A single member LLC converts to an S-Corp this year. The owner, had taken out a home-equity loan to buy the business in an asset aquisition last year. The owner was deducting the points and interest on the loan on Schedule C.

Now that there is an S-corp requirement carry a balance sheet, I'm a little confused. The owner's home equity loan does not belong on the balance sheet so I am trying to determine how to proceed. Here is what I propose:

The balance of the loan at the beginning of the year is converted to a shareholder loan so the books can remain balanced. The corporation repays the loan to the shareholder with interest. The corp deducts it and the shareholder claims it as income. The shareholder pays the mortgage herself. The interest on the mortgage is also deducted by the corp through interest tracing and she posts a capital contribution each year to offset the deductible interest on the mortgage. This way the corp books stay balanced and she can take funds out for repayment and can use them to pay the mortgage. Since the corp deducts shareholder loan interest and she claims it personally as income, there is a wash - so to get a deduction for the loan to purchase the business, it is added to corporate books with an offsetting capital contribution.

Does this sound like the correct approach?

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What wash? What offsetting cap contrib?

The interest is deducted on the 1120s for the s corp. S corp in this instance issues a 1099int to the shareholder.

Shareholder reports int inc on sched b. Mtge int is deducted on sched a.

The loan is recorded on the s corp as a shareholder loan acct. It is a l/t liab. A shareholder loan acct is counted toward the shareholder basis.

You, however are required to set up cap stock in accordance with the articles of incorporation. READ THEM.

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>>Mtge int is deducted on sched a.<<

Since the taxpayer was deducting interest on Schedule C, she has made an irrevocable election to not treat the loan as qualified home equity debt.

The scenario doesn't sound right to me somehow. Her capital contribution was the FMV of the business itself, not the loan P&I. Payments from the corporation are not principal and interest unless she actually sold the assets in a taxable transaction. Another way could have been to lease the assets to the corporation, but neither of those arrangements happened in this case.

It seems like she exchanged property (FMV of tangible and intangible business assets) for stock. Those assets were financed so she has an investment interest expense. Any payments are wages, return of capital, pass through items, or other normal S-corp distributions.

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"A single member LLC converts to an S-Corp this year" was the transaction, and now we're trying to describe what happened, right?

Were there documents at the time?

What was contributed, and

What debt was it subject to when it was contributed?

And, round these parts, the books would stay in balance no matter what happens as long as each entry is a balanced entry... :-)

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