Is the deduction of interest on tax deficiencies finally over?

• Author: Bakale, Anthony

Since the mid-1990s, there has been a plethora of disputes between noncorporate taxpayers and the IRS about the deductibility of interest incurred on income tax underpayments. Prior to the Tax Reform Act of 1986 (TRA '86), taxpayers could deduct substantially all interest. The TRA '86, however, included Sec. 163(h), which disallowed the deduction of personal interest. The issue in dispute since the TRA '86 has been whether or not interest on an underpayment of income tax directly related to a taxpayer's trade or business is deductible. That question now seems to be settled for most taxpayers, but not in their favor.

The Issue

Sec. 163(h) disallows a deduction for personal interest, defined as any interest other than:

* Interest properly allocable to a trade or business;

* Investment interest;

* Interest from a passive activity;

* Qualified residence interest; and

* Interest on an unpaid portion of estate tax for the period during which an extension of time for payment is in effect.

Based on a literal reading of Sec. 163(h), it would appear that interest on a tax deficiency attributable to a taxpayer's sole proprietorship would be deductible, as this interest would be properly allocable to a trade or business.

Example: Taxpayer T's income is derived from operation of a sole proprietorship. His return is audited and a correction to Schedule C income is made. An inventory valuation adjustment or an error in conversion from accrual-basis to cash-basis accounting could be the cause. Additional tax and interest on the underpayment are also due.

The Tax Court took a pro-taxpayer stance, ruling that the interest on the underpayment properly allocable to T's trade or business is deductible. The Service, on the other hand, relied on Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), which states that nondeductible personal interest includes interest on underpayments of Federal income tax, regardless of the source of the income generating the tax liability. This seems to be in conflict with Sec. 163(h)(A), which declares that interest properly allocable to a trade or business is not personal interest.

The Taxpayer's Position

Generally, the argument the taxpayer makes is that (1) historically, interest related to business debt is an ordinary and necessary business expense under Sec. 162 and (2) Sec. 63(a) allows trade or business deductions to arrive at adjusted gross income. While Sec. 163(h) disallows a deduction for personal interest, a specific exception is...