Tax deficiency interest ... personal or business?

The Tax Reform Act of 1986 eliminated the individual income tax deduction for personal interest. However, the Code does not define the term "personal interest" other than by indicating that it is a residual category of interest expense; that is, if the interest expense is not allocated to a specific category of expense, it is considered "personal." One such specific category of expense is interest allocable to a trade or business (Sec. 163(h)(2)(A)). Accordingly, interest paid on indebtedness incurred in carrying on a trade or business is not personal interest. However, under Temp. Regs. Sec. 1.163-9T(b)(2), the term "personal interest" includes interest on deficiencies of individual Federal, state or local income taxes, even if the underlying deficiency is related to carrying on a trade or business (such as a Schedule C). Two recent district court decisions considered the deductibility of deficiency interest relating to individual income tax returns. Both decisions may provide support for characterizing deficiency interest as allocable to a trade or business and therefore fully deductible.

In True, DC Wyo., 1993, the taxpayers owned, and were active participants in, several partnerships and S corporations. In 1986, the Trues were contesting proposed Federal income tax adjustments for years as far back as 1971. As a result of the elimination of the deduction for personal interest, and in accordance with an IRS announcement suggesting that taxpayers remit contested deficiencies and interest to obtain a full tax deduction, the Trues paid the taxes and interest relating to their individual income tax returns. Since the deficiencies resulted from their partnership and S corporation businesses, the Trues deducted the interest on their 1986 Schedule E, Part II, Income or Loss from Partnerships, S Corporations, Estates or Trusts. The Service disallowed the interest payments, treating the businesses as investments and the related deduction as investment expense deductible only to the extent of investment income.

The district court agreed with the IRS's treatment, holding that the interest payments on the alleged tax deficiencies could not be taken as business expenses by the Trues in their individual capacities, because the interest was not paid or incurred in connection with a trade or business carried on by the Trues as individuals. The court further held that they could not deduct the interest payments because they were under no obligation to pay taxes or interest on tax deficiencies.

If, however, the Trues had operated their businesses as sole proprietors, under the court's reasoning the interest payments would have been made in connection with a trade or business carried on by the Trues individually and therefore would have been fully deductible.

In Miller, DC N. Dak., 1993, the taxpayers filed a Schedule F, Farm Income and Expenses, with their 1988 individual return. On their Schedule F, they deducted the interest expense paid in 1988 for Federal and state tax deficiencies. Presumably, all or a substantial portion of the interest expense arose from prior year adjustments to their Schedule F. Nevertheless, the IRS disallowed the 1988 interest deduction, classifying it as a personal interest under Sec. 163(h).

The Miller court found Temp. Regs. Sec. 1.163-9T to be "unreasonable and therefore invalid" as beyond the scope of congressional intent. The court noted that a "[r]egulation is not a reasonable statutory interpretation unless it harmonizes with the statute's origin and purpose." According to the opinion, case law has consistently held that deficiency interest on personal income incurred in connection with a taxpayer's trade or business is deductible under Secs. 162 and 62(a). The court concluded that there was a lack of congressional intent to overturn these prior court decisions. In so holding, the court expressly rejected the Joint Committee on Taxation's commentary, which defined personal interest to include deficiency interest.

Accordingly, both true and Miller support the deduction on Form 1040, with appropriate disclosures, of deficiency interest by taxpayers arising from Schedule C or Schedule F activities.