Tax Court allows deduction for interest on tax deficiency.

A deeply divided Tax Court held that individuals were allowed a deduction for interest on income tax deficiencies caused by accounting errors in a proprietorship business, holding that such interest was not personal interest, as IRS regulations provide. Thus, the court ruled that Temp. Regs. Sec. 1.163-9T (b) (2) (i) (A) was invalid to the extent it disallowed such a deduction.

In Redlark, 106 TC 2 (1996), the Redlarks' individual tax returns were audited for 1979-1985. Adjustments were made to their returns for accounting errors of their unincorporated business. They were assessed deficiencies and paid interest, which they took as a deduction on Schedule C of their 1989 and 1990 Federal income tax returns.

The Redlarks deducted the income tax deficiency interest expense as a Sec. 162 ordinary and necessary trade or business expense.

The Service argued that the interest was personal interest under Sec. 163(h) because, under Temp. Regs. Sec. 1.163-9T (b) (2) (i) (A), interest on a Federal income tax deficiency is nondeductible personal interest, regardless of the source.

The Redlarks claimed that Temp. Regs. Sec. 1.163-9T (b) (2) (i) (A) was invalid to the extent it precluded a deduction for interest on a deficiency that was an ordinary and necessary expense of a trade or business. Sec. 163 (h) (2) (A) provides an exception to personal interest if such interest is attributable to a trade or business.

The majority opinion concluded that the first issue was whether the interest expense was attributable to a trade or business. Citing several cases that held that taxpayers were allowed a deduction for interest expense on income tax deficiencies if attributable to a trade or business, the court held that in this instance the interest expense was an ordinary and necessary trade or business expense (Standing, 28 TC 89 (1957), aff'd, 259 F2d 450 (4th Cir. 1985); Polk, 31 TC 412 (1958), aff'd, 276 F2d 601 (10th Cir. 1960); Reise, 35 TC 571 (1961), aff'd, 299 F2d 380 (7th Cir. 1962)). The court ruled that accounting errors were sufficiently ordinary occurrences in the context of a trade or business to create the possibility that interest on income tax deficiencies would be assessed.

The court then considered the IRS's authority to issue the regulatory provision in question. The opinion states that, although temporary regulations are to be given equivalent weight as final regulations, regulations issued under Sec. 7805 are interpretive and not accorded the same weight as statutorily required regulations. Temp. Regs. Sec. 1.163-8T and -9T are interpretive regulations issued under Sec. 7805. The court referenced the congressional committee reports that state that "[p]ersonal interest also generally includes interest on tax deficiencies," and concluded that the word "generally" signals that not all interest relating to income, estate and gift tax deficiencies was included in "personal interest." According to the opinion, "[t]he logical explanation for what is excluded by `generally' is such interest that constitutes an ordinary and necessary business expense and is therefore `allocable to an indebtedness of a trade or business' within the meaning of the exception clause of section 163 (h) (2) (A)."

This same conclusion was reached by the district court in Miller, 841 F Supp 305 (N.D. 1993), although the court ruled on other grounds that the taxpayer's interest was not related to a trade or business, and therefore not deductible. Subsequently, the Eighth Circuit ruled that the temporary regulation was valid, reversing the district court ruling on this issue but affirming the disallowance of a deduction for the interest expense (Miller, 65 F3d 687 (1995)).

Redlark opens the door to a deduction for individuals who, in any open year, have paid interest on income tax deficiencies attributable to an unincorporated business. Therefore, practitioners should go through their client base to determine which clients should file amended returns. Clients should be made aware that the Service can be expected to appeal the case, and is unlikely to issue refunds while its appeal is pending.