Is interest on taxes always personal?

• Author: Monroe, Tracy J.

A hotly contested issue of late is an individual's deduction of interest on tax deficiencies related to S corporation and schedule C adjustments. The crux of the inquiry is whether the statutory definition of business interest is ambiguous, thus requiring the IRS to issue interpretive regulations to clarify Congress's legislative intent, and whether the regulations are a valid interpretation of such intent.

The general rule of Sec. 163 states that "there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." However, Sec. 163(h) disallows a deduction for personal interest, defined as interest that is not (1) interest properly allocable to a trade or business, (2) investment interest, (3) interest from a passive activity, (4) qualified residence interest or (5) interest payable on any unpaid portion of estate tax for the period in which an extension of time for payment is in existence. It would appear that interest related to tax deficiencies from flowthrough trade or business adjustments are ordinary and necessary business expenses, and, therefore, deductible. Additionally, it would appear that this interest would be properly allocable to a trade or business based on the allocation rule provided in Temp. Regs. Sec. 1.163-8T, which provides that interest expense allocated to a trade or business expenditure is taken into account under Sec. 163(h)(2)(A), and, therefore, by definition, is not personal interest.

The basis for the debate over whether interest on business-related tax deficiencies is personal or not stems from Temp. Regs. Sec. 1.163-9T(b)(2), which states that personal interest includes interest paid on underpayments of Federal, state or local income taxes, and on indebtedness used to pay such taxes (regardless of the source of the income generating the tax liability).

Example: A, an individual, owns stock of an S corporation. On its return for 1987, the corporation underreports its taxable income. Consequently, A underreports A's share of that income on his personal tax return. In 1989, A pays the resulting deficiency plus interest to the IRS. The interest paid by A in 1989 on the tax deficiency is personal interest, despite the fact that the additional tax liability may have arisen out of income from a trade or business.

The result would be the same if A's business had been operated as a sole proprietorship.

Prior to the adoption of Temp. Kegs. Sec. 1.163-9T in 1987, the courts had...