Possible deduction for interest paid on form 1040.

In Miller, N. Dak., 1993, a district court held that Temp. Regs. Sec. 1.163-9T was invalid insofar as it provided that interest expense incurred in connection with a tax deficiency was nondeductible personal interest despite the fact that the adjustment generating the deficiency related to a trade or business activity. The court's rationale arguably reverses the temporary regulation's holding that interest expense on a tax deficiency incurred in connection with an investment activity is also nondeductible personal interest.

The Tax Reform Act of 1986 (TRA) significantly altered the treatment governing the deductibility of interest. The TRA's most sweeping change was to repeal a noncorporate taxpayer's personal interest deduction. Sec 163(h)(1) was amended to provide that "[i]n the case of a taxpayer other than a corporation, no deduction shall be allowed under this chapter for personal interest ...." Personal interest is defined in Sec. 163(h)(2) to include:

...any interest allowable under this chapter other than -

(An) interest paid or accrued in indebtedness properly allocable to a trade or business....

Acting on this change, the Treasury issued temporary regulations in December 1987 providing, in part, that interest paid on income tax deficiencies incurred in connection with a noncorporate trade or business is nondeductible personal expense.

The taxpayer in Miller was engaged in the business of farming. The IRS audited the taxpayer's 1982 and 1983 form 1040 and disallowed certain expenses deducted on Schedule F. In 1988, the taxpayer settled his case with Federal and state authorities and paid interest to the Service and to North Dakota on the resulting deficiency. The interest payments were deducted on the taxpayer's 1988 Schedule F. The IRS disallowed the interest deduction. The taxpayer paid the tax and filed a claim for refund. The refund claim was denied and the taxpayer filed suit in district court.

The court analyzed the statutory construction of Sec. 163(h). It concluded that an express exception from the definition of personal interest exists for trade or business interest, but found that no definition of business interest was provided.

The legislative history of Sec. 163(h) was also considered. The court concluded that the legislative history was silent on this issue other than to state "[p]ersonal interest also generally includes interest on tax deficiencies." (Emphasis added by court.) The court agreed with the taxpayer's argument that the use of the word "generally" would be unnecessary if all interest on tax deficiencies were personal. However, little emphasis seemed to be placed on this argument by the court in arriving at its holding.

Finding little guidance in the statute and legislative history, the court's holding relied heavily on the pre-TRA case law dealing with the deductibility of interest on tax deficiencies. Citing Standing, 4th Cir., 1958, and its progeny, the court found that interest on a tax deficiency incurred in connection with a trade or business has consistently been allowed as a business expense in computing an individual's adjusted gross income. Additionally, the opinion noted that the statute's broad language exempting trade or business interest from the definition of personal interest "closely tracts" the language found in Secs. 62(a)(1) and 162, the provisions controlling the deductibility of interest on tax deficiencies as business expenses in Standing.

The opinion found the fact that Secs. 62(a)(1) and 162 were not amended by the TRA strong evidence that Congress did not intend to change the results of prior case law:

... absent evidence of a contrary Congressional intent, the legislature is presumed to have approved of a statute's judicial construction when that provision is reenacted in the same or substantially the same language.

It is important to note that the taxpayer was not necessarily allowed a deduction for the interest in Miller. Secs. 62(a)(1) and 162 both require that expenses be "ordinary and necessary" before they are deductible. The court ordered that additional discovery be performed to determine if the interest deduction was ordinary and necessary.

Interestingly, the opinion noted that the General Explanation of the Tax Reform Act of 1986 prepared by the Staff of the Joint Committee on Taxation provided a clear explanation that interest on tax deficiencies constituted personal interest regardless of whether the deficiency was from a trade or business activity. The court indicated that this explanation did not rise to the level of legislative history and apparently found it unpersuasive in discerning legislative intent.

Practitioners and taxpayers should consider filing amended returns for any open years in which interest was paid or incurred on tax deficiencies relating to trade or business or investment activities.

Prior to the Miller decision, practitioners and taxpayers had little alternative but to disclose on Form 8275-R, Regulation Disclosure Statement, any interest deducted on tax deficiencies (given the penalty possibilities). This decision, the only guidance other than the temporary regulations and the General Explanation of the Tax Reform Act of 1986, seems to, at least currently, provide substantial authority for the deductibility of interest on certain tax deficiencies.

As it seems likely that the IRS will appeal this decision, this is probably not the final word on the issue.