Is interest on taxes always personal?
The general rule of Sec. 163 states that "there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." However, Sec. 163(h) disallows a deduction for personal interest, defined as interest that is not (1) interest properly allocable to a trade or business, (2) investment interest, (3) interest from a passive activity, (4) qualified residence interest or (5) interest payable on any unpaid portion of estate tax for the period in which an extension of time for payment is in existence. It would appear that interest related to tax deficiencies from flowthrough trade or business adjustments are ordinary and necessary business expenses, and, therefore, deductible. Additionally, it would appear that this interest would be properly allocable to a trade or business based on the allocation rule provided in Temp. Regs. Sec. 1.163-8T, which provides that interest expense allocated to a trade or business expenditure is taken into account under Sec. 163(h)(2)(A), and, therefore, by definition, is not personal interest.
The basis for the debate over whether interest on business-related tax deficiencies is personal or not stems from Temp. Regs. Sec. 1.163-9T(b)(2), which states that personal interest includes interest paid on underpayments of Federal, state or local income taxes, and on indebtedness used to pay such taxes (regardless of the source of the income generating the tax liability).
Example: A, an individual, owns stock of an S corporation. On its return for 1987, the corporation underreports its taxable income. Consequently, A underreports A's share of that income on his personal tax return. In 1989, A pays the resulting deficiency plus interest to the IRS. The interest paid by A in 1989 on the tax deficiency is personal interest, despite the fact that the additional tax liability may have arisen out of income from a trade or business.
The result would be the same if A's business had been operated as a sole proprietorship.
Prior to the adoption of Temp. Kegs. Sec. 1.163-9T in 1987, the courts had long established that this type of interest was an ordinary and necessary business expense and, therefore, deductible. For example, in Standing, 259 F2d 450 (4th Cir. 1958), the Fourth Circuit concluded that legal expenses and deficiency interest on an adjustment to a sole proprietor's tax liability could be deducted as an ordinary and necessary business expense. The Fourth Circuit noted that in Kornhauser, 276 US 145 (1928), the Supreme Court held that when "a suit or action against a taxpayer is directly connected with his business the expense incurred is a business expense within the meaning of the Code." Thus, the Standing court concluded that the interest claimed as a deduction was an ordinary and necessary business expense; this general holding was reaffirmed in Polk, 276 F2d 601 (10th Cir. 1960) and Reise, 299 F2d 380 (7th Cir. 1962).
Subsequent to the issuance of Temp. Regs. Sec. 1.163-9T there have been a number of cases focusing on the validity of this regulation. The Tax Court held the regulation invalid in Kikalos, TC Memo 1998-92, and Redlark, 106 TC 31 (1996). Additionally, the district courts have held the regulation invalid in Allen, 487 F Supp 460 (DC N.C. 1997) and Miller, 841 F Supp 305 (DC N.D. 1993).
Generally, in reviewing tax regulations, a court owes the same deference to temporary regulations as to final regulations. However, interpretive regulations, which merely interpret a tax statute, are afforded less weight than legislative regulations, which are promulgated by the IRS pursuant to congressional grant of authority to define a statutory term. The Supreme Court, in Chevron U.S.A., 467 US 837 (1984), prescribed a two-part test for lower courts to use in determining whether an administrative agency's interpretation of a statute is reasonable. Chevron requires a court reviewing an interpretation of a statute to determine first whether Congress has directly spoken to the question at issue. If the intent of Congress is clear, that is the end of the matter. If the court determines that Congress has not directly addressed the question at issue and the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute. Thus, if an agency's interpretation of a statute "fills a gap or defines a term in a way that is reasonable in light of-the legislature's revealed design," the interpretation is given controlling weight.
The Allen court found that the statute was clear and unambiguous. It concluded that business interest was not personal interest under Sec. 163(h); thus, Temp. Regs. Sec. 1.163-9T(b)(2) contradicted the statute and was invalid. The Miller court determined that the intent of Congress was unclear, since the term "business interest" was not defined in the Code. It then proceeded to the second prong of the Chevron test to determine whether the Service's interpretation of congressional intent was based on a permissible construction of the statute. In Miller, the court stated that Congress did not intend to change a consistent history of case law and that Temp. Regs. Sec. 1.163-9T(b)(2) did not harmonize with the Code. Additionally, the Miller court cited the Conference Report from the Tax Reform Act of 1986, which provided that "personal interest also generally includes interest on tax deficiencies," and concluded that the word "generally" would not be necessary if Congress intended that all interest on tax deficiencies was to be classified as personal interest. In Kikalos, the court noted that it followed the rationale of Redlark. In all of those cases, the courts concluded that the statute was ambiguous and the regulation contradicted the allocation rules provided in Temp. Regs. Sec. 1.163-8T. Therefore, the provision that classifies interest related to tax deficiencies from trade or business follow-through items as personal interest was invalid.
The favorable decisions in Miller and Redlark have been overturned by the Eighth and Ninth Circuits. The appellate courts also used the Chevron tests to determine that the term "properly allocable" to a trade or business in Sec. 163(h)(2)(A) is ambiguous and permits regulatory interpretation. These courts support the Service's position that the words "properly allocable" are deliberately ambiguous and constitute a delegation of authority to the IRS to determine when an expense may be properly allocated to a trade or business. Both appellate courts held that Temp. Regs. Sec. 1.163-9T was a reasonable interpretation of legislative intent and the fact that interest on deficiencies arising from business were historically deductible is irrelevant. The Eighth Circuit in Miller, 65 F3d 687 (1995), cited as support for its position the General Explanation of the Tax Reform Act of 1986, which states that personal interest also includes interest on underpayments of individual Federal, state or local taxes, notwithstanding that all or a portion of the income may have arisen from the conduct of a trade or business. The court admits that this document does not rise to the level of legislative history, because it was prepared by congressional staff after the enactment of the statute, but it is highly indicative of what Congress did in fact intend. In Miller, the court also cited the fact that no subsequent legislative actions have indicated any disagreement with the interpretation. As a result of the foregoing, Miller concluded that the regulation represented a permissible construction of the statute. In Redlark, 9th Cir., 4/10/98, the appellate court stated that it agreed with the conclusions reached in Miller.
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|Author:||Monroe, Tracy J.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1998|
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