When is interest on a tax deficiency deductible?

On the Schedule F, Farm Income and Expenses, accompanying their 1988 return, the Millers deducted $367,000 in interest paid on income tax deficiencies for prior years.

The IRS disallowed the deduction, claiming it was "personal interest" under Internal Revenue Code section 163(h), which prohibits deduction of such interest by noncorporate taxpayers. The IRS relied on temporary regulations section 1.163-9T, which says personal interest includes interest paid on underpayments of income taxes regardless of the type of income involved.

In a pretrial motion, the court ruled the regulation was overbroad and invalid, and the interest would be deductible under IRC section 162 if the Millers could prove the interest expense was ordinary and necessary," as that section requires.

In a second pretrial motion, the IRS claimed the tax deficiency interest was not deductible.

Result: For the IRS. To qualify for a business deduction of tax deficiency interest, the taxpayer must show the underlying tax deficiency is ordinarily and necessarily an expected occurrence in the taxpayer's line of business. Otherwise stated, the error that led to the tax deficiency must be typical of, and reasonably anticipated in, the taxpayer's field.

This could not have been the case here. The Millers engaged in a tax-deferral scheme, which could not be said to be an ordinary and necessary element of conducting a farming business.

* David Miller (No. Dak. DC, 1994).

Edited by Anne Wagenbrenner, JD, LLM, editor, AICPA client newsletters.