Individual taxpayers disallowed deficiency interest deduction.
In an even more recent decision (McDonnell, 5/27/99), the Sixth Circuit once again held Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) valid and disallowed the taxpayer's claim for refund based on an investment interest deduction attributable to deficiency interest paid. The Fourth and Sixth Circuits now join the Eighth and Ninth Circuits in disallowing the deduction of deficiency interest arising from an unincorporated trade or business. Two Tax Court cases have allowed the deduction. In Redlark, 106 TC 31 (1996), a sharply divided Tax Court allowed the deduction; the Ninth Circuit, however, reversed this decision. The other Tax Court case allowing the deduction (Kikalos, TC Memo 1998-92) relied on the Tax Court Redlark decision and is currently on appeal to the Seventh Circuit. Although the issue remains somewhat unclear, it is now more difficult for individual taxpayers to deduct deficiency interest as a business or investment expense.
Sec. 163(h) disallows the deduction of personal interest, defined as any interest other than interest specifically provided for in the Code, including interest paid or accrued on "indebtedness properly allocable to a trade or business." At issue is the validity of Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), which provides that personal interest includes interest paid or accrued on underpayments of taxes, "regardless of the source of the income generating the tax liability." If this temporary regulation is valid, all deficiency interest paid by individuals--including interest properly allocable to a trade or business or investment income--is nondeductible personal interest.
The district court in Alien agreed with the majority and concurring Tax Court opinions in Redlark and ruled that the temporary regulation was invalid. The court reasoned that Sec. 163(h)(2)(A) was inherently clear and that interest properly allocable to a trade or business was excluded from the definition of personal interest. It cited several cases decided prior to the Tax Reform Act of 1986 (TRA '86) in support of its position that interest on a tax deficiency could be a deductible business expense. Although these cases were decided prior to the TRA '86, the court stated that it should be presumed that Congress was familiar with the judicial interpretations of what constitutes a trade or business expense when it drafted Sec. 163(h)(2)(A). Even if Congress was not familiar with this line of cases, the district court felt that the statute spoke for itself; interest properly allocable to a trade or business was deductible under Sec. 163(h)(2)(A) and the temporary regulation that contradicted the clear *** and unambiguous statute was invalid.
In reversing the district court, the Fourth Circuit found that Sec. 163(h) was facially ambiguous and that Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) was a reasonable construction of the statute. As a result, the Fourth Circuit joined the Eighth and Ninth Circuits in holding that individual taxpayers may not deduct income tax deficiency interest, regardless of the source of the income. In finding Sec. 163(h) ambiguous, the Court of Appeals cited the sharply divergent majority, concurring and dissenting opinions in Redlark, in which the Tax Court could not agree on a single meaning of the statute.
The Court of Appeals did not find the pre-TRA '86 cases cited by the district court controlling; prior to 1986, most forms of interest were deductible and the cases dealt with the type of interest deduction (above-the-line or itemized), not with whether interest was deductible per se. Finding Sec. 163(h) ambiguous, the court had no problem finding Temp. Kegs. Sec. 1.163-9T(b)(2)(i)(A) a reasonable interpretation of the statute.
In McDonnell, the IRS moved to dismiss the taxpayer's refund suit on the grounds that the interest at issue was personal interest under the regulations. The district court denied the motion, holding that Temp. Regs. Sec. 1.163-9T(b) (2)(i)(A) was invalid (based on the Tax Court's decision in Redlark). However, it granted a motion to dismiss on other grounds. The taxpayer appealed the case to the Sixth Circuit, which affirmed the district court decision, while holding the temporary regulation valid.
Individual taxpayers residing in the Fourth, Sixth, Eighth and Ninth Circuits are barred from deducting deficiency interest; the issue is more uncertain for taxpayers in other circuits. It has yet to be determined whether the Tax Court will abandon its majority opinion in Redlark. Until then, the Tax Court opinion in Redlark, along with Kikalos, probably still constitute "substantial authority" to take the position that deficiency interest properly allocable to a trade or business (and possibly investment income) is deductible. In the absence of a Seventh Circuit decision in favor of the taxpayers in Kikalos (which would create a split among the circuits and possibly a Supreme Court decision on the issue), the issue remains somewhat unclear. Although they can probably support their position, taxpayers outside the Fourth, Sixth, Eighth and Ninth Circuits who deduct deficiency interest related to a trade or business or investment income are exposing themselves to some degree of risk and can certainly expect a challenge from the IRS.
FROM TIMOTHY R. KOSKI, CPA, PH.D., ASSISTANT PROFESSOR, UNIVERSITY OF SOUTHERN INDIANA, EVANSVILLE, IN (NOT ASSOCIATED WITH SUMMIT INTERNATIONAL ASSOCIATES, INC.)
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|Author:||Koski, Timothy R.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1999|
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