Individual Income Tax Underpayment Interest Is Nondeductible

An Robinson, 119 TC No. 4 (2002), the Tax Court ruled that interest paid on income tax underpayments and deficiencies is nondeductible personal interest, even though the tax resulted from the taxpayers' trade or business. This decision applies to over 20 million noncorporate businesses. It overrules Redlark, 141 F3d 936 (9th Cir. 1998), rev'g and rem'g 106 TC 31 (1996), and follows the rulings of the Fourth, Sixth, Seventh, Eighth and Ninth Circuits. Robinson is appealable to the Fifth Circuit.

Sec. 162(a) allows a deduction for all ordinary and necessary business ex-penses paid or incurred in carrying on a trade or business. Sec. 62(a) specifies that deductions attributable to a trade or business are deductions from gross income. Sec. 163(a) specifies that all interest paid or accrued within a tax year is deductible. However, Sec. 163(h)(1), enacted as part of the Tax Reform Act of 1986, disallows the deduction under chapter 1 of personal interest for individual (noncorporate) taxpayers. Sec. 163(h)(2)(A) defines personal interest as any deductible interest other than interest on debt “properly allocable to a trade or business” (other than the trade or business of being an employee). Also, Sec. 163(h)(2)(E) exempts interest on certain estate tax payments from the personal interest category.

Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), issued Dec. 22, 1987, specifies that personal interest includes interest paid on underpayments of individual Federal, state or local income tax and on debt incurred to pay such tax, regardless of the source of the income generating the tax liability. The Conference Committee report, after noting the trade or business exception to the personal interest category, states that personal interest “generally includes interest on tax deficiencies.” The report adds that personal interest does not include interest on certain estate tax payments (1986-3 CB (vol. 4)).

In Redlark, the Tax Court ruled that Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) is invalid and interest on income tax deficiencies from the operation of an unincorporated business was properly allocable to the business under Sec. 163(h)(2)(A). Relying on pre-Sec. 163(h) cases, the court reasoned that the interest expense satisfied the Sec. 162(a) “carrying on” and the Sec. 62(a) “attributable to” requirements and that Congress did not indicate it was overruling prior case law in enacting Sec. 163(h).

In Robinson, the Service issued a deficiency to Edward and Diana Robinson on their 1987 return, which included $195,716 in Schedule C adjustments relating to Edward's law practice. The Service seized the Robinsons' property in 1994, sold it in 1995 and applied $69,617 to interest on the 1987 underpayment. The Robinsons deducted the $69,617 as interest on their 1995 Schedule C. The IRS disallowed the deduction as personal interest. Relying on Redlark, the Robinsons argued that the interest was properly allocable to Edward's business under Sec. 163(h)(2)(A).

The Tax Court first noted that in Redlark it did not examine the difference in statutory language between “carrying on” and “attributable to,” interpreted in the pre-Sec. 163 opinions, as compared to “properly allocable to” in Sec. 163(h)(2)(A). It then pointed out that a change in statutory language ordinarily indicates a change in meaning. Also, Sec. 163(h)(1) specifies that it overrides all of chapter 1. The court concluded that it could not rely on the Redlark analysis of the pre-Sec. 163 statutes, to determine the meaning of “properly allocable to.” Without much analysis of Sec. 163(h)(2)(A), the Tax Court ruled that the meaning of “properly allocable to a trade or business” is unclear and that the Conference report did not provide a clear answer to the statute's meaning.

By ruling that Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) is valid, the Tax Court ruled that the Robinson's interest is nondeductible personal interest.

Three dissents noted:

1. The plain meaning of Sec. 163(h)(2)(A) allows the deduction of interest on income tax underpayments and deficiencies relating to a trade or business;

2. The Conference report can reasonably be interpreted to eliminate all trade or business interest from personal interest, leaving only interest on income tax deficiencies unrelated to a trade or business as nondeductible;

3. The Joint Committee on Taxation summary and the 1986 Blue Book, which the majority stated clearly supported Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), are not reliable indicators of Congressional intent;

4. Congress would not likely deny an interest deduction to all noncorporate businesses, without a clearer statement of legislative intent; and

5. In Mead, 533 US 218 (2001), the Supreme Court raised the standard for judicial reliance on interpretive regulations.

As to Mead, Judge Vasquez, dissenting, argued that the majority and the five circuits accorded Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) “Chevron deference,” the pre-Mead approach that would validate a regulation if it implemented the statute in some reasonable manner. Mead requires interpretive regulations to be “persuasive” for a court to defer to them as a correct interpretation of the statute. Judge Swift, dissenting, argued that because there was no hearing, no notice and comment and no evidence of policy development for Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), the regulation is not persuasive.

Although Robinson creates a nationwide rule disallowing the deduction of interest paid on income tax underpayments and deficiencies for noncorporate businesses, the dissents' well-reasoned arguments may result in Robinson's reversal in the Fifth Circuit and a reconsideration of this issue in other circuits.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, Uni-versity of Wisconsin–Whitewater, Whitewater, WI (Not affiliated with AFAi)