Kinkalos v. Comm'r of Int'l Revenue

• Citation: 190 F.3d 791
• Decision Date: 08 September 1999
• Docket Number: Nos. 98-2631,98-2632,s. 98-2631
• Parties: (7th Cir. 1999) NICK KIKALOS and HELEN KIKALOS, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant
• Court: U.S. Court of Appeals — Seventh Circuit

Page 791

190 F.3d 791 (7th Cir. 1999)

NICK KIKALOS and HELEN KIKALOS, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

Nos. 98-2631, 98-2632

United States Court of Appeals, Seventh Circuit

ARGUED NOVEMBER 10, 1998

DECIDED SEPTEMBER 8, 1999

Appeal from the United States Tax Court Nos. 10244-96, 4924-97

Before COFFEY, MANION, and ROVNER, Circuit Judges.

ILANA DIAMOND ROVNER, Circuit Judge.

On their income tax returns for 1992 and 1994, Nick and Helen Kikalos deducted as a business expense the interest they paid on tax deficiencies that had been assessed for prior years. The Internal Revenue Service disallowed the deduction pursuant to a temporary regulation that deems interest owed on tax underpayments to be nondeductible personal interest, even if the income giving rise to the tax liability derives from the taxpayer's business. See Temp. Treas. Reg. sec. 1.163-9T(b)(2) (i)(A), 26 C.F.R. sec. 1.163-9T(b)(2)(i)(A). Following its decision in Redlark v. Commissioner, 106 T.C. 31 (1996), rev'd, 141 F.3d 936 (9th Cir. 1998), which by a divided vote held that regulation invalid, the tax court concluded that the tax underpayments were properly allocable to Nick Kikalos' unincorporated business, see 26 U.S.C. sec. 163(h)(2)(A), and that the interest on the underpayments was therefore deductible as a business expense. Kikalos v. Commissioner, 75 T.C.M. (CCH) 1924, 1932-33, 1998 WL 90729 (1998). The Commissioner of Internal Revenue appeals. In accord with every other circuit that has addressed the issue, we sustain the Commissioner's determination that interest owed on individual income tax deficiencies is not deductible as a business expense, irrespective of the source of the income giving rise to the tax liability. See McDonnell v. United States, 180 F.3d 721, (6th Cir. May 27); Allen v. United States, 173 F.3d 533 (4th Cir. 1999); Redlark v. Commissioner, 141 F.3d 936 (9th Cir. 1998); Miller v. United States, 65 F.3d 687 (8th Cir. 1995); see also Stecher v. United States, 1998 WL 427369 (D. Col. June 1); In re Vale, 204 BR. 716, 739-44 (Bankr. N.D. Ind. 1996). We therefore reverse the decision of the tax court in this respect.

I.

Since 1971, Nick Kikalos has operated a sole proprietorship, Nick's Liquors, which purveys beer, liquor, and cigarettes to the public. During the relevant tax years, Nick's Liquors did business at three locations in Hammond, Indiana. Nick and his wife Helen supervised one of the stores, while their son and daughter managed the other two. Hammond is located near the Illinois state line, not far from Chicago. Owing to disparate state taxes, cigarettes were generally less expensive to buy in Indiana while liquor was the better buy in Illinois. The result was a substantial and fiercely competitive cross-border trade in both items. The aim of Nick's Liquors in this environment was to keep prices low and volume high. The strategy appears to have paid off: Gross sales ranged from approximately $8.5 to $9.0 million per year by the early 1990s, and Mr. and Mrs. Kikalos were reporting taxable income in excess of $500,000 annually.

In 1992, the Commissioner made substantial adjustments to the gross income that Nick and Helen Kikalos had reported receiving from Nick's Liquors for the 1986 and 1987 tax years.¹ As a result, the couple owed an additional $286,147.50 in taxes for the 1986 tax year and another $272,146 for the 1987 tax year. The Kikalos were also required to pay interest on those deficiencies in the total amount of $393,024. On the Schedule C submitted with their 1992 tax return, they claimed that amount as a business expense and deducted it from their income.

In 1994, the Kikalos were required to pay additional income tax and penalties of $458.230.43 for the 1988 tax year and $441,669.22 for 1989, again due to adjustments in the gross income that they reported for Nick's Liquors. The interest that they owed on the income tax deficiencies for those years amounted to another $499,895.11. As they had on their 1992 return, the Kikalos deducted that interest from their income on their 1994 tax return.

The IRS subsequently reviewed the Kikalos' tax returns for 1992 and 1994 and determined that the interest they had paid on the income tax deficiencies was not deductible as a business expense. The disallowance of the interest deduction, in addition to other adjustments, rendered the Kikalos liable for additional income tax in those years. They petitioned the tax court for review and redetermination. The tax court, as we have noted, concluded that the interest deductions were proper, relying on its previous opinion in Redlark.

II.

A.

We review the tax court's judgment using the same standards that we apply when examining a district court's decisions in a civil bench trial. 26 U.S. C. sec. 7482(a)(1); e.g., Pittman v. Commissioner, 100 F.3d 1308, 1312 (7th Cir. 1996). That is, we review the court's findings of fact for clear error, but we consider its legal determinations de novo. Id. at 1312-13. Whether the Kikalos were entitled to deduct the interest assessed on their income tax deficiencies depends on the validity of the treasury regulation, and that in turn presents a question of law over which our review is plenary. Herbel v. Commissioner, 129 F.3d 788, 790 (5th Cir. 1997), citing Tate & Lyle, Inc. v. Commissioner, 87 F.3d 99, 102 (3d Cir. 1996); E. Norman Peterson Marital Trust v. Commissioner, 78 F.3d 795, 797-98 (2d Cir. 1996), Cramer v. Commissioner, 64 F.3d 1406, 1412 (9th Cir. 1995). Given that the decision in this case rests on Redlark, we will look to that opinion for the tax court's rationale.

The Internal Revenue Code has long permitted individual taxpayers to deduct from their income all ordinary and necessary expenses that they accrue in the course of carrying on a trade or business. See 26 U.S.C. sec. 162(a). And prior to the Tax Reform Act of 1986, the tax court in several cases had deemed an income tax deficiency to be an ordinary and necessary business expense for purposes of determining a taxpayer's adjusted gross income, net operating loss carryover, and net operating carryback, so long as that deficiency was attributable to the ordinary operation of the taxpayer's business. See Standing v. Commissioner, 28 T.C. 789 (1957), aff'd, 259 F.2d 450 (4th Cir. 1958); Polk v. Commissioner, 31 T.C. 412 (1958), aff'd, 276 F.2d 601 (10th Cir. 1960); Reise v. Commissioner, 35 T.C. 571 (1961), aff'd, 299 F.2d 380 (7th Cir. 1962); see also 26 U.S.C. sec. 62(a)(1) (adjusted gross income); 26 U.S.C. sec. 172(d)(4) (net operating loss) (formerly sec. 122(d)(5) of the 1939 tax code). That nexus would be satisfied, for example, when the deficiency resulted from mundane accounting errors in the manner of reporting the income of the business (Reise, 35 T.C. 571), or in the valuation of its inventory (Polk, 31 T.C. 412). See Redlark, 106 T.C. at 37.

Among the provisions added to the Code by the 1986 act was one precluding noncorporate taxpayers from deducting "personal interest." 26 U.S.C. sec. 163(h)(1). This marked a significant departure from prior law, under which most forms of interest were deductible. See, e.g., 26 U.S.C. sec. 163 (1985); see also John Y. Taggart, Denial of the Personal Interest Deduction, 41 Tax Lawyer 195 (1988). In the new regime, certain types of interest are statutorily deemed not to be "personal," including "interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee)." 26 U.S.C. sec. 163(h)(2)(A).² However, the Commissioner has taken the view that an individual's income tax deficiency cannot be considered "indebtedness properly allocable to a trade or business," even when the income underlying the deficiency originates from the taxpayer's business.³ Thus, Temporary Treasury Regulation sec. 1.163-9T(b)(2)(i)(A) includes within the category of nondeductible personal interest any interest due "on underpayments of individual Federal, State, or local income taxes . . . regardless of the source of the income generating the tax liability."

There can be no question that the unequivocal language of this regulation forecloses to the Kikalos any deduction for the interest they have paid on their own income tax deficiencies. Only if we, like the tax court, were to conclude that the regulation amounts to an impermissible construction of the statute might the deficiency interest qualify for deduction.

B.

A majority of the tax court viewed the regulation as being inconsistent with the statute and therefore invalid. It began with the "key phrase" from section 163(h)(2)(A) referring to "interest paid or accrued on indebtedness properly allocable to a trade or business." Redlark, 106 T.C. at 39. Looking to the line of cases pre-dating the statute (supra at 4-5), the tax court believed that the language of section 163(h)(2)(A) preserved the deductibility of deficiency interest, at least so long as the income adjustments giving rise to the deficiency could reasonably be linked to the ordinary operation of the taxpayer's business. Id. at 37-39.

Still, the court recognized that the statute was not so clear as to foreclose regulatory interpretation on this subject, see id. at 39; and so it examined the temporary regulation in light of the legislative history. The only portion of the legislative record directly on point is the following passage from the conference committee report:

Under the conference agreement, personal interest is not deductible. Personal interest is any interest, other than interest incurred or continued in connection with the conduct of a trade or business (other than the trade or business of performing services as a[n] employee), investment interest, or interest taken into account in computing the taxpayer's income or loss from passive activities for the year. Personal interest also generally includes interest on tax...