Tax Court allows deduction for interest on tax deficiency.

• Author: Payne, Jay

A deeply divided Tax Court held that individuals were allowed a deduction for interest on income tax deficiencies caused by accounting errors in a proprietorship business, holding that such interest was not personal interest, as IRS regulations provide. Thus, the court ruled that Temp. Regs. Sec. 1.163-9T (b) (2) (i) (A) was invalid to the extent it disallowed such a deduction.

In Redlark, 106 TC 2 (1996), the Redlarks' individual tax returns were audited for 1979-1985. Adjustments were made to their returns for accounting errors of their unincorporated business. They were assessed deficiencies and paid interest, which they took as a deduction on Schedule C of their 1989 and 1990 Federal income tax returns.

The Redlarks deducted the income tax deficiency interest expense as a Sec. 162 ordinary and necessary trade or business expense.

The Service argued that the interest was personal interest under Sec. 163(h) because, under Temp. Regs. Sec. 1.163-9T (b) (2) (i) (A), interest on a Federal income tax deficiency is nondeductible personal interest, regardless of the source.

The Redlarks claimed that Temp. Regs. Sec. 1.163-9T (b) (2) (i) (A) was invalid to the extent it precluded a deduction for interest on a deficiency that was an ordinary and necessary expense of a trade or business. Sec. 163 (h) (2) (A) provides an exception to personal interest if such interest is attributable to a trade or business.

The majority opinion concluded that the first issue was whether the interest expense was attributable to a trade or business. Citing several cases that held that taxpayers were allowed a deduction for interest expense on income tax deficiencies if attributable to a trade or business, the court held that in this instance the interest expense was an ordinary and necessary trade or business expense (Standing, 28 TC 89 (1957), aff'd, 259 F2d 450 (4th Cir. 1985); Polk, 31 TC 412 (1958), aff'd, 276 F2d 601 (10th Cir. 1960); Reise, 35 TC 571 (1961), aff'd, 299 F2d 380 (7th Cir. 1962)). The court ruled that accounting errors were sufficiently ordinary occurrences in the context of a trade or business to create the possibility that interest on income tax deficiencies would be assessed.

The court then considered the IRS's authority...