NewsNotes

Lesli S. Laffie, J.D., LL.M.

Personal Interest Nondeductible Exempt Organization Issues Partnership Installment Obligations 2004 Inflation Adjustments (Chart)

Court Decisions

Personal Interest Nondeductible

In a case of first impression for the Fifth Circuit, it joined the Tax Court and the Fourth, Sixth, Seventh, Eighth and Ninth Circuits, in upholding the validity of Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) and denying an interest deduction for an unincorporated law practices tax deficiency. (For background, see Barton, Tax Clinic, Individual Income Tax Underpayment Interest is Nondeductible, TTA, December 2002; Price and Weld, Is the Deduction of Interest on Tax Deficiencies Finally Over? TTA, August 2000.)

Facts: In Daniel Alfaro, 5th Cir., 11/6/03, the taxpayer operated a law practice as a sole proprietor. The IRS audited his 19821988 returns and assessed deficiencies solely relating to that practice. In 1995, the taxpayer paid over $1.5 million in accrued statutory interest on his agreed income tax deficiencies for the years at issue and deducted the underpayment interest on Schedule C of his 1996 return. The IRS denied the deduction under Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A).

Tax Court: The taxpayer argued that the interest was deductible under Code Sec. 163(h)(2)(A) as being properly allocable to a trade or business and that Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) was invalid. The Tax Court agreed with IRS that the regulation was an authoritative interpretation of an ambiguous statute and denied the taxpayers interest deduction.

Fifth Circuit: On appeal, the Fifth Circuit stated that the temporary regulation is based on a permissible construction of the statutory rules. The court gave weight to the fact that the temporary regulation tracks the Tax Reform Act of 1986 Blue Book. Although the Blue Book is not binding authority, the court said it does provide a valuable aid to understanding statutory rules.

The court also noted that Congress had revisited the definition of personal interest after the regulation was issued without revealing any dissatisfaction with its conclusion. Finally, the statutory interest provisions are designed to encourage full and timely payment of taxes and make Treasury whole for the lost use of funds between the due date and the time the funds are actually paid. Allowing taxpayers to deduct statutory interest on deficiencies arising from an unincorporated business or practice would undercut both of these goals.

From the IRS

Exempt Organization Issues

The Services Exempt Organizations Division (EO) is considering a voluntary compliance program under which tax-exempt organizations could disclose Sec. 4958 violations (excess benefit transactions for disqualified persons). The EO is very interested in the idea of voluntary compliance, but does not want to administer it on an ad hoc basis. A formal program is being explored, but no decision has yet been made, nor any timetable set.

The EO is also working on guidelines for when agents should recommend both intermediate sanctions and revocation of an organizations exempt status; for now, the Service is looking at such situations on a case-by-case basis. Any agent making such a recommendation must run it through the IRSs Washington, DC, headquarters.

The EO plans to issue an article within the next few weeks on automatic excess-benefit transactions under Sec. 4958. The IRS is looking for substantially excessive compensation of nonprofits officers (i.e., those who receive $300,000 or $400,000 more than they should).

Regulations

Partnership Installment Obligations

Proposed regulations (REG-160330-02, 11/21/03) clarify how certain property transfers and dispositions in partnerships are treated for Secs. 704(c) and 737 purposes. If a partnership disposes of Sec. 704(c) property for an installment obligation, the obligation itself would be treated as Sec. 704(c) property.

The proposed regulations would also clarify that, if a partner contributes a contract that is Sec. 704(c) property to a partnership, and the partnership subsequently acquires property under that contract in a transaction in which less than all of the gain or loss is recognized, the acquired property is treated as Sec. 704(c) property.

Background: Sec. 704(c)(1)(A) provides that income, gain, loss or deduction on property contributed to a partnership by a partner is shared among partners to take into account the variation between the basis of the property to the partnership and its fair market value (FMV) on contribution. Under Sec. 704(c)(1)(B), any partner who contributes Sec. 704(c) property to a partnership must recognize gain or loss on the distribution to another partner within seven years of the contribution. The gain or loss recognized is the amount that would have been allocated to the partner under Sec. 704(c)(1)(A) had the partnership sold the property to the distributee partner for its FMV at the time of the distribution.

Under Sec. 737(a), any partner who contributes Sec. 704(c) property to a partnership can recognize gain on a distribution of property by the partnership to that partner. The gain recognized is the lesser of the amount by which the distributed propertys FMV exceeds the distributee partners adjusted tax basis in the partnerships interest, or the partners net precontribution gain.

Proposed rules: According to the IRS, the proposed regulations would amend Regs. Sec. 1.704-4(d)(1) to provide that an installment obligation received by a partnership and property acquired pursuant to a contributed contract are treated as Sec. 704(c) property for Sec. 704(c)(1)(B) purposes to the extent that the installment obligation or the acquired property is Sec. 704(c) property under Regs. Sec. 1.704-3(a)(8). As a result, if the partnership distributes the installment obligation or property acquired via a contributed contract to a partner other than the contributing partner within seven years of the contribution, the contributing partner may recognize gain or loss under Sec. 704(c)(1)(B) (a similar rule under Regs. Sec. 1.737-2(d)(3) is included in the proposed regulations).

The proposed regulations would apply to installment obligations a partnership received in exchange for Sec. 704(c) property and to property acquired after Nov. 23, 2003.