80 T.C. 27">*27 OPINION

Respondent determined the following deficiencies in petitioners' Federal income tax: 80 T.C. 27">*28

After numerous concessions by petitioners, the only issue is whether1983 U.S. Tax Ct. LEXIS 130">*135 certain income derived by petitioners as shareholders of three subchapter S corporations is "investment income" within the meaning of section 163(d)(3)(B), ² thereby allowing petitioners a greater investment interest expense deduction.

All the facts have been stipulated and are found accordingly.

Petitioners William H. Crook and Eleanor B. Crook resided in San Marcos, Tex., at the time they filed their petition herein.

During relevant years, petitioners owned stock in three corporations which elected1983 U.S. Tax Ct. LEXIS 130">*136 to be treated as small business corporations under section 1372. Each corporation derived all its income through the operation of an automobile dealership. None of these corporations held investments; thus, no items of investment interest, investment income, or investment expense as those terms are defined in section 163(d) were paid or accrued by these corporations.

During each of their taxable years 1974 through 1977, petitioners paid a substantial amount of investment interest as that term is defined in section 163(d). ³ In addition, petitioners were required to report in their individual gross income both actual distributions treated as dividends under section 316(a) and undistributed taxable income of the subchapter S corporations which is treated as dividend income under section 1373(b).

On their 1974 through 1977 Federal income tax returns, petitioners1983 U.S. Tax Ct. LEXIS 130">*137 deducted amounts of investment interest expense 80 T.C. 27">*29 paid in those years. In his notice of deficiency, respondent, pursuant to the limitation on investment interest under section 163(d), disallowed a portion of those deductions.

At issue is the proper characterization of the operating income of a subchapter S corporation, which is passed through to its shareholders, for purposes of determining the limitation of investment interest allowable as a deduction under section 163(d). If such income qualifies as "investment income" to the shareholders under section 163(d)(3)(B), then petitioners are allowed a greater investment interest deduction. Respondent contends income at the corporate level retains its character at the shareholder level. Since none of the subchapter S corporations had investment income, respondent concludes petitioners derived no investment income for purposes of the section 163(d) limitation. Petitioners contend such operating income of the corporation does not retain its character at the shareholder level, but rather, constitutes investment income to the shareholder in the form of dividends. For the following reasons, we agree with petitioner.

Section 163(a)1983 U.S. Tax Ct. LEXIS 130">*138 allows a deduction for all interest paid on indebtedness. Section 163(d), enacted as part of the Tax Reform Act of 1969, ⁴1983 U.S. Tax Ct. LEXIS 130">*139 limits an individual taxpayer's deduction for interest paid solely for investment purposes. As noted in the House report:

Where the interest expense exceeds the taxpayer's investment income, it, in effect, is used to insulate other income from taxation. For example, a taxpayer may borrow substantial amounts to purchase stocks which have growth potential but which return small dividends currently. Despite the fact that the receipt of the income from the investment may be postponed * * *, the taxpayer will receive a current deduction for the interest expense even though it is substantially in excess of the income from the investment. [H. Rept. 91-413 (1969), 1969-3 C.B. 245.]

Thus, it was the mismatching of income and expenses that occurred when a taxpayer was allowed a current deduction for interest paid on funds borrowed solely for investment purposes 80 T.C. 27">*30 and which produced little current income that Congress sought to rectify. ⁵

In computing his investment interest deduction, a taxpayer is allowed to increase the limitation by the amount of his net investment income. Sec. 163(d)(1)(B). Such net investment income includes various items of a taxpayer's income from investments, one item of which is gross income from "dividends." Sec. 163(d)(3)(B)(i). ⁶ There is no question the included amounts at issue which were required to be included in petitioners' income are dividends under sections 316(a) and 1373(b). Nevertheless, respondent contends section 163(d)(4)(C) attributes the business character of the corporations' income to its shareholders and, in doing so, overrides sections 316(a) and 1373(b). Thus, respondent claims such income is not investment income to the shareholders for purposes of the section 163(d) limitation. We disagree.

1983 U.S. Tax Ct. LEXIS 130">*140

Section 163(d)(4)(C) provides:

(C) Shareholders of electing small business corporations. -- In the case of an electing small business corporation (as defined in section 1371(b)), the investment interest paid or accrued by such corporation and other items of income and expense which would be taken into account if this subsection applied to such corporation shall, under regulations prescribed by the Secretary, be treated as investment interest paid or accrued by the shareholders of such corporation and as items of such shareholders, and shall be apportioned pro rata among such shareholders in a manner consistent with section 1374(c)(1). ⁷

Thus, any investment interest paid by a subchapter S corporation is attributed to its shareholders. In addition, other items of income and expense of the corporation are attributed to its shareholders. The statute makes it clear that those "other items" are items of investment income and investment expenses (those terms being defined in sections 163(d)(3)(B) and 163(d)(3)(C), respectively) of the subchapter S corporation 80 T.C. 27">*31 which would have entered into the computation of the investment interest limitation of section 163(d) had such limitation1983 U.S. Tax Ct. LEXIS 130">*141 applied to the subchapter S corporation. In other words, any item of income or expense directly connected with an investment of the subchapter S corporation retains its investment character in the hands of the shareholders for purposes of determining the shareholders' section 163(d) limitation. Since the subchapter S corporations at issue herein paid or accrued no items of investment interest, investment income, or investment expense, section 163(d)(4)(C) simply does not apply to these facts. The statute does not purport to attribute the character of the operating income of the corporation to its shareholders; nor does it purport to limit or to provide the exclusive means by which a shareholder may receive investment income from a subchapter S corporation. The section merely attributes the character of such a corporation's investment items to its shareholders. ⁸

1983 U.S. Tax Ct. LEXIS 130">*142 Our holding that section 163(d)(4)(C) does not attribute the character of all types of a subchapter S corporation's income to its shareholders does not render that section a nullity, as respondent contends. One of the prime reasons for electing subchapter S status is to allow expected losses to pass through to the shareholders. Since items of income, deduction, or credit generally are not separately stated in the shareholders' 80 T.C. 27">*32 returns, losses of a subchapter S corporation are passed through as a bottom-line net operating loss deduction to its shareholders. Moreover, this net operating loss deduction is considered a deduction attributable to a trade or business carried on by the shareholders. Sec. 1374(b). Thus, without section 163(d)(4)(C), any investment interest of a subchapter S corporation that was reflected in a net operating loss would lose its investment character in the hands of its shareholders, thereby allowing taxpayers to escape the limitation. The statute requires that the corporation's investment interest, along with other items of investment income and expenses, be carved out and entered into the computation of the shareholder's individual section 163(d)1983 U.S. Tax Ct. LEXIS 130">*143 limitation. ⁹ Thus, section 163(d)(4)(C) effectively eliminates the right of a shareholder to convert investment interest of a subchapter S corporation into a net operating loss which is not subject to the limitation.

Respondent argues that the limitation easily can be avoided by operating a trade or business in the form of a subchapter S corporation which would generate investment income in the form of "dividends." In essence, respondent urges this Court to import judicial gloss1983 U.S. Tax Ct. LEXIS 130">*144 on the applicable statutory provisions in order to find that dividends under sections 316(a) and 1373(b) are not dividends for purposes of section 163(d). For the following reasons, we decline to do so.

That the included amounts are dividends could not be made more explicit by the Code. Secs. 316(a) and 1373(b). Moreover, when Congress has desired that dividends from a subchapter S corporation (including dividends under sec. 1373(b)) should not be treated as dividends for certain purposes, Congress has expressly provided for such exceptions. See sec. 1375(b). ¹⁰1983 U.S. Tax Ct. LEXIS 130">*145 No similar exception was provided for purposes of the section 80 T.C. 27">*33 163(d) limitation. We also note respondent has consistently treated subchapter S corporation dividends under sections 316(a) and 1373(b) as dividends for other purposes. ¹¹

1983 U.S. Tax Ct. LEXIS 130">*146 We recognize that by escaping tax at the corporate level, the income at issue is not dividend income in the traditional sense of being distributions out of income already taxed once at the corporate level. Nevertheless, the Code treats such income as dividends. While we certainly do not subscribe to the inflexible view that a "dividend" is necessarily a "dividend" for all purposes, we are unwilling to ascribe a different meaning to that term for purposes of the section 163(d) limitation. Only upon a showing of clear congressional intent to the contrary or other compelling reasons will we consider deviating from clear statutory language. ¹²

1983 U.S. Tax Ct. LEXIS 130">*147 The separate existence of corporations is firmly established under the tax law ( Moline Properties, Inc. v. Commissioner, 319 U.S. 436">319 U.S. 436 (1943)), and this Court has recognized that the business of a subchapter S corporation is separate and distinct from that of its shareholders. Buono v. Commissioner, 74 T.C. 187">74 T.C. 187 (1980); Howell v. Commissioner, 57 T.C. 546">57 T.C. 546 (1972). Our holding that the operating income of a subchapter S corporation is not to be attributed as such to its shareholders is wholly 80 T.C. 27">*34 consistent with these decisions. Whatever merit there is to respondent's contention, the applicable statutory law during the years in issue simply does not support his position. ¹³1983 U.S. Tax Ct. LEXIS 130">*148 Accordingly, we hold the included amounts are dividends within the meaning of section 163(d)(3)(B)(i); therefore, petitioners are entitled to treat such dividends as investment income for purposes of the limitation on the investment interest deduction under section 163(d). ¹⁴

To reflect concessions,

Decision will be entered under Rule 155.