Deductibility of deficiency interest.

The deductibility of interest paid by individuals on tax deficiencies has been in dispute ever since the Tax Reform Act of 1986 banned deductions of consumer interest such as that charged on credit cards or auto loans. Recently, the U.S. District Court for the Eastern District of North Carolina addressed the issue.

Robert Allen, a real estate developer, contributed real property to his closely held corporation to persuade a bank to lend it the working capital it needed. The corporation then sold the contributed property and reported the gain on its tax return. On audit, the IRS held that the gains should have been reported by Allen, not the corporation. In settlement, Allen paid a tax deficiency plus interest. He then deducted the interest as a business expense on his tax return. The IRS denied the deduction, claiming the interest Allen paid was personal interest.

Result: For the taxpayer. Temporary regulations section 1.1639T(b) (2)(i) (A) provides that interest paid by individuals on tax deficiencies is nondeductible. The district court, citing prior decisions, held the regulation to be invalid. Therefore, Allen can deduct the deficiency interest to the extent it is an ordinary and necessary business expense.

To obtain such a deduction, the interest must be related to the business. This is generally determined under the interest allocation rules of temporary regulations section 1.163-8T(c)(3)(ii). To the extent the tax deficiency arises from a business transaction, the interest should be allocated to the business.

A taxpayer must also show that the interest is "ordinary and necessary." As the court pointed out, if the adjustment that gave rise to the interest is expected or unavoidable, it is almost certainly ordinary and necessary. On the other hand, if there is no nexus between the deficiency and the taxpayer's business or if the deficiency is the result of bad faith on the taxpayer's part, the interest is not ordinary. The circumstances in between are subject to debate.

The court viewed the underlying transaction in this case--a sale of real estate by a real estate dealer--as ordinary and necessary. It rejected the IRS argument that the deficiency that generated the interest was caused by the transfer of property to the corporation, not by the sale. By phrasing the issue in this manner, the court may have increased the number of business transactions that qualify for interest deductions. As long as the direct cause of the tax is a business transaction, the interest is ordinary and necessary. Taxpayers attempting to deduct deficiency interest should identify an ordinary and necessary business transaction that gave rise to the tax. If they are able to do so, the interest paid may be deductible.

After the district court decision was rendered, the Ninth Circuit Court of Appeals reversed the Tax Court decision in Redlark, which also had held the regulation invalid. To date, the Eighth and Ninth Circuit Courts have held the regulation valid while the lower courts have ruled for the taxpayer. Since this current case is appealable to the Fourth Circuit, taxpayers may have a third opportunity to convince an appellate court that deficiency interest may be deductible if it is allocable to a trade or business.

Richard R. Allen, Sr. v. U.S., 1998-1 USTC P50, 196; 1997 U.S. Dist. Lexis 20252; United States District Court for the Eastern District of North Carolina.

Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama.