need. Just use the CA schedule as described, and make the adjustment in column B as i outlined.

Customer :

Ok - thanks. I'll approve your answer -- in addition, I'd be willing to pay a bonus if you could direct me toward any texts justifying this approach, especially the use of columns B (or C) to show the state allocation -- that part still seems odd to me given that I understood those columns to be used for tallying differences between federal and state law (which this doesn't seem to be)

Customer:

The allocation method is the difference between Federal and state. The best way to describe it is to split the income up among the states allocable, and if no odd adjustments are in place, the total state income would equal the federal.

Customer :

Would that mean that Columns D and E are always equal?

Customer:

no. D and E are resident and nonresident. Those two added up are the total Ca income to report, but after allocation.

Customer:

I could not find a good guide for the allocation. FTB does provide the support, but the methodology is as discussed with you already.

Customer:

Please advise if you need anything else.

Customer :

just one more thing-- in your example. columns D and E WILL be the same, correct? Column E will be 644, and column D will also be 644 (since the instructions for column D say to take A - B + C). THat's your understand too, yes?

Customer:

yes

Customer:

then the column B amount is transferred to 540NR line 14.

Customer :

ok - thank you for your answer

PDtax, CPA firm owner
Category: Tax
Satisfied Customers: 1970
Experience: 32 years tax experience, including four years at a Big 4 firm.
PDtax and 2 other Tax Specialists are ready to help you
Customer: replied 11 months ago.

The substance of a justifiable way to attribute the business expense was helpful and re-assuring. However, I just re-read this in the instructions to CA(540NR), which makes me second guess the reporting part of this answer:


 


 


"Column B and Column C — Subtractions and Additions
Use these columns to enter subtractions and additions to federal amounts in column A that are necessary because of the differences between ­ California and federal law. Enter all amounts on line 7 through line 36 as positive numbers.


 


Do not deduct income that was earned while a nonresident of California or from sources outside of California. There must be a difference in tax law. Generally, if a California resident cannot subtract the income in column B, a nonresident or part-year resident may not subtract income from column B."

Expert:  PDtax replied 11 months ago.

That's an incorrect application. Just to check, I prepared a CA nonresident return, with sample figures. Column B of the income adjustment schedule reflects the non- CA taxable portion, as we discussed. Your nonresident income for CA is computed and taxed as if you are a resident, so column D and E are the CA allocated portion of the s corp income. The remainder of the return is straight forward. Thanks for asking at Just Answer.

 

To explain further, Subtractions column is there to reflect income not taxable in CA. That is a vaild subtraction.

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