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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.

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

  2. 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?

  3. 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.

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First of all, this is a situation when a consultation with a EA working with S-Corporations in California, CA-licensed CPA or tax preparer (California licenses tax preparers as well) is in order. I'm neither of those, and my answer is not a tax advice of any kind.

You're looking at schedule CA line 17 (see page 42 in the 540NR booklet). The instructions refer you to form 3885A. You need to read the instructions carefully. California is notorious for not conforming to the Federal tax law. Specifically, to the issue of the interest attributable to investment in S-Corp, I do not know if CA conforms. I couldn't find any sources saying that it doesn't, but then again - I'm not a professional. It may be that there's an obscure provision invalidating this deduction, living in California myself - I wouldn't be surprised. So I suggest hiring a CA-licensed tax preparer to do this tax return for you, at least for the first year.

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