Prior to the Tax Reform Act of 1986, there were few. limitations imposed on the deductibility of interest expense incurred by an individual. Interest expense incurred for noninvestment purposes and outside of the context of a construction project was almost always deductible; this was true regardless of whether the indebtedness giving rise to the interest expense had a business connection or whether it was incurred to purchase con, sumer goods. One important example of deductible interest was interest paid on tax deficiencies.

The 1986 Act changed this regime in many important respects. In particular, a new provision was added to the Internal Revenue Code prohibiting the deduction of "personal interest." This new rule was phased in over the period from 1987 through 1990, but it is now an established part of our tax system. The prohibition on the deductibility of "personal interest" is very broadly phrased. All interest expense incurred by an individual is personal interest, unless it falls into one of five exceptions: (1) interest "properly allocable to a trade or business" (but interest allocable to the trade or business of performing services as an employee is personal interest); (2) investment interest; (3) interest allocable to a "passive activity"; (4) "qualified residence interest" attributable to certain home mortgages; and (5) interest on certain deferred payments of Federal estate taxes.

In late 1987, the Internal Revenue Service issued "temporary" Regulations which interpret the personal interest rules to include any interest paid on "underpayments of Federal, State or local income taxes ... regardless of the source of the income generating the tax liability." This interpretation is taken almost verbatim from the "General Explanation of the Tax Reform Act of 1986," which was prepared by the staff of the Congressional Joint Committee on Taxation several months after passage of the 1986 Act. By contrast, the Congressional committee reports issued contemporaneously with the passage of the Act contain only a more general statement to the effect that "[p]ersonal interest ... generally includes interest on tax deficiencies."In view of the skimpy support in the legislative history for the restrictive position taken in the Regulations, it is not surprising that taxpayers have challenged their validity. In a recent case, a sharply-divided Tax Court held (by a vote of 11-8) in favor of the taxpayer and struck down the Regulations, at least to the extent that they purport to apply to Federal income tax deficiencies arising from adjustments to the income of sole proprietorships. Redlarck v. Commissioner (Jan. 11, 1996).

The facts in Redlark were simple. The taxpayer operated an unincorporated business, apparently as a sole proprietorship. On audit of the taxpayer's returns for the years 1979 through 1985, the Service made adjustments to the returns, reflecting in part the correction of errors made in converting the reporting of income of the business for tax purposes from the accrual method to the cash method. The taxpayer paid the deficiencies arising from the adjustments, as well as interest on the deficiencies, during 1989 and 1990. The taxpayer and the Service agreed on the amount of interest that was allocable to the portion of the deficiencies attributable to adjustments to the income of the proprietorship, but disagreed regarding whether that interest was deductible. The taxpayer contended that the interest fell under the first exception to the definition of personal interest -- the exception for interest "properly allocable to a trade or business."

The plurality opinion in the Tax Court (joined by eight or nine of the 19 judges who participated in deciding the case) began by reviewing a series of cases that had considered the deductibility of interest on tax deficiencies and similar expenditures in a variety of contexts that, like the personal interest provision added in 1986, treated expenses differently depending on whether or not they were somehow connected with the taxpayer's trade or business. The first such context was the distinction between those deductions that are allowable in computing "adjusted gross income" (so-called "above the line" deductions) and those that are allowable only in computing "taxable income" ("below the line" deductions). Here, it was clear prior to 1986 that interest on an income tax deficiency resulting from the improper reporting of the income of a sole proprietorship could be deducted "above the line" as a business expense.

Similarly, interest on a tax deficiency could be considered a business expense for purposes of computing a net operating loss carryover or carryback. While interest on a deficiency might be considered a business expense only if the nature of the adjustments giving rise to the deficiency were itself "ordinarily and necessarily to be expected," the Tax Court felt that this test was met by the adjustments made by the Service to Redlark's proprietorship income.

These authorities involving the interest on tax deficiencies, then, were all favorable to the taxpayer. The Court also mentioned some contrasting cases in which Treasury Regulations treating state income taxes imposed on business income as a nonbusiness expense had been upheld by the courts. The Court referred only in a footnote to another, unfavorable case, decided in 1994, but relating to a taxable year before the effective date of the 1986 Act, in which a Court of Appeals had held that interest relating to deficiencies attributable to adjustments to the income of partnerships in which the taxpayer was a partner could not be deducted "above the line" as business expenses. The Court dealt with this case summarily, by distinguishing without any explanation between deficiencies attributable to sole proprietorships and those attributable to partnerships.

Finally, the Court acknowledged that the precise issue of the validity of the personal interest Regulations had been presented in 1995 to the Court of Appeals for the Eighth Circuit and that the Court of Appeals had held that the Regulations were valid.

The Tax Court then turned to its own analysis of the validity of the Regulations. If the "intent of Congress [to allow a deduction] is clear," the Supreme Court has said, "that is the end of the matter" and an administrator, like the Internal Revenue Service, cannot change the result. However, if the statute is "silent or ambiguous," the administrator's judgment will be given controlling weight if "based on a permissible construction of the statute." Were it not for the (scant) legislative history, the Court would have found this an easy case to decide in the taxpayer's favor, since it saw little in the words of the statute that supported the Regulations. The Congressional committee report stating that interest on deficiencies is "generally" not deductible gave the Court some pause, but the Court concluded that the exception implicit in the word "generally" was precisely the situation at issue in the case at hand -- interest on a deficiency that is attributable to a trade or business. The Joint Committee's "General Explanation," while "entitled to respect," was disregarded in the absence of any corroboration in the "real" legislative history. Thus, there was insufficient basis to support a regulation that seemed to the Court to run contrary to the words of the statute passed by Congress. The Court held the Regulations invalid as applied to the interest paid by Redlark.

Many questions still remain regarding the scope of the Tax Court's holding: Does it apply to interest on deficiencies attributable to income earned through partnerships? How does it apply to interest on deficiencies arising from "passive" activities? How does one determine the portion of a deficiency attributable to "business" items in a complicated audit with many adjustments?

Any taxpayer who has during the last few years paid, but not deducted, interest on any business-related income tax deficiency must give serious consideration to the filing of refund claims, before the statute of limitations makes the issue moot!