Redlark v. Comm'r of Internal Revenue, 4445–94.

• Court: United States Tax Court
• Citation: 106 T.C. No. 2,106 T.C. 31
• Docket Number: No. 4445–94.,4445–94.
• Parties: James E. REDLARK and Cheryl L. Redlark, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Decision Date: 11 January 1996

106 T.C. 31

106 T.C. No. 2

James E. REDLARK and Cheryl L. Redlark, Petitioners,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 4445–94.

United States Tax Court.

Jan. 11, 1996.

Clare Golnick, S Lake Tahoe, CA, for petitioners.

Paul L. Dixon, Las Vegas, NV, for respondent.

Ps deducted the amount of interest on the portion of a deficiency in Federal income tax arising out of adjustments caused by accounting errors of their unincorporated business. They claimed that the interest was properly allocable to business indebtedness and therefore not personal interest under sec. 163(h)(2)(A), I.R.C. R disallowed such deduction on the ground that it was personal interest under sec. 1.163–9T(b)(2)(I)(A), Temporary Income Tax Regs., 52 Fed.Reg. 48409 (Dec. 22, 1987), and limited Ps' total interest deduction to the amounts allowed by sec. 163(h)(5), I.R.C. Held,sec. 1.163–9T(b)(2)(I)(A), Temporary Income Tax Regs., is invalid insofar as it applies under the circumstances involved herein. Held, further, the amount of the interest so allocated by Ps is deductible as interest on an “indebtedness properly allocable to a trade or business” within the meaning of sec. 163(h)(2)(A), I.R.C.

OPINION

TANNENWALD, Judge:

Respondent determined deficiencies in petitioners' 1989 and 1990 Federal income taxes in the amounts of $46,409 and $6,927, respectively. The issue in dispute is whether petitioners may deduct certain interest on Federal income tax deficiencies, paid by petitioners in 1989 and 1990, where the deficiencies arose in part due to a correction for errors made in computing petitioners' income from their business.

All the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference.

Background

At the time the petition was filed, petitioner James E. Redlark was a resident of Palm Springs, California, and petitioner Cheryl L. Redlark was a resident of South Lake Tahoe, California.

Respondent examined petitioners' Federal income tax returns for 1979, 1980, 1981, 1982, 1983, 1984, and 1985, following which respondent and petitioners agreed to adjustments to petitioners' income for each of the years.

The adjustments were due in part to a correction for errors made in converting petitioners' revenue from Carrier Communications, petitioners' unincorporated business, from an accrual basis to cash basis for tax purposes. The adjustments involved the timing of the reporting of business income.

In 1989 and 1990, petitioners paid interest on the Federal income tax deficiencies for the 1982, 1984, and 1985 years.

On Schedule C of their 1989 and 1990 Federal income tax returns, petitioners claimed an allocable portion of such interest as a business expense.

Respondent disallowed a business deduction for the interest but did allow 20 percent of the interest paid in 1989 and 10 percent of the interest paid in 1990 as a deduction under the phase-in provisions of section 163(h)(5). ¹

Petitioners assert that the amount of the interest expense which they have calculated as being attributable to Carrier Communications is an ordinary and necessary expense of a trade or business under section 162, deductible in computing adjusted gross income under section 62(a), and is therefore not personal interest under section 163(h).

Respondent argues that petitioners are not entitled to a deduction because, under section 1.163–9T(b)(2)(i)(A), Temporary Income Tax Regs., 52 Fed.Reg. 48409 (Dec. 22, 1987), interest on a Federal individual income tax deficiency is nondeductible personal interest under section 163(h).

Petitioners reply that section 1.163–9T(b)(2)(i)(A), Temporary Income Tax Regs., is invalid insofar as it disallows a deduction for interest on a deficiency that is an ordinary and necessary expense of a trade or business.

Section 62(a) provides in part:

(a) General Rule.—For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:

(1) Trade and business deductions.—The deductions allowed by this chapter (other than by part VII of this subchapter) which are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.

Section 162(a) provides in part:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *

Section 163(h) provides in part:

(h) Disallowance of Deduction for Personal Interest.—

(1) In General.—In the case of a taxpayer other than a corporation, no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year.

(2) Personal Interest.—For purposes of this subsection, the term “personal interest” means any interest allowable as a deduction under this chapter other than—

(A) 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),

Before proceeding to a determination of the effect of pertinent regulations, we must first consider whether the interest expense involved herein is sufficiently connected to the business of Carrier Communications so as to satisfy the “properly allocable to a trade or business” exception of section 163(h)(2)(A), without regard to the regulations.

Initially, we note that respondent does not question petitioners' calculation of the amounts of the total interest payments that are allocable to those portions of the income tax deficiencies based on adjustments to the income from Carrier Communications. Moreover, respondent has stipulated that those adjustments reflected the correction of errors made in converting the revenue of Carrier Communications giving rise to such income from the accrual to the cash basis, i.e., the timing of reporting such income. In this context, petitioners have satisfied some of the conditions that have thus far enabled us to avoid a decision as to the impact of section 163(h)(2)(A) and the temporary regulation thereunder. Tippin v. Commissioner, 104 T.C. 518, 529 (1995) (taxpayer failed to show any relationship between the interest expense and any business); Crouch v. Commissioner, T.C.Memo. 1995–289 (record failed to support taxpayer's allocation); Rose v. Commissioner, T.C.Memo. 1995–75 (investment interest).² The question remains, however, whether the elements giving rise to the deficiencies to which the interest herein relates are of such a nature as to permit such interest to constitute a business expense within the meaning of section 162(a), and therefore of section 62(a), and, as a result, to be characterized as interest “on indebtedness properly allocable to a trade or business” within the meaning of section 163(h)(2)(A) ³ in the event that the temporary regulation is not applicable. We think a review of the cases decided prior to the enactment of section 163(h)(2)(A), in respect of the deductibility of interest on income tax deficiencies as a business expense, will throw light on this question and is therefore a significant element in our analysis of the impact of that section on petitioners' claimed interest deduction. It is to that review that we first turn our attention.

In Standing v. Commissioner, 28 T.C. 789 (1957), affd. 259 F.2d 450 (4th Cir.1958), we faced the question of whether interest on a deficiency in Federal income tax resulting in part from improper reporting of income from a sole proprietorship on the cash basis instead of the accrual basis, along with related attorney's and accountant's fees, was deductible as a business expense. The taxpayers took a deduction under section 22(n)(1) of the Internal Revenue Code of 1939, the predecessor of section 62(a), in order to arrive at adjusted gross income. While our analysis was focused on the deductibility of attorney's fees, we held that the deficiency was based on adjustments “attributable to the business of the sole proprietorship” and allowed the deduction for deficiency interest as an ordinary and necessary business expense. Our reasoning was adopted by the Court of Appeals.

In Polk v. Commissioner, 31 T.C. 412 (1958), affd. 276 F.2d 601 (10th Cir.1960), we had to decide whether interest on a deficiency, arising out of inventory valuation corrections, was a deductible business expense for purposes of calculating a net operating loss carryover. Finding that the deficiency arose in connection with the taxpayer's business, the Court determined that the case was controlled by Standing v. Commissioner, supra, and held that the interest was deductible as an ordinary and necessary business expense and was to be taken into account in determining the net operating loss carryover. Again, our reasoning was adopted by the Court of Appeals.

In Reise v. Commissioner, 35 T.C. 571 (1961), affd. 299 F.2d 380 (7th Cir.1962), we again had to decide whether certain expenses, including interest on a Federal income tax deficiency, stemming from the reporting of sales on a cash basis instead of an accrual basis, were deductible as business expenses in computing a net operating loss carryback. Recognizing that prior to Standing v. Commissioner, supra, and Polk v. Commissioner, supra, we had denied taxpayers a deduction for deficiency interest in Aaron v. Commissioner, 22 T.C. 1370 (1954), we concluded that, in Standing and Polk, we had departed from the restrictive view of the phrase “attributable to trade or business carried on by the taxpayer” utilized in Aaron ⁴ and that Aaron should no longer be followed where net operating losses were concerned. Reise v. Commissioner, supra at 579. We reaffirmed the reasoning of Standing and Polk and, finding the factual situation indistinguishable from those cases, held the deficiency interest deductible as a business expense in determining the amount of a net operating loss...