Can an individual deduct interest paid on a business-related tax deficiency?

• Author: Karlinsky, Stewart S.

EXECUTIVE SUMMARY

Currently, there is dissension in the courts as to whether interest paid by an individual on a tax deficiency can qualify as deductible trade or business interest. According to Temp. Regs. Sec. 1.163-9T(b) (2) (i) (A), which is predicated on the Blue Book to the Tax Reform Act of 1986 (TRA '86), such interest is nondeductible personal interest; however, the TRA '86 Conference Report states that personal interest generally includes interest on tax deficiencies, not that interest on all tax deficiencies is personal interest. A recent Tax Court case, Redlark, invalidated the temporary regulation, in conflict with Miller, a decision of the Eighth Circuit holding the regulation valid. This article examines the deductibility of such interest and how much deference the Blue Book is to be given in making this determination.

Introduction.

The Tax Reform Act of 1986 (TRA '86), Section 511, significantly restricted an individual's ability to deduct interest; after 1986, an interest expenditure must be classified in one of six categories under Sec. 163, based on the use of the underlying debt: trade or business, passive activity, investment, qualified residence, personal and tax-exempt. Each category has its own rules; the most generous allow full deductibility (trade or business interest) and the least bar deductibility (personal interest). Thus, the proper categorization of interest has become more important, complex and controversial. One such controversy involves an individual paying interest on a tax deficiency related to an audit of either his business activity or his interest in a passthrough entity (i.e., partnership, limited liability company or S corporation). This article examines the deductibility of tax deficiency interest on Schedule C, E and F business activities, then extends the analysis to interests held in passthrough entities.

Deducting Tax Deficiency Interest

Post-TRA '86 Sec. 163(h) (1) provides that no deduction is allowed an individual for "personal interest"; Sec. 163(h) (2) defines personal interest as other than interest paid or accured on debt properly allocable to a trade or business, any investment interest, any passive activity interest and any qualified residence interest. Temp. Regs. Sec. 1.163-9T, issued in 1987, ostensibly implements Sec. 163(h) (2); under Temp. Regs. Sec. 1.163-9T(b) (2) (i) (A), personal interest includes interest paid on underpayments of individual income taxes and on debt used to pay such taxes, regardless of the source of the income generating the tax liability. Thus, the temporary regulation disallows the deduction of interest paid on individual income tax deficiencies, even if the income is trade or business related.

Several recent cases(1) have addressed the deductibility of tax deficiency interest arising from an IRS adjustment of trade or business income. Prior to 1987, the courts consistently held that a noncorporate taxpayer could deduct tax deficiency interest arising from business income in computing adjusted gross income (AGI) under Sec. 62(a) (1).(2) The courts also held that the interest was deductible under Sec. 162 as a trade or business expense. If valid, Temp. Regs. Sec. 1.163-9T(b) (2) (i) (A) would overturn long-standing case law in this area. Since 1986, the courts appear to be divided; the decisions hinge on the type of entity used to conduct the trade or business and the court in which the case was tried.

Miller: Temp. Reg. Is Valid

In Miller,(3) the taxpayer was assessed a deficiency arising from adjustments to his 1982 and 1983 farming business income. The IRS disallowed a deduction for interest paid and deducted in 1988 related to those deficiencies, under Temp. Regs. Sec. 1.163-9T(b) (2) (i) (A). The district court held that regulation to be invalid because it provided that interest paid on an underpayment of noncorporate income tax was per se nondeductible. According to the court, Sec. 163(h) (2) (A) specifically excludes from "personal interest" any interest allocable to a trade or business. The court found that the principal purpose in enacting Sec. 163(h) (2) (A) was to disallow a noncorporate taxpayer's deduction of nonbusiness interest. According to the TRA '86 Conference Report,(4) Congress did not intend to change prior case law holding deductible deficiency interest incurred in connection with the conduct of a trade or business. In the court's view, the inclusion in "personal interest" of interest on deficiencies derived from business income was overly broad. The court also noted that, according to the Conference Report, personal interest generally includes interest on tax deficiencies; however, nothing in the report indicated that Congress believed interest on all tax deficiencies to be personal interest.

The IRS argued that, under the General Explanation of the Tax Reform Act of 1986 ("Blue Book"), personal interest includes interest on underpayments of individual income taxes, regardless of whether the income arose from a trade or business, because such taxes are not considered derived from the conduct of a trade or business.(5) Because the Blue Book was not prepared until a year after the TRA '86 was enacted, the district court found that such post-enactment explanation did not reach the level of legislative history and, therefore, was not authority. The court held the regulation to be invalid and ordered further discovery to determine whether the interest was an ordinary and necessary business expense.

On rehearing, the district court disallowed the deduction for the tax deficiency interest on the grounds that it was not an ordinary and necessary business expense. In the court's view, the taxpayer operated an improper deferral scheme to postpone the reporting of substantial amounts of taxable income. Nevertheless, the district court maintained that Temp. Regs. Sec. 1.163-9T(b) (2) (i) (A) was invalid; the Eighth Circuit affirmed the decision in Miller, but held that the temporary regulation was valid and thus, dispositive of the interest deduction issue.

Return Positions Contrary to Regulations

Taking a return position contrary to a temporary regulation is generally not advisable. Regs. Sec. 1.6662-3(c) (2) requires a taxpayer taking a return position in disregard of a regulation to file with the return Form 8275-R, Regulation Disclosure Statement. While filing this form could lead to an audit, there have been several instances in which an interpretative temporary or final regulation has been held invalid because it did not reflect Congress's legislative intent. (An interpretative regulation is one promulgated pursuant to the general authority granted to the Treasury Secretary under Sec. 7805(a) and not pursuant to specific legislative authority.) For example, in Vogel...