Deducting personal interest.

The Tax Reform Act (TRA) of 1986 put an end to the deductibility of personal interest, except for a few exceptions, such as investment and mortgage interest. The deduction of business-related interest generally has not been a problem for unincorporated sole proprietorships. However, Treasury regulation 1.163-9T(3) (2) (i)(A) said a deduction derived from a federal tax deficiency--whether or not it was a business-related deduction-- was personal interest and nondeductible under Internal Revenue Code section 163(h).

In James E. Redlark v. Commissioner, 106 TC no. 2 (1996), taxpayers made errors when converting their unincorporated business from the accrual to the cash basis. They deducted the interest on the resulting federal deficiencies as a business expense on their personal tax returns for years after the 1986 TRA.

The Tax Court said the Treasury regulation did not apply to Redlark because the deficiencies arising from business-related errors, such as changing from cash to accrual and inventory valuations, were ordinary and necessary deductions. The court's decision does not apply to principals of pass-through entities.

The Tax Court did not go along with Miller v. Commissioner, 65 F3rd 687 (1995), an earlier Eighth Circuit Court case which considered interest on federal deficiencies related to an improper tax deferral. The court said Miller's interest expense was not business-related and therefore not deductible.

Observation: The Tax Court made a distinction in the Redlark case for unincorporated businesses operated as sole proprietors: Interest on federal deficiencies related to normal business activities are considered ordinary and necessary deductions while interest on federal deficiencies caused by improper activities will continue to be considered nondeductible personal interest.

It is very possible that the Internal Revenue Service will appeal this decision. Practitioners should be alert to the possibility of filing claims for refunds for open years for their unincorporated business clients who did not deduct the interest on federal tax deficiencies caused by situations similar to those in Redlark. Those in the Eighth Circuit will not be eligible because of the Miller decision.

As for planning, preparers should deduct any interest on federal tax deficiencies if they meet the criteria of Redlark. This would include interest on income derived from unincorporated businesses reported on form 1040, and on Schedules C, E or E --Stanley Person, CPA, partner of Person & Co., New York City.

FYI 

* In private letter ruling 9628001, the Internal Revenue Service ruled that physicians who contracted with a general partnership that provided emergency room services were not commonlaw employees of the partnership for employment tax purposes, because the partnership did not exercise any control or discretion over how services were to be performed. The doctors were flee to and actually did provide services for other emergency care facilities. Also, the doctors were not required to work any particular hours, they were not supervised and they were paid on a percentage basis.

* A revised version of IRS Publication 1 (IR-96-32), Your Rights as a Taxpayer, is now available. Besides explaining taxpayer rights when dealing with the IRS, it explains how to file a claim for a refund and how to obtain forms, publications and other materials from the IRS.

* IRS Announcement 96-62 alerts taxpayers and preparers of the revision of many of the estate and gift tax forms and instructions. They should be available this month.