Casting doubt on the accrual of interest.

• Author: Borghino, Jeff

Due to the recent turmoil in the credit markets, creditors and borrowers alike are evaluating the tax treatment of interest accruals related to troubled loans. Generally under Regs. Sec. 1.446-2(a), interest is taken into account by a taxpayer according to the taxpayer's regular method of accounting. Beyond the specific rules for accrual-method taxpayers, there are established rules for determining:

* Whether interest related to troubled loans is a deductible expense to the borrower (the issuer of a note) as it accrues; and

* Whether interest related to troubled loans is income to the lender (the holder of a note) as it accrues. This item summarizes the current law related to interest accruals and further addresses the uncertainties and recent developments related to the tax law.

Whether Interest Is Deductible to the Borrower as It Accrues

Taxpayers may generally deduct interest paid or accrued within a tax year under Sec. 163(a). Accrual-method taxpayers deduct interest under Regs. Sec. 1.461-1(a)(2) when:

1. All events have occurred that establish the interest as a liability;

2. The amount of the interest can be determined with reasonable accuracy; and

3. Economic performance has occurred with respect to the interest.

Economic performance occurs as interest economically accrues (Regs. Sec. 1.461-4(e)).

If the borrower experiences financial hardship, can the borrower deduct interest that it may not be able to pay? Case law provides that the lack of ability to pay is not sufficient to prevent an issuer's accrual and deduction. In Zimmerman Steel Co., 130 F.2d 1011 (8th Cir. 1942), the Eighth Circuit allowed a taxpayer's deduction of interest despite the fact that the taxpayer's liabilities exceeded its assets for the period that such interest accrued. (See also Cohen, 21 T.C. 855 (1954).)

Even though the lack of ability to pay is not enough to prevent an issuer's deduction, issues may arise when a taxpayer is under bankruptcy proceedings. The IRS ruled in Rev. Rul. 70-367 that a taxpayer in bankruptcy could deduct interest as it accrues despite there being no reasonable expectancy that it would pay such interest in full. The ruling states, "The doubt as to the payment of such interest is not a contingency of a kind that postpones the accrual of the liability until the contingency is resolved."

Subsequently, courts have held that taxpayers could not deduct interest related to pre-bankruptcy debt that accrues after the issuer enters bankruptcy (postpetition interest) when the taxpayer did not have sufficient assets to pay the...