Individual taxpayers disallowed deficiency interest deduction.

• Author: Koski, Timothy R.

The Fourth Circuit has dealt yet another blow to taxpayers attempting to claim a business expense deduction for interest paid on a tax deficiency arising from an unincorporated business. In Allen (4/20/99), the Fourth Circuit held that an individual taxpayer may not deduct income tax deficiency interest, regardless of the source of the income causing the deficiency.

In an even more recent decision (McDonnell, 5/27/99), the Sixth Circuit once again held Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) valid and disallowed the taxpayer's claim for refund based on an investment interest deduction attributable to deficiency interest paid. The Fourth and Sixth Circuits now join the Eighth and Ninth Circuits in disallowing the deduction of deficiency interest arising from an unincorporated trade or business. Two Tax Court cases have allowed the deduction. In Redlark, 106 TC 31 (1996), a sharply divided Tax Court allowed the deduction; the Ninth Circuit, however, reversed this decision. The other Tax Court case allowing the deduction (Kikalos, TC Memo 1998-92) relied on the Tax Court Redlark decision and is currently on appeal to the Seventh Circuit. Although the issue remains somewhat unclear, it is now more difficult for individual taxpayers to deduct deficiency interest as a business or investment expense.

The Issue

Sec. 163(h) disallows the deduction of personal interest, defined as any interest other than interest specifically provided for in the Code, including interest paid or accrued on "indebtedness properly allocable to a trade or business." At issue is the validity of Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), which provides that personal interest includes interest paid or accrued on underpayments of taxes, "regardless of the source of the income generating the tax liability." If this temporary regulation is valid, all deficiency interest paid by individuals--including interest properly allocable to a trade or business or investment income--is nondeductible personal interest.

The district court in Alien agreed with the majority and concurring Tax Court opinions in Redlark and ruled that the temporary regulation was invalid. The court reasoned that Sec. 163(h)(2)(A) was inherently clear and that interest properly allocable to a trade or business was excluded from the definition of personal interest. It cited several cases decided prior to the Tax Reform Act of 1986 (TRA '86) in support of its position that interest on a tax deficiency could be a...