Hello and thank you for your question.
The owner of an S corp does get the benefit of the corporation's
investment in tax-free municipal bonds.
The way this works is, the owner increases his or her basis in the
corporate stock by the exempt interest that the corporation earns, and
decreases his or her basis for the amount of cash distributed.
So for example (and ignoring restrictions on overall passive income
that S corps can earn), suppose I form an S corporation by
contributing $1,000 of capital to it which the corporation uses to
purchase a municipal bond. After one year the bond yields $50 of
interest, and let's say I then liquidate the corporation and collect
the $1,050 on hand. Since when the interest was earned my basis goes
up from $1,000 to $1,050, I can receive the entire $1,050 tax-free.
That's explained in the box on page 2 of the instructions to Form 1120S
2004 Instruction 1120 S SCH K-1
Also see page 8 of those instructions, for how to fill in Box 16
Tax-exempt interest earned in the corporation also increases its Other
Adjustments Account (OAA) which likewise allows it to be distributed
tax-free to the shareholder. This is important for corporations that
have accumulated earnings and profits, since it's the OAA that allows
distributions to be made tax-free to the shareholder, since they're
deemed not to be distributions of accumulated earnings and profits.
"[The] Form 1120S instructions mention only tax-exempt bond interest
and interest expense on funds borrowed to purchase tax-exempt bonds as
examples of items placed in the OAA. In effect, OAA is a secondary
account to "hold" cumulative tax-exempt interest income and related
"Example 7: Liquiway, Inc., an S corporation with [accumulated
earnings and profits], has $5,000 of taxexempt interest and $16,000
(20% of $80,000) disallowed meals and entertainment expense. The
tax-exempt interest would be in the OAA...."
This is obviously a very technical area. But in one word, the answer
to your question "Is there a rule that prevents the owner of a S corp
from getting the
benefits of the corporation's investment in Tax Free Municipals?" is ....
Search terms used:
"s corporation" tax-exempt interest
"s corporation" tax-exempt interest site:irs.gov
Thanks again for letting us help