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Carryover of pre- 1987 investment interest expense.

In tax years beginning before 1987, noncorporate taxpayers were entitled to deduct investment interest expenses to the extent of net investment income plus $10,000. Investment interest expense deductions above that amount were disallowed under Sec. 163(d)(1), but an indefinite carryover of the disallowed amount to succeeding years was permitted under Sec. 163(d)(2). Before the Tax Reform Act of 1986 (TRA), Sec. 163(d)(3)(E) provided that "disallowed investment interest" meant the amount not allowable as a deduction solely because of the limitation in Sec. 163(d)(1). Because the term "solely" was removed from the language of Sec. 163(d) in 1986, the following discussion does not affect investment interest expenses incurred in tax years beginning after 1986.

In Beyer, 92 TC 1304 (1989), rev'd, 916 F2d 153 (4th Cir. 1990), nonacq., the IRS asserted that Congress did not intend to allow taxpayers an investment interest expense carryover in excess of their taxable income. Thus, non-corporate taxpayers who complied with the Service's taxable income limitation on investment interest deductions and carryovers on any pre-1987 returns should take note of the reversal of the Tax Court's decision in Beyer. For any open tax years still under the statute of limitations, refund claims should be considered.

At issue in Beyer was whether interest expense that was "clearly not allowable" under Sec. 163(d)(1), "was |otherwise allowable' because [Sec.] 163(d)(1) was the |sole' basis for excluding the deduction." The Fourth Circuit held that the carryover of disallowed investment interest expense generated in the current year was not limited to taxable income for that year. However, the court did not disturb the Tax Court's holding that the carryover of excess investment interest from earlier years was not limited by the current year's taxable income. Thus, the full amount of investment interest disallowed by the Sec. 163(d)(1) limitation was carried over to future years indefinitely.

IRS position

The Service argued that an inherent limitation in the tax system prevented taxpayers from claiming deductions in excess of their taxable income for a given year, i.e., taxable income cannot be a negative amount. Following this reasoning, the IRS argued that any investment interest expense disallowed under Sec. 163(d)(1) that exceeded current year taxable income could not increase a net operating loss (NOL) under Sec. 172. (Ordinarily, excess investment interest deductions, if allowed, could not increase an NOL because any excess of nonbusiness deductions over nonbusiness income cannot be included in an NOL.) While the Service conceded that no express statutory language provided any such independent limitation, it argued that this interpretation was nonetheless supported by the committee reports to the 1969 and 1976 tax laws.

Tax Court's opinion

In Beyer, the Tax Court was confronted with a situation in which both current year and prior year excess investment interest would be limited under the IRS's position. It endorsed the Service's interpretation of Sec. 163(d)(3)(E) for interest actually incurred in the current (loss) year, i.e., such interest was subject to the taxable income limitation. However, the court concluded that Sec. 163(d)(2) did not transform an amount carried over from a prior year into an actual current year expense that could again be subject to the taxable income limitation.

Fourth Circuit's decision

The Fourth Circuit reversed the Tax Court's holding that the taxpayer's current year interest expense in excess of taxable income could not be carried over. Finding no statutory support for imposing a cap on the carryover provision in Sec. 163(d) based on taxable income, the court stated: Except for the investment income limitation in [Sec.] 163(d), all of the investment interest expense incurred by the Beyers was "allowable" as a deduction. . . . While some of those interest deductions may not have been "allowed" because they exceeded taxable income, they were nonetheless "allowable."

According to the court, this interpretation of the statute is consistent with the basic purpose of the investment interest deduction limitation and carryover provisions, which is to prevent sheltering of noninvestment income and to promote investment in potentially profitable projects. The IRS's interpretation, in contrast, "arbitrarily prevents taxpayers with little earned income from reaping the benefit of the deduction for ventures profitable in the long run. . . ."

The court held that the legislative history contained inconsistencies and inconclusive references and that Congress did not intend to impose a limitation based on taxable income on the carryover of investment interest expense.

At present, the issue remains unresolved, at least according to the Service. The IRS has announced its nonacquiescence to the Fourth Circuit's decision in AOD 1991-010, while indicating it would follow the Tax Court's holdings in Beyer.

Post-TRA investment interest expense

The TRA deleted the term "solely" from the law. Therefore, neither Beyer nor Rev. Rul. 86-70 is relevant to investment interest incurred after 1986, and the calculation limiting the carryover to the prior year's taxable income has been deleted from Form 4952, Investment Interest Expense Deduction.
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Author:Klaus, Kenton J.
Publication:The Tax Adviser
Date:Nov 1, 1991
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