Prop. Treas. Reg. § 1.163-14 Allocation of interest expense among expenditures—Passthrough Entities.

Par. 2. Section 1.163-14 is added to read as follows:

(a) In general —(1) Application. This section prescribes rules for allocating interest expense associated with debt proceeds of a partnership or S corporation (a passthrough entity ). In general, interest expense on a debt of a passthrough entity is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures of a passthrough entity.

(2) Cross-references. This paragraph provides the general manner in which interest expense of a passthrough entity is allocated. See paragraph (b) of this section for the treatment of interest expense allocated under the rules of this section, paragraph (c) for the manner in which debt proceeds of a passthrough entity are allocated and the manner in which interest expense allocated under this section is treated, paragraph (d) for rules relating to debt allocated under the rules of § 1.163-8T to distributions to owners of a passthrough entity, paragraph (e) for rules relating to debt repayments, paragraph (f) for rules relating to debt allocated under the rules of § 1.163-8T to expenditures for interests in passthrough entities, paragraph (g) for change of ownership rules for interest expense allocation purposes, and paragraph (h) for examples.

(b) Treatment of interest expense —(1) General rule. Except as otherwise provided in section § 1.163(j)-8T(m), interest expense allocated under the rules of this section is treated in the following manner:

(i) Interest expense allocated to trade or business expenditures (as defined in paragraph (b)(2)(v) of this section) is taken into account under section 163(j) by the passthrough entity;

(ii) Interest expense allocated to other trade or business expenditures (as defined in paragraph (b)(2)(ii) of this section) is taken into account under the rules of § 1.163-8T, as applicable, by the passthrough entity owner allocated such interest expense;

(iii) Interest expense allocated to rental expenditures (as defined in paragraph (b)(2)(iv) of this section) is taken into account under the rules of § 1.163-8T, as applicable, by the passthrough entity owner allocated such interest expense;

(iv) Interest expense allocated to investment expenditures (as defined in paragraph (b)(2)(i) of this section) is taken into account under the rules of § 1.163-8T, as applicable, by the passthrough entity owner allocated such interest expense;

(v) Interest expense allocated to personal expenditures (as defined in paragraph (b)(2)(iii) of this section) is taken into account under the rules of § 1.163-8T, as applicable, by the passthrough entity owner allocated such interest expense;

(vi) Interest expense allocated to distributions to owners of a passthrough entity is taken into account in the manner provided under paragraph (d) of this section.

(2) Definitions. For purposes of this section—

(i) Investment expenditure means an expenditure defined in § 1.163-8T(b)(3), including any expenditure made with respect to a trade or business described in section 163(d)(5)(A)(ii) to the extent such expenditure is properly allocable under section 704(b) to partners that do not materially participate (within the meaning and for purposes of section 469) in the trade or business.

(ii) Other trade or business expenditure means an expenditure made with respect to any activity described in § 1.469-4(b)(1)(ii) and (iii).

(iii) Personal expenditure means an expenditure (other than a distribution) not described in paragraphs (b)(2)(i), (ii), (iv) and (v) of this section.

(iv) Rental expenditure means an expenditure made with respect to any activity described in § 1.469-4(b)(2) that is not a trade or business, as defined in § 1.163(j)-1(b)(44).

(v) Trade or business expenditure means an expenditure made with respect to a trade or business, as defined in § 1.163(j)-1(b)(44), except for an expenditure made with respect to a trade or business described in section 163(d)(5)(A)(ii) to the extent such expenditure is properly allocable under section 704(b) to partners that do not materially participate (within the meaning and for purposes of section 469) in the trade or business.

(c) Allocation of debt and interest expense. Except as otherwise provided in this section, the rules of § 1.163-8T apply to partnerships, S Corporations, and their owners.

(d) Debt allocated to distributions by passthrough entities —(1) Allocation of distributed debt proceeds —(i) Available expenditures. To the extent a passthrough entity has available expenditures (as defined in paragraph (d)(5)(ii) of this section), the passthrough entity shall first allocate distributed debt proceeds (as defined in paragraph (d)(5)(iii) of this section) to such available expenditures. If a passthrough entity has multiple available expenditures, the passthrough entity shall allocate distributed debt proceeds to such available expenditures in proportion to the amount of each expenditure.

(ii) Debt financed distributions. If a passthrough entity's distributed debt proceeds exceeds its available expenditures, the passthrough entity shall allocate such excess amount of distributed debt proceeds to distributions to owners of the passthrough entity (debt financed distributions).

(2) Allocation of interest expense —(i) Interest expense allocated to debt financed distributions. If distributed debt proceeds are allocated to distributions to owners of the passthrough entity (pursuant to paragraph (d)(1)(ii) of this section), the passthrough entity shall determine the portion of each passthrough entity owner's allocable interest expense that is debt financed distribution interest expense. The amount of a passthrough entity owner's debt financed distribution interest expense equals the lesser of such passthrough entity owner's allocable interest expense (as defined in paragraph (d)(5)(i) of this section) or the product of—

(A) The portion of the debt proceeds distributed to that particular passthrough entity owner; multiplied by

(B) A fraction, the numerator of which is the portion of the passthrough entity's distributed debt proceeds allocated to debt financed distributions (determined under paragraph (d)(1)(ii) of this section), and the denominator of which is the passthrough entity's total amount of distributed debt proceeds; multiplied by

(C) The distributed debt proceeds interest rate (as defined in paragraph (d)(5)(iv) of this section).

(ii) Interest expense allocated to available expenditures. If distributed debt proceeds are allocated to available expenditures (pursuant to paragraph (d)(1)(i) of this section), the passthrough entity shall determine the portion of each passthrough entity owner's allocable interest expense that is expenditure interest expense. The amount of a passthrough entity owner's expenditure interest expense equals the product of—

(A) The portion of the passthrough entity's distributed debt proceeds allocated to available expenditures (determined under paragraph (d)(1)(i) of this section); multiplied by

(B) The distributed debt proceeds interest rate; multiplied by

(C) A fraction, the numerator of which is the excess of that particular passthrough entity owner's allocable interest expense over its debt financed distribution interest expense (determined under paragraph (d)(2)(i) of this section) (remaining interest expense), and the denominator of which is aggregate of all the passthrough owners' remaining interest expense amounts.

(iii) Excess interest expense. To the extent a passthrough entity owner's allocable interest expense is not treated as either debt financed distribution interest expense (determined under paragraph (d)(2)(i) of this section) or expenditure interest expense (determined under paragraph (d)(2)(ii) of this section), such allocable interest expense is excess interest expense.

(3) Tax treatment of interest expense —(i) Debt financed distribution interest expense. The tax treatment of a passthrough entity owner's debt financed distribution interest expense (determined under paragraph (d)(2)(i) of this section), if any, shall be determined by the passthrough entity owner under the rules of § 1.163-8T, as applicable, in accordance with such passthrough entity owner's use of its portion of the passthrough entity's distributed debt proceeds. The passthrough entity shall separately state the amount of each owner's debt financed distribution interest expense. Debt financed distribution interest expense is not treated as interest expense of the entity for purposes of this section.

(ii) Expenditure interest expense. The tax treatment of a passthrough entity owner's expenditure interest expense (determined under paragraph (d)(2)(ii) of this section), if any, shall be determined based on how the distributed debt proceeds were allocated among available expenditures (pursuant to paragraph (d)(1)(i) of this section). For example, if distributed debt proceeds are allocated to a rental activity under paragraph (d)(1)(i) of this section, the interest expense associated with such debt should be taken into account by the passthrough entity in computing income or loss from the rental activity that is reported to the owner.

(iii) Excess interest expense. The tax treatment of a passthrough entity owner's excess interest expense (determined under paragraph (d)(2)(iii) of this section), if any, shall be determined by allocating the distributed debt proceeds among all the assets of the passthrough entity, pro-rata, based on the adjusted basis of such assets. For purposes of the preceding sentence, the passthrough entity shall use either the adjusted tax bases of its assets reduced by any debt of the passthrough entity allocated to such assets, or determine its adjusted basis in its assets in accordance with the rules in § 1.163(j)-10(c)(5)(i), reduced by any debt of the passthrough entity allocated to such assets. Once a passthrough entity chooses a method for determining its adjusted basis in its assets for this purpose, the passthrough entity must consistently apply the same method in all subsequent tax years. Any assets purchased in the same taxable year as the distribution (such that the expenditure for those assets was taken into account in § 1.163-14(b)(1)) are not included in this allocation.

(4) Treatment of transfers of interests in a passthrough entity by an owner that received a debt financed distribution —(i) In general. In the case of a transfer of an interest in a passthrough entity, any debt financed distribution interest expense of the transferor shall be treated as excess interest expense by the transferee. However, in the case of a transfer of an interest in a passthrough entity to a person who is related to the transferor, any debt financed distribution interest expense of the transferor shall continue to be treated as debt financed distribution interest expense by the related party transferee, and the tax treatment of such debt financed distribution expense under paragraph (d)(3) of this section shall be the same to the related party transferee as it was to the transferor. The term related party means any person who bears a relationship to the taxpayer which is described in section 267(b) or 707(b)(1).

(ii) Anti-avoidance rule. Arrangements entered into with a principal purpose of avoiding the rules of this paragraph, including the transfer of an interest in a passthrough entity by an owner who treated a portion of its allocable interest expense as debt financed distribution interest expense to an unrelated party pursuant to a plan to transfer the interest back to the owner who received the debt financed distribution interest expense or to a party who is related to the owner who received the debt financed distribution interest expense, may be disregarded or recharacterized by the Commissioner of the IRS to the extent necessary to carry out the purposes of this paragraph.

(5) Definitions. For purposes of this paragraph—

(i) Allocable interest expense means a passthrough entity owner's share of interest expense associated with the distributed debt proceeds allocated under section 704 or section 1366(a).

(ii) Available expenditure means an expenditure of a passthrough entity described in paragraph (b)(2) of this section made in the same taxable year of the entity as the distribution, to the extent that debt proceeds (including other distributed debt proceeds) are not otherwise allocated to such expenditure.

(iii) Distributed debt proceeds means debt proceeds of a passthrough entity that are allocated under § 1.163-8T and this section to distributions to owners of the passthrough entity in a taxable year. If debt proceeds from multiple borrowings are allocated under § 1.163-8T to distributions to owners of the passthrough entity in a taxable year, then all such borrowings are treated as a single borrowing for purposes of this section.

(iv) Distributed debt proceeds interest rate means a fraction, the numerator of which is the amount of interest expense associated with distributed debt proceeds, and the denominator of which is the amount of distributed debt proceeds.

(e) Repayment of passthrough entity debt —(1) In general. If any portion of passthrough entity debt is repaid at a time when such debt is allocated to more than one expenditure, the debt is treated for purposes of this section as repaid in the following order:

(i) Amounts allocated to one or more expenditures described in paragraph (b)(2)(iii);

(ii) Amounts allocated to one or more expenditures described in paragraph (b)(2)(i) (relating to investment expenditures as defined in § 1.163-8T(b)(3));

(iii) Amounts allocated to one or more expenditures described in paragraphs (b)(2)(ii) and (iv) (relating to expenditures with respect to any activities described in § 1.469-4(b)(1)(ii) and (iii), and § 1.469-4(b)(2)); and

(iv) Amounts allocated to one or more expenditures described in paragraph (b)(2)(v) (generally relating to expenditures made with respect to a trade or business as defined in § 1.163(j)-1(b)(44)).

(2) Repayment of debt used to finance a distribution. Any repayment of debt of a passthrough entity that has been allocated to debt financed distributions under paragraph (d)(1)(ii) of this section and to one or more available expenditures under paragraph (d)(1)(i) of this section may, at the option of the passthrough entity, be treated first as a repayment of the portion of the debt that had been allocated to such debt financed distributions.

(f) Debt allocated to expenditures for interests in passthrough entities. In the case of debt proceeds allocated under the rules of § 1.163-8T and this section to contributions to the capital of or to the purchase of an interest in a passthrough entity, the character of the debt proceeds and any associated interest expense shall be determined by allocating the debt proceeds among the adjusted tax bases of the entity's assets. For purposes of this paragraph, the owner must allocate the debt proceeds either in proportion to the relative adjusted tax basis of the entity's assets reduced by any debt allocated to such assets, or based on the adjusted basis of the entity's assets in accordance with the rules in § 1.163(j)-10(c)(5)(i) reduced by any debt allocated to such assets. Once the owner chooses a method for allocating the debt proceeds for this purpose, the owner must consistently apply the same method in all subsequent tax years. Individuals shall report interest expense paid or incurred in connection with debt-financed acquisitions on their individual income tax return in accordance with the asset to which the interest expense is allocated under this paragraph.

(g) Change in ownership. Any transfer of an ownership interest in a passthrough entity is not a reallocation event for purposes of § 1.163-8T(j), except as provided for in paragraph (d)(4) of this section.

(h) Examples —(1) Example 1 —(i) Facts. A (an individual) and B (an individual) are partners in partnership PRS. PRS conducts two businesses; a manufacturing business, which is a trade or business as defined in § 1.163(j)-1(b)(44) (manufacturing), and a separate commercial real estate leasing business, which is an activity described in § 1.469-4(b)(2) (leasing). In Year 1, PRS borrowed $100,000 from an unrelated third-party lender (the loan). Other than the loan, PRS does not have any outstanding debt. During Year 1, PRS paid $80,000 in manufacturing expenses, $120,000 in leasing expenses, and made a $100,000 distribution to A, the proceeds of which A used to make a personal expenditure. Under § 1.163-8T, PRS treated the $100,000 of loan proceeds as having been distributed to A. As a result, in Year 1 PRS had $200,000 of available expenditures (as defined in paragraph (d)(5)(ii) of this section) and $100,000 of distributed debt proceeds (as defined in paragraph (d)(5)(iii) of this section). PRS paid $10,000 in interest expense that accrued during Year 1 on the loan, and allocated such interest expense under section 704(b) equally to A and B ($5,000 each). Thus, A and B each had $5,000 of allocable interest expense (as defined in paragraph (d)(5)(i) of this section).

(ii) Applicability. Because PRS treated all $100,000 of the loan proceeds as having been distributed under § 1.163-8T, PRS allocated all $10,000 of the interest expense associated with the loan to the distribution. Thus, pursuant to paragraph (b)(1)(vi) of this section, PRS must determine the tax treatment of such $10,000 of interest expense in the manner provided in paragraph (d) of this section.

(iii) Debt allocated to distributions. Under paragraph (d)(1)(i) of this section, to the extent PRS has available expenditures (as defined under paragraph (d)(5)(ii) of this section), it must allocate any distributed debt proceeds (as defined under paragraph (d)(5)(iii) of this section) to such available expenditures. Here, PRS has distributed debt proceeds of $100,000 and available expenditures of $200,000 (manufacturing expenditures of $80,000, plus leasing expenditures of $120,000). Thus, PRS allocates all $100,000 of the distributed debt proceeds to available expenditures as follows: $40,000 to manufacturing expenditures ($100,000 × ($80,000/$200,000)) and $60,000 to leasing expenditures ($100,000 × ($120,000/$200,000)). Because the amount of PRS's distributed debt proceeds is less than its available expenditures, none of the distributed debt proceeds are allocated to debt financed distributions pursuant to paragraph (d)(1)(ii) of this section.

(iv) Allocation of interest expense. Because all of PRS's distributed debt proceeds are allocated to available expenditures (pursuant to paragraph (d)(1)(i) of this section), A and B each treat all $5,000 of their allocable interest expense as expenditure interest expense.

(v) Tax treatment of interest expense. Pursuant to paragraph (d)(3)(ii) of this section, each partner treats its expenditure interest expense (determined under paragraph (d)(2)(ii) of this section) in the same manner as the distributed debt proceeds that were allocated to available expenditures under paragraph (d)(1)(i) of this section. Thus, A's $5,000 of expenditure interest expense comprises of $2,000 of business interest expense ($5,000 × ($40,000/$100,000)) and $3,000 of interest expense allocated to rental expenditures ($5,000 × ($60,000/$100,000)). B's $5,000 of expenditure interest expense similarly comprises of $2,000 of business interest expense and $3,000 of interest expense allocated to rental expenditures. As a result, $4,000 of interest expense associated with the distributed debt proceeds (A's $2,000 plus B's $2,000 of expenditure interest expense treated as business interest expense) is business interest expense of PRS, subject to section 163(j) at the PRS level.

(2) Example 2 —(i) Facts. The facts are the same as in Example 1 in paragraph (h)(1)(i) of this section, except PRS did not have any rental expenditures in Year 1. As a result, in Year 1 PRS had $80,000 of available expenditures (as defined in paragraph (d)(5)(ii) of this section) and $100,000 of distributed debt proceeds (as defined in paragraph (d)(5)(iii) of this section).

(ii) Applicability. Because PRS treated all $100,000 of the loan proceeds as having been distributed to A under § 1.163-8T, PRS allocated all $10,000 of the interest expense associated with the loan to the distribution. Thus, pursuant to paragraph (b)(1)(vi) of this section, PRS must determine the tax treatment of such $10,000 of interest expense in the manner provided in paragraph (d) of this section.

(iii) Debt allocated to distributions. Under paragraph (d)(1)(i) of this section, to the extent PRS has available expenditures (as defined under paragraph (d)(5)(ii) of this section), it must allocate any distributed debt proceeds (as defined under paragraph (d)(5)(i) of this section) to such available expenditures. Here, PRS has distributed debt proceeds of $100,000 and available expenditures of $80,000. Thus, $80,000 of the distributed debt proceeds are allocated to such available expenditures. Pursuant to paragraph (d)(1)(ii) of this section, PRS allocates the remaining $20,000 of the distributed debt proceeds to debt financed distributions.

(iv) Allocation of interest expense—debt financed distribution interest expense. Pursuant to paragraph (d)(2)(i) of this section, A treats $2,000 of its allocable interest expense as debt financed distribution interest expense, which is the lesser of $5,000 or $2,000 ((A) the portion of debt proceeds distributed to A ($100,000), multiplied by (B) a fraction, the numerator of which is the portion of PRS's distributed debt proceeds allocated to debt financed distributions pursuant to paragraph (d)(1)(ii) of this section ($20,000), and the denominator of which is PRS's total amount of distributed debt proceeds ($100,000), multiplied by (C) the distributed debt proceeds interest rate, as defined in paragraph (d)(5)(iii) of this section, of 10% (the amount of interest expense associated with distributed debt proceeds ($10,000), divided by the amount of distributed debt proceeds ($100,000))) and B treats $0 of its allocable interest expense as debt financed distribution interest expense, which is the lesser of $5,000 or $0 ((A) $0 × (B) 20% × (C) 10%).

(v) Allocation of interest expense—expenditure interest expense. Pursuant to paragraph (d)(2)(ii) of this section, A treats $3,000 of its allocable interest expense as expenditure interest expense ((A) the portion of PRS's distributed debt proceeds allocated to available expenditures pursuant to paragraph (d)(1)(i) of this section ($80,000), multiplied by (B) the distributed debt proceeds interest rate (10%), multiplied by (C) a fraction, the numerator of which is A's remaining interest expense (that is, the excess of A's allocable interest expense ($5,000) over its debt financed distribution interest expense as determined under paragraph (d)(2)(i) of this section ($2,000)), and the denominator of which is the aggregate of A's and B's remaining interest expense amounts ($3,000 + $5,000)) and B treats $5,000 of its allocable interest expense as expenditure interest expense ((A) $80 × (B) 10% × (C) 62.5%).

(vi) Allocation of interest expense—excess interest expense. Neither partner treats any of its allocable interest expense as excess interest expense under paragraph (d)(2)(iii) of this section.

(vii) Tax treatment of interest expense. Pursuant to paragraph (d)(3)(i) of this section, each partner determines the tax treatment of its debt financed distribution interest expense (determined under paragraph (d)(2)(i) of this section) based on its use of the distributed debt proceeds. Because A used its $100,000 of distributed debt proceeds on a personal expenditure, A's $2,000 of debt financed distribution interest expense is personal interest subject to section 163(h) at A's level. Pursuant to paragraph (d)(3)(ii) of this section, each partner treats its expenditure interest expense (determined under paragraph (d)(2)(ii) of this section) in the same manner as the distributed debt proceeds that were allocated to available expenditures under paragraph (d)(1)(i) of this section. Thus, all $3,000 of A's expenditure interest expense and all $5,000 of B's expenditure interest expense is business interest expense. As a result, $8,000 interest expense associated with the distributed debt proceeds (A's $3,000 plus B's $5,000 of expenditure interest expense treated as business interest expense) is business interest expense of PRS, subject to section 163(j) at the PRS level.

(3) Example 3 —(i) Facts. The facts are the same as in Example 2 in paragraph (h)(2)(i) of this section, except PRS paid $20,000 in manufacturing expenses, made a distribution of $75,000 to A (the proceeds of which A used on a personal expenditure), and made a distribution of $25,000 to B (the proceeds of which B used on a trade or business expenditure). As a result, in Year 1 PRS had $20,000 of available expenditures (as defined in paragraph (d)(5)(ii) of this section) and $100,000 of distributed debt proceeds (as defined in paragraph (d)(5)(iii) of this section). The $20,000 manufacturing expenditure was to acquire assets used in PRS's manufacturing business. At the end of Year 1, the adjusted tax basis of PRS's assets used in manufacturing was $720,000 and the adjusted tax basis of PRS's assets used in leasing was $200,000. In addition, at the end of Year 1, the adjusted basis of PRS's assets held for investment (within the meaning of section 163(d)(5)) was $100,000.

(ii) Applicability. Because PRS treated all $100,000 of the loan proceeds as having been distributed under § 1.163-8T, PRS allocated all $10,000 of the interest expense associated with the loan to the distribution. Thus, pursuant to paragraph (b)(1)(vi) of this section, PRS must determine the tax treatment of such $10,000 of interest expense in the manner provided in paragraph (d) of this section.

(iii) Debt allocated to distributions. Under paragraph (d)(1)(i) of this section, to the extent PRS has available expenditures (as defined under paragraph (d)(5)(ii) of this section), it must allocate any distributed debt proceeds (as defined under paragraph (d)(5)(i) of this section) to such available expenditures. Here, PRS has distributed debt proceeds of $100,000 and available expenditures of $20,000. Thus, PRS allocates $20,000 of the distributed debt proceeds to available expenditures. Pursuant to paragraph (d)(1)(ii) of this section, PRS allocates the remaining $80,000 of distributed debt proceeds to debt financed distributions.

(iv) Allocation of interest expense—debt financed distribution interest expense. Pursuant to paragraph (d)(2)(i) of this section, A treats $5,000 of its allocable interest expense as debt financed distribution interest expense, which is the lesser of $5,000 or $6,000 ((A) $75,000 × (B) 80% × (C) 10%) and B treats $2,000 of its allocable interest expense as debt financed distribution interest expense, which is the lesser of $5,000 or $2,000 ((A) $25,000 × (B) 80% × (C) 10%).

(v) Allocation of interest expense—expenditure interest expense. Pursuant to paragraph (d)(2)(ii) of this section, A does not treat any of its allocable interest expense as expenditure interest expense ((A) $20,000 × (B) 10% × (C) 0%) and B treats $2,000 of its allocable interest expense as expenditure interest expense ((A) $20,000 × (B) 10% × (C) 100%).

(vi) Allocation of interest expense—excess interest expense. Pursuant to paragraph (d)(2)(iii) of this section, A does not treat any of its allocable interest expense as excess interest expense ($5,000 of allocable interest expense, less $5,000 of debt financed distribution interest expense, less $0 of expenditure interest expense) and B treats $1,000 of its allocable interest expense as excess interest expense ($5,000 of allocable interest expense, less $2,000 of debt financed distribution interest expense, less $2,000 of expenditure interest expense).

(vii) Tax treatment of interest expense. Pursuant to paragraph (d)(3)(i) of this section, each partner determines the tax treatment of its debt financed distribution interest expense based on its use of the distributed debt proceeds. A used its share of the distributed debt proceeds to make personal expenditures. Thus, A's $5,000 of debt financed distribution interest expense is subject to section 163(h) at A's level. B used its share of the distributed debt proceeds to make trade or business expenditures. Thus, B's $2,000 of debt financed distribution interest expense is subject to section 163(j) at B's level. Pursuant to paragraph (d)(3)(ii) of this section, B treats its $2,000 of expenditure interest expense in the same manner as the distributed debt proceeds were allocated to available expenditures under paragraph (d)(1)(i) of this section. Thus, B's $2,000 of expenditure interest expense is business interest expense, subject to section 163(j) at the level of PRS. Pursuant to paragraph (d)(3)(iii) of this section, B determines the tax treatment of its $1,000 of excess interest expense by allocating distributed debt proceeds among the adjusted basis of PRS's assets, reduced by any debt allocated to such assets. For purposes of paragraph (d)(3)(iii) of this section, PRS's has $700,000 ($720,000−$20,000 debt proceeds allocated to such assets) of basis in its manufacturing assets, $200,000 of basis in its leasing assets, and $100,000 of basis in its assets held for investment. Thus, B's $1,000 of excess interest expense is treated as $700 of business interest expense subject to 163(j) at the PRS level, $200 of interest expense related to a rental activity, and $100 of investment interest expense.

(4) Example 4. The facts are the same as in Example 2 in paragraph (h)(2)(i) of this section. In Year 2, A sells its interest in PRS to C. C is not related to either A or B under the rules of either section 267(b) or section 707(b)(1). No facts have changed with respect to PRS's loan. Under these facts, and only for purposes of this section, C's share of the debt financed distribution interest expense will be treated as excess interest expense pursuant to paragraph (d)(4)(i) of this section. Accordingly, C will determine the character of its share of this interest expense by allocating the debt proceeds associated with this interest expense among the assets of PRS under paragraph (d)(3)(iii) of this section.

(5) Example 5. The facts are the same as in Example 4 in paragraph (h)(4) of this section, except that C is a party that is related to A under the rules of either section 267(b) or section 707(b)(1). Under these facts, and only for purposes of this section, A's $2,000 of debt financed distribution interest expense shall, pursuant to paragraph (d)(4)(i) of this section, continue to be treated as debt financed distribution interest expense of C, subject to the same tax treatment as it was to the transferor (personal interest expense).

(6) Example 6. The facts are the same as in Example 2 in paragraph (h)(2)(i) of this section, except that in Year 2 B sells its interest in PRS to D. D is not related to either A or B under the rules of either section 267(b) or section 707(b)(1). No other facts have changed with respect to PRS's loan. Under these facts, the tax treatment of the expenditure interest expense does not change with respect to PRS or any of the partners as a result of the ownership change pursuant to paragraph (g) of this section. Accordingly, the tax treatment of the expenditure interest expense allocable to D under section 704(b) is identical to the expenditure interest expense that had been allocable to B prior to the sale.

(7) Example 7 —(i) Facts. A (an individual) and B (an individual) are equal shareholders in S corporation X. X conducts a manufacturing business, which is a trade or business as defined in § 1.163(j)-1(b)(44) (manufacturing). In Year 1, X borrowed $100,000 from an unrelated third-party lender (the loan). Other than the loan, X does not have any outstanding debt. During Year 1, X paid $100,000 in manufacturing expenses and made a $50,000 distribution to each of its shareholders, A and B, which each shareholder used to make a personal expenditure. Under § 1.163-8T, X treated all $100,000 of the loan proceeds as having been distributed to A and B. As a result, in Year 1 X had $100,000 of available expenditures (as defined in paragraph (d)(5)(ii) of this section) and $100,000 of distributed debt proceeds (as defined in paragraph (d)(5)(iii) of this section). X paid $10,000 in interest expense that accrued during Year 1 on the loan, and allocated such interest expense under section 1366(a) equally to A and B ($5,000 each). Thus, A and B each had $5,000 of allocable interest expense (as defined in paragraph (d)(5)(i) of this section).

(ii) Applicability. Because X treated all $100,000 of the loan proceeds as having been distributed to A and B under § 1.163-8T, PRS allocated all $10,000 of the interest expense associated with the loan to the distributions. Thus, pursuant to paragraph (b)(1)(vi) of this section, PRS must determine the tax treatment of such $10,000 of interest expense in the manner provided in paragraph (d) of this section.

(iii) Debt allocated to distributions. Under paragraph (d)(1)(i) of this section, to the extent X has available expenditures (as defined under paragraph (d)(5)(ii) of this section), it must allocate any distributed debt proceeds (as defined under paragraph (d)(5)(iii) of this section) to such available expenditures. Here, X has distributed debt proceeds of $100,000 and available expenditures of $100,000. Thus, PRS allocates all $100,000 of the distributed debt proceeds to available expenditures

(iv) Allocation of interest expense. Because all of X's distributed debt proceeds are allocated to available expenditures (pursuant to paragraph (d)(1)(i) of this section), A and B each treat all $5,000 of their allocable interest expense as expenditure interest expense.

(v) Tax treatment of interest expense. Pursuant to paragraph (d)(3)(ii) of this section, each partner treats its expenditure interest expense (determined under paragraph (d)(2)(ii) of this section) in the same manner as the distributed debt proceeds that were allocated to available expenditures under paragraph (d)(1)(i) of this section. Thus, A's $5,000 of expenditure interest expense and B's $5,000 of expenditure interest expense is treated as business interest expense of X, subject to section 163(j) at X's level.

(h) Applicability date. This section applies to taxable years beginning on or after [DATE 60 DAYS AFTER DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL REGISTER ]. However, taxpayers and their related parties, within the meaning of sections 267(b) and 707(b)(1), may choose to apply the rules of this section to a taxable year beginning after December 31, 2017, and before [DATE 60 DAYS AFTER DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL REGISTER ], provided that they consistently apply the rules of this section to that taxable year and each subsequent taxable year.