No noncorporate deduction for underpayment interest: a big blow to unincorporated businesses.

The Tax Court held in Edward A. Robinson III, 119 TC no. 4 (2002), that interest paid on income tax underpayments and deficiencies was nondeductible personal interest even if the tax resulted from the taxpayer's trade or business. This ruling, which potentially applies to more than 20 million noncorporate businesses, overrules the Tax Court's prior decision in Redlark, 116 TC 31 (1996). CPAs should familiarize themselves with this decision, so they can advise clients accordingly.

DEDUCTING OVERPAYMENT INTEREST

IRC section 162(a) allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred in "carrying on" a trade or business, including, under section 163(a), interest paid or accrued during the tax year. However, section 163 (h)(1) bars individuals from deducting "personal interest." Section 163(h)(2)(A) defines this term as any interest allowable as a deduction, other than that paid or accrued on debt "properly allocable to a trade or business" (other than the trade or business of being an employee).

Temporary regulations section 1.163-9T(b)(2)(i)(A) specifies that personal interest includes interest paid on underpayments of individual federal, state or local income taxes and on debt incurred to pay such taxes, regardless of the source of the income generating the tax liability. The section 163(h)(2)(A) legislative history, after noting the trade or business exception to the personal interest category, states that personal interest "generally includes interest on tax deficiencies." In Redlark, the Tax Court ruled temporary regulations section 1.163-9T(b)(2)(i)(A) invalid.

FACTS

In Robinson, the IRS issued a deficiency to Edward and Diana Robinson for their 1987 return, which included $195,716 in schedule C adjustments from Edward's sole proprietorship law practice. The service seized the Robinsons' property in 1994, sold it in 1995 and applied $69,617 of the proceeds to interest on the 1987 underpayment. The Robinsons deducted the $69,617 as interest on their 1995 schedule C, which the service disallowed.

COURT'S HOLDING

According to the Tax Court, the issue was not whether the taxpayers' interest on their 1987 income tax deficiency was "personal" but, rather, whether it was "properly allocable to a trade or business."

In concluding it was not so allocable, the court held that temporary regulations section 1.163-9T(b)(2)(i)(A) was a permissible interpretation of the statute as supported by its legislative history. Further, the regulation was supported by the Blue Book (General Explanation of the 7ix Reform Act of 1986), written by the staff of the Joint Committee on Taxation.

RAMIFICATIONS 

At the moment, Robinson creates a nationwide rule disallowing the deduction of interest paid on income tax underpayments and deficiencies for noncorporate business taxpayers.

CPAs need to understand the ruling's implications for their unincorporated business clients. For more information, see the Tax Clinic, edited by Michael Koppel, in the December 2002 issue of The Tax Adviser.

--Lesli S. Laffe, editor The Tax Adviser