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Investment interest expense carryover controversy continues.

Reversing an earlier position, the full Tax Court has now held that the carryover of pre-1987 investment interest expense from one tax year to succeeding years is not limited by the amount of a taxpayer's taxable income in the year the expense is paid or incurred (Lenz, 101 TC No. 17 (1993)). Despite this reversal and similar losses in the Fourth Circuit and the Claims Court, it appears that the Service will continue to pursue its position that pre-1987 investment interest expense is subject to a taxable income limitation. Even more surprisingly, IRS personnel have indicated informally that their position applies to post-1986 investment interest expense, despite statutory changes made in 1986 that caused practitioners to assume that the issue was moot for post-1986 interest.


Prior to changes made by the Tax Reform Act of 1986 (TRA), Sec. 163(d)(1) limited the amount of investment interest expense that could be deducted by noncorporate taxpayers for a tax year to the taxpayer's investment income plus $10,000. Sec. 163(d)(2) provided for a carryforward of any "disallowed investment interest" expense to succeeding tax years. Sec. 163(d)(3)(e) defined "disallowed investment interest" as the amount "not allowable as a deduction solely by reason of" the Sec. 163(d)(1) limitation. (Emphasis added.)

Although not specifically addressed in the law or regulations, the Service historically took the position that the amount of investment interest expense carryover from each year is limited to a taxpayer's taxable income for that year. The IRS theory is that a taxpayer with inadequate taxable income does not have investment interest that is not allowable solely by reason of the Sec. 163(d)(1) $10,000/investment income limitation; rather, this investment interest is not allowable because the taxpayer has inadequate taxable income to claim additional deductions. The Service relies heavily on the legislative history that accompanied the 1969 and 1976 amendments to Sec. 163(d), which enacted the investment interest carryover provisions, and specifically on a House Report and the General Explanation of the Tax Reform Act of 1969 (the "Blue Book"), which explain that investment interest carryovers are subject to a taxable income limitation.

In Beyer, 92 TC 1304 (1989), rev'd, 916 F2d 153 (4th Cir. 1990), nonacq., the Tax Court agreed with the IRS. The Fourth Circuit, however, reversed the Tax Court's decision, holding that there was no statutory support for imposing a taxable income limitation on the carryover of investment interest expense provided by Sec. 163(d). To the contrary, the use of "allowable" (rather than "allowed") in Sec. 163(d) indicated that a taxpayer with investment interest expense not allowable because it was subject to the $10,000/investment income limitation had investment interest expense that was otherwise allowable as a carryover, even if it would not have been allowed because of inadequate taxable income. The court found the legislative history inconclusive - the House Report relied on so heavily by the Service was accompanied by a bill that did not contain a taxable income limitation; furthermore, neither the Senate or Conference Reports nor the bills made any mention of a taxable income limitation. The court also noted that the House bill that accompanied the pertinent House Report referred to investment interest that was "disallowed" as being eligible for carryover, while the final bill permitted a carryover for investment interest not "allowable." This change suggested that Congress eliminated the taxable income limitation, if one existed at all. In its response to the Fourth Circuit's decision, the IRS indicated that it would continue to follow the Tax Court's holding in Beyer for all cases arising outside the Fourth Circuit (AOD 1991-010).

In 1992, the Service's position was dealt another blow, when the Claims Court, in Sharp, rejected the government's claim that Sec. 163(d) contained a taxable income limitation. The court found no merit in the argument that the net operating loss limitations on nonbusiness expenses set forth in Sec. 172(d)(4) caused investment interest in excess of taxable income to be treated as not "allowable" within the meaning of Sec. 163(d)(3)(E). The Claims Court, like the Fourth Circuit, found that investment interest expense that is not allowable under Sec. 163(d)(1) is nevertheless allowable as a carryover, even if the deduction would have been disallowed because the taxpayer had insufficient taxable income or otherwise would not have resulted in a tax benefit in the current year. Any argument based on the legislative history of Sec. 163(d) was "weak," since the statute was not ambiguous, and the legislative history, for the reasons stated by the Fourth Circuit, was not helpful. Despite sound defeats in the Fourth Circuit and the Claims Court, the IRS in 1993 raised this issue in the Tax Court, in the hopes of successfully reestablishing its position.


In Lenz, the Tax Court was again presented with the issue of whether a taxable income limitation applied to the carryover of investment interest expense under Sec. 163(d). The Service once again argued that the taxable income limitation should apply, relying on the same statutory and legislative history arguments advanced in Beyer and Sharp. The Tax Court, in a reviewed decision (13-1, judge Tannenwald dissenting), acknowledged that its earlier decision in Beyer was incorrect, and held instead that an investment interest expense carryover is not limited to taxable income.

The Tax Court reiterated the assertions of the Fourth Circuit and the Claims Court that the use of the word "allowable" in the statute meant that excess investment interest expense not allowable because it is subject to the $10,000/investment income limitation is allowable as a carryover, even if the taxpayer has inadequate taxable income. The court also held that the legislative history of Sec. 163 did not present "unequivocal evidence" that Congress was attempting to place a taxable income limitation on the carryover of investment interest. Accordingly, the statute's literal words, which contained no taxable income limitation, were to be followed.

The court noted that its interpretation of the statute was consistent with the congressional purpose for enacting the investment interest deduction limitation and carryover provisions, i.e., to allow an investor to match the investment expenses incurred to generate investment income with such income over time. To impose a taxable income limitation could, for example, penalize those investors who borrow and invest the proceeds in growth stocks with long-term yields, since the investor may otherwise have limited amounts of taxable income during the life of the loan, thus preventing any matching of the investment interest expense with the investment income to be recognized in the future.

The IRS has not issued a formal response to the Lenz decision. However, based on informal discussions with its representatives, the Service continues to maintain its position concerning the presence of an inherent taxable income limitation in Sec. 163(d). IRS personnel have indicated that the Service will appeal Lenz to the Eleventh Circuit, possibly in an effort to create a conflict among the circuits that will ultimately be resolved by the Supreme Court. However, based on the Tax Court's reviewed decision, and the decisions of the Fourth Circuit and the Claims Court, taxpayers, at least for now, can safely deduct pre-1987 investment interest without regard to any taxable income limitation.

Post-TRA investment

interest expense

The decisions in Beyer, Sharp and Lenz all address investment interest carryovers from tax years beginning before 1987. Sec. 163(d) was amended in 1986, so that many of the terms and definitions interpreted by the courts in these cases were either revised or deleted, including the deletion of "solely" from the statute, a key word in the IRS statutory argument. In addition, beginning in 1988, the Service deleted from Form 4952, Investment Interest Expense Deduction, a line that required taxpayers to compute a taxable income limitation. The deletion strongly suggests that the IRS believed that the 1986 legislative changes eliminated the taxable income limitation that it argued had existed under prior law. However, based on informal discussions with IRS personnel, the Service's position may be that the TRA had no effect on the existence of a taxable income limitation. This could come as quite a surprise to many practitioners, who believed that the issue was a dead one for post-1986 investment interest.
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Author:Hartman, Christina M.
Publication:The Tax Adviser
Date:Dec 1, 1993
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