Federal Circuit allows cash-method issuer to deduct interest payments before due date.

Dana Corporation, 174 F3d 1344 (Fed. Cir. 1999) allowed a cash-method taxpayer to deduct accrued interest paid before its payment date. Dana holds that the Service abused its discretion in asserting that the early payment did not clearly reflect income.

In a consolidated return, the income of Dana's subsidiary, Leverage Leasing, was reported on the cash method of accounting, while Dana and other subsidiaries reported gross income and expenses using the accrual method. Leverage Leasing was entitled to receive accrued rents in arrears; in turn, it was obligated to pay interest, also in arrears, on loans related to the properties for which rent was received. Under financing agreements, Leverage Leasing paid interest in arrears that accrued in 1984 but, by the terms of the loan, was not actually due for payment until the following tax year. It repeated the same process for the following year.

As a consequence, Leverage Leasing's ordinary and necessary business expenses exceeded gross income for 1984 and 1985, which resulted in no tax liability. The IRS determined that the cash method of accounting caused excess interest deductions and did not clearly reflect Leverage Leasing's income. The court held that advance payments of accrued interest in arrears were deductible because they represented a charge for the use or forbearance of borrowed money. The court reasoned that the Code allows the payment of interest obligations in advance for tax advantages, provided that they have already been accrued.

Conceding that the advance interest payments resulted in "an odd portrayal of Leverage Leasing's taxable income," the court said Congress had allowed it through taking no action to prevent "the payment of interest in arrears before the due date, so long as the interest was allocable to the year in which it accrued." Consequently, the IRS abused its discretion in determining that Leverage Leasing's deductions for payments of accrued interest in advance did not clearly reflect income.

Conclusion

The Dana principle would be applicable to any cash-basis taxpayer. In addition to being applicable to interest obligations, it would appear to apply to service expense obligations and leases of tangible property of $250,000 or less. (However, it must be noted that Dana applies only to stated interest.) Also, consideration must be given to whether such payments could result in debt modifications under Regs. Sec. 1.1001-3 or 1.1275-2(j) (both of which have been promulgated since Dana). The effect of either regulation could be to change what would otherwise be regular stated interest into original issue discount.

FROM RICH GODSHALK, J.D., FRANK DEVLIN, CPA, J.D., AND DON HERSKOVITZ, J.D., LL.M., WASHINGTON, DC