IRS Notice 89-35: Rules for Interest Expense Allocation

IRS Notice 89-35 provides guidance for owners of pass-through entities, such as partnerships and S corporations, on the proper allocation of interest expenses. The notice establishes how to classify interest when debt is involved in entity transactions, which directly impacts how that interest can be deducted. It addresses situations where an owner borrows to invest in an entity or when the entity itself borrows and distributes funds to its owners.

The rules connect the interest expense to the specific use of the borrowed funds, a process known as tracing. This connection determines whether the interest is treated as business, investment, or personal for tax purposes, which is subject to limitations under Internal Revenue Code Section 163 and Section 469.

Allocating Interest on Debt Financed Acquisitions

When a taxpayer borrows funds to acquire an interest in a pass-through entity, Notice 89-35 provides rules for allocating the associated interest expense. This applies whether the funds are used to purchase an interest from an existing owner or to make a direct capital contribution. The debt proceeds are traced to the underlying assets of the partnership or S corporation to determine the character of the interest.

For a purchase from another owner, the interest expense must be allocated among the entity’s assets using a reasonable method, such as the fair market value or book value of the assets, which must be applied consistently. For example, a taxpayer borrows $100,000 to purchase a 25% interest in a partnership. The partnership’s assets consist of a commercial building (a business asset) with a fair market value of $300,000 and investment securities with a fair market value of $100,000.

Using the fair market value method, 75% of the debt ($75,000) would be allocated to the business asset, and 25% ($25,000) to the investment securities. Consequently, the interest paid on the acquisition debt is split. The interest attributable to the $75,000 is classified as trade or business interest, while the interest on the remaining $25,000 is classified as investment interest.

If the debt proceeds are used to make a capital contribution, the taxpayer can allocate the debt among all the entity’s assets as described above. Alternatively, the taxpayer can trace the contributed funds to the specific expenditures made by the entity, as if the entity itself had incurred the debt. This second option provides more precision if the entity uses the capital for a single purpose.

Treating Interest on Debt Financed Distributions

The tax treatment of interest is different when a pass-through entity incurs debt and distributes the proceeds to its owners in a debt-financed distribution. Under Treasury Regulation §1.163-8T, the use of the funds must be traced at the owner level. The character of the interest deduction for each owner depends on what that specific owner does with the distributed cash.

For instance, if an owner uses the distributed funds to purchase a personal automobile, the associated interest expense is non-deductible personal interest. If another owner buys investment property, their share of the interest is treated as investment interest. This method can be administratively complex for the entity.

Recognizing this, Notice 89-35 provides an optional allocation rule. This allows the entity to allocate the distributed debt and related interest to its own expenditures made during the same tax year. The entity can only use this option for expenditures not already financed by other debt.

For example, a partnership borrows $50,000 and distributes it to its sole partner. In the same year, the partnership also paid for $80,000 in business operating expenses from its capital reserves. Under the optional rule, the partnership can elect to allocate the $50,000 of debt to those business expenses. As a result, the interest passed through to the partner is fully deductible as a trade or business expense, regardless of how the partner actually used the distributed $50,000.

Reporting Interest Expense on Tax Forms

Once the interest expense is allocated and characterized, it must be reported on the correct tax forms. The process begins with the pass-through entity, which reports the owner’s share of interest on their Schedule K-1. For debt-financed distributions, this is often reported on the “other deductions” line with a statement identifying it as “interest expense allocated to debt-financed distributions.”

Deductible trade or business interest is reported by the owner on Schedule E (Form 1040), Supplemental Income and Loss. This interest is deducted directly against the income from the pass-through entity in Part II of the form.

Interest related to a passive activity is subject to separate limitations and flows to Form 8582, Passive Activity Loss Limitations. Taxpayers use this form to calculate the amount of any passive loss that is allowed for the current year. The interest expense is combined with all other passive activity expenses, and its deductibility is limited to the amount of passive income the taxpayer has from all sources.

Investment interest expense is reported on Form 4952, Investment Interest Expense Deduction. On this form, the taxpayer calculates the amount of their deductible investment interest, which is limited to their net investment income for the year. Any disallowed investment interest can be carried forward to future years. The deductible portion from Form 4952 is then reported as an itemized deduction on Schedule A (Form 1040).

Allocation Rules for Debt Repayments

When a single debt is allocated to different types of expenditures, specific rules govern how repayments of that debt are applied. The regulations establish a required ordering for how these repayments must be allocated, which impacts the remaining interest expense characterization. This ordering is beneficial to the taxpayer, as it reduces the portion of the debt that generates non-deductible personal interest first.

Principal repayments must be applied to the underlying expenditures in the following sequence:

• Personal expenditures
• Investment expenditures
• Passive activity expenditures
• Trade or business expenditures