Whether to deduct or not to deduct… - interest on individual tax deficiencies may deductible - Small Business Financial Adviser - Brief Article

Nation's Business, August, 1996

When the Internal Revenue Service audits a sole proprietor's books and says he or she owes additional taxes plus interest, that's bad enough for the business owner. When the agency won't permit that business owner to deduct the interest, it adds insult to injury. A recent court decision offers some hope to sole proprietors for interest deductibility, however.

The IRS regulations state that such interest paid by a sole proprietor is always nondeductible personal interest regardless of the source of the income generating the tax liability. But the applicable language in the Internal Revenue Code seems to say otherwise.

A recent U.S. Tax Court decision held that the language in the Internal Revenue Code did not support the regulations conclusion that interest paid on individual tax deficiencies is always nondeductible. The court ruled the regulation to be invalid.

The Tax Court's decision is somewhat limited. It applies only to deficiencies arising from errors in the normal course of business, such as in inventory valuation or other items of accounting. Interest on a deficiency resulting from overly aggressive claims on a tax return, for example, probably would not be deductible under this decision.

Keep in mind that this decision is not the final word. It probably will be appealed, particularly in view of a contrary decision in a federal appeals court. As a result, it appears unlikely that sole proprietors could obtain refunds any time soon.

As a practical matter, the statute of limitations may run out before the courts reach a final decision.

Accordingly, sole proprietors who have been audited by the IRS in recent years and who have paid additional taxes and interest as a result of errors in the ordinary course of business should discuss with their tax advisers the possibility of filing "protective claims." This, in effect, is a request for a refund--even though the IRS will not grant it--to keep the statute of limitations open until this issue is decided once and for all in court.

--Albert B. Ellentuck

The author is counsel to the Washington, D.C., law firm of King & Nordlinger.