Did a South Carolina resident owe state income tax on operating-income distributions from a Tennessee S corporation, and could she deduct interest paid to buy the stock?

Plain-English summary

South Carolina Private Letter Ruling 88-12 reached two connected conclusions for a South Carolina resident who owned stock in a Tennessee S corporation:

1. The corporation's 1987 distributions representing its operating income generally were not taxable in South Carolina, because the corporation did all of its business in Tennessee. The ruling listed exceptions for amounts distributed as salaries, dividends, interest, or gains and losses from sales of intangible personal property not connected with the taxpayer's business.
2. The shareholder's approximately $60,000 of interest expense incurred to buy the S-corporation stock was not deductible in South Carolina, because it related to income that South Carolina did not tax.

The Commission applied the same source and matching concepts to S-corporation income that it used for partnership income.

The shareholder and corporation

Mrs. X, a South Carolina resident, owned approximately 45% of XYZ, Inc., a Tennessee S corporation that conducted 100% of its business in Tennessee.

For the year ended December 31, 1987:

• her Schedule K-1 was expected to show $436,500 as her share of the corporation's taxable income;
• she received approximately $523,000 of distributions, including some corporate income from 1986; and
• she paid approximately $60,000 of interest on money borrowed in 1987 to buy the XYZ stock.

The loan was secured by the corporation's stock.

How the ruling sourced S-corporation income

Section 12-7-410 started with federal individual income, subject to South Carolina modifications. Section 12-7-430(e) directed income subject to allocation or apportionment to the rules in Article 9, including section 12-7-1120.

The ruling described the general allocation approach this way:

• interest, dividends, and gains or losses from sales of intangible personal property not connected with the taxpayer's business were allocated to the individual's domicile;
• residents' personal-service income also was allocated to the domicile; and
• other income was allocated or apportioned to the state where it was earned.

Section 12-7-235(b) gave South Carolina S corporations pass-through treatment similar to partnerships. Each item retained the source and character it had when earned or incurred by the corporation.

Reading those provisions together, the Commission concluded that the Tennessee corporation's operating income was not taxable to Mrs. X in South Carolina. The specified domicile-based categories remained potential South Carolina income.

Why the stock-purchase interest was not deductible

The Commission treated expenses related to S-corporation income similarly to expenses related to partnership income.

It relied on Wallace B. Dalton and Shirley B. Dalton v. South Carolina Tax Commission, where interest paid to acquire partnership interests was disallowed because it related to partnership income allocated to another state.

Mrs. X's loan interest was incurred to acquire the Tennessee S-corporation stock. Because the related S-corporation income was not taxable in South Carolina under the ruling's allocation analysis, the matching doctrine denied the interest deduction.

What this means for you

South Carolina residents owning out-of-state S corporations

PLR 88-12 did not treat every cash distribution as automatically taxable or exempt. It looked through to the source and character of the S corporation's income.

S-corporation shareholders

Operating income earned entirely by the Tennessee business received the ruling's nontaxable result. Salaries, dividends, interest, and specified intangible gains or losses were expressly carved out from that conclusion.

Investors borrowing to buy pass-through interests

The Commission matched acquisition interest with the income produced by the investment. When the related income was not taxed by South Carolina, the related interest expense was not deducted.

Accountants and tax professionals

The ruling distinguished the K-1 income's source and character from the amount of cash distributed. Some distributions in 1987 represented 1986 corporate income, but the conclusion focused on distributions representing corporate income and the statutory source categories.

Readers applying the ruling today

PLR 88-12 applied 1987 allocation, S-corporation, and interest-deduction rules. Current residency, pass-through entity, sourcing, basis, distribution, investment-interest, and expense-allocation provisions must be checked independently.

Common questions

Q: Was Mrs. X's share of the Tennessee operating income taxable in South Carolina?

A: Generally no under the ruling, because XYZ conducted all of its business in Tennessee and the income was sourced where earned.

Q: Were all categories of S-corporation income excluded?

A: No. The ruling identified salaries, dividends, interest, and gains and losses from sales of nonbusiness intangible personal property as taxable exceptions for a South Carolina resident.

Q: Did the cash distribution amount alone determine the answer?

A: No. The Commission applied pass-through rules under which items retained their source and character from the corporation.

Q: Was the $60,000 interest expense deductible?

A: No. It related to the stock that produced income not taxable in South Carolina, so the matching doctrine disallowed the deduction.

Q: Did it matter that the loan was secured by the stock?

A: That was part of the stated facts, but the Commission's conclusion focused on the interest expense's relationship to the S-corporation income.

Q: Can another shareholder rely on PLR 88-12?

A: No. The ruling states that it applied only to Mr. and Mrs. X's specific facts, had no precedential value, and was not intended for general distribution.

Citations and references

• S.C. Code section 12-7-1120 (Supp. 1987) — allocation and apportionment
• S.C. Code section 12-7-410 (Supp. 1987) — South Carolina individual income starting point
• S.C. Code sections 12-7-430 and 12-7-435 (Supp. 1987) — South Carolina income modifications
• S.C. Code section 12-7-235(b) (Supp. 1987) — Subchapter S pass-through treatment
• Wallace B. Dalton and Shirley B. Dalton v. South Carolina Tax Commission, Opinion No. 1129 — matching doctrine for interest related to out-of-state partnership income
• S.C. Code section 12-3-170 (1976) and SC Revenue Procedure 87-3 — private-letter-ruling authority

Source

• Landing page: https://dor.sc.gov/advisory-opinion-search
• Original PDF: https://dor.sc.gov/sites/dor/files/policies/PLR88-12.pdf

Original ruling text

SC PRIVATE LETTER RULING #88-12

TO:

Mr. & Mrs. X

SUBJECT:

Taxability of corporate distribution from out of state corporation and
deductibility of interest expense incurred to buy out-of-state stock.

REFERENCE:

S.C. Code Ann. Section 12-7-1120 (Supp. 1987)
S.C. Code Ann. Section 12-7-410 (Supp. 1987)
S.C. Code Ann. Section 12-7-430 (Supp. 1987)
S.C. Code Ann. Section 12-7-435 (Supp. 1987)
S.C. Code Ann. Section 12-7-235 (Supp. 1987)

AUTHORITY:

S.C. Code Ann. Section 12-3-170 (1976)
SC Revenue Procedure #87-3

SCOPE:

A Private Letter Ruling is a temporary document issued to a taxpayer,
upon request, and it applies only to the specific facts or circumstances
related in the request. Private Letter Rulings have no precedential value
and are not intended for general distribution.

Question:
1.

Are 1987 distributions from a nonresident "S" corporation representing income from
the corporation taxable in South Carolina?

2.

Is the $60,000 of interest expense incurred to purchase the corporation's stock
deductible in South Carolina?

Facts:
Mrs. X, a South Carolina resident, owns approximately 45% of XYZ, Inc., a Tennessee
corporation. XYZ is a "S" corporation and does 100% of its business in Tennessee. For tax year
ended December 31, 1987, Mrs. X's K-1 will reflect $436,500 as her share of XYZ, Inc's 1987
corporate taxable income. She also received approximately $523,000 in distributions from XYZ
for stock she owned, some of which represented distributions of corporate income for the year
1986. The funds used to purchase the stock in XYZ borrowed by the taxpayer in 1987. This
loan is collateralized by the corporation's stock. During the year 1987, the taxpayer paid interest
in the approximate amount of $60,000 on this loan.
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Discussion:

1. S.C. Code of Laws Ann. Section 12-7-410 (Supp. 1987) states that the South Carolina
   gross income, adjusted gross income, and taxable income of an individual is the same as
   that determined for federal purposes with the modifications specified in 12-7-430 and 127-435. Section 12-7-430(e) provides that if the income of a taxpayer is subject to
   allocation or apportionment, or both, the South Carolina taxable income is modified as
   provided in Article 9 of Chapter 7. Section 12-7-1120 as amended provides guidance in
   the modification. In general, interest, dividends, and gains and losses from the sale of
   intangible personal property not connected with the business of the taxpayer are allocated
   to the individual taxpayer's domicile in addition to income received by residents for
   personal services. All other income is allocated or apportioned to the state in which it is
   earned.
   Section 12-7-235(b) provides Subchapter S treatment for electing small businesses in
   South Carolina. Pursuant to Subchapter S, shareholders are treated in essentially the
   same manner as partners in a partnership. Certain items of income, loss, and deduction
   are "passed-through" to the shareholders. Each such item is treated as if it were realized
   by the shareholder directly from the source from which it was realized by the corporation
   or as if it were incurred by the shareholder in the same manner as incurred by the
   corporation. When reading this provision in conjunction with Section 12-7-1120, only
   interest, dividends, or proceeds from the sale of intangible property flowing through to
   the shareholder from a nonresident Subchapter S corporation would be taxed.
2. As the treatment of Subchapter S income is essentially the same as partnership income,
   the treatment of expenses relating to such income is likewise similar. In the case of
   Wallace B. Dalton and Shirley B. Dalton v. South Carolina Tax Commission, Opinion
   No. 1129, the Court of Appeals upheld the Commission's matching doctrine. In that case
   interest expense incurred for the purchase of partnership interests was disallowed as
   expenses related to partnership income allocable to another state. Thus, in the instant
   case, the interest expense incurred to acquire Subchapter S stock is related to the
   Subchapter S income and is thus not deductible as the income is not taxable.
   Conclusion:
3. The 1987 distributions to a South Carolina resident from a nonresident "S" corporation
   representing income from the corporation would not be taxable in South Carolina unless
   distributed in the form of salaries, dividends, interest, or gains and losses from the sale of
   intangible personal property not connected with the taxpayer's business
4. Interest expense in the amount of $60,000 incurred to purchase the corporation's stock is
   not deductible since the income to which it relates is not taxable in South Carolina.

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SOUTH CAROLINA TAX COMMISSION

s/S. Hunter Howard Jr.
S. Hunter Howard, Jr., Chairman

s/John M. Rucker
John M. Rucker, Commissioner

s/A. Crawford Clarkson Jr.
A. Crawford Clarkson, Jr., Commissioner

Columbia, South Carolina
June 23
, 1988

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