September 1998 Issue

Federal Taxation


By Ed Morris, CPA, Rosenberg, Neuwirth & Kuchner

The Ninth Circuit has just overturned a controversial Tax Court decision and held that interest paid on a Schedule C related tax deficiency is not deductible as a business expense on Form 1040. The decision conforms with a 1995 Eighth Circuit case (Miller, 76 AFTR 2d 95-6193, 65 F3d 687) which upheld an IRS temporary regulation. No other circuits have addressed this issue; accordingly, taxpayers residing in other circuits such as New York and New Jersey (the Second and Third Circuits, respectively) may still have some authority for a contrary position.

In 1989 and 1990, James and Cheryl Redlark paid interest on Federal tax deficiencies arising from 1982, 1984, and 1985 adjustments. Part of the adjustments related to errors the Redlarks made when converting their unincorporated business from the accrual to cash basis. In preparing their 1989 and 1990 returns, the Redlarks claimed the portion of the interest related to the accounting method adjustments on Schedule C. The IRS disallowed the above-the-line deduction, stating that interest on a tax deficiency is always personal interest. In support of its position, the IRS cited Treasury Regulations section 1.163­9T(b)(2).

The Tax Court noted that prior to the 1986 Tax Reform Act, courts had allowed above-the-line business expense deductions for interest paid on deficiencies related to business activities. The court felt that the act's prohibition against the deduction of personal interest was not intended to change prior case law. The act's conference committee report did not invalidate this conclusion when it stated that "personal interest also generally includes interest on tax deficiencies." The court ignored the act's legislative intent to prohibit the deduction for interest on tax deficiencies set forth in the "Blue Book." Accordingly, the court, with many dissents, declared the IRS regulation to be invalid and allowed the deduction.

The Ninth Circuit examined the provisions of IRC section 163 that exempted from the definition of personal interest "interest paid or accrued on indebtedness properly allocable to a trade or business." The court felt that the words "properly allocable" were vague and, in effect, gave the IRS authority to make the call. The temporary regulations that the IRS issued were, in the court's view, reasonable and supported by the 1986 act's conference committee report and its Blue Book position, which was instructive as to the reasonableness of the IRS's interpretation. The Ninth Circuit held that there were no suggestions from Congress allowing an exception for interest on income tax deficiencies arising in the ordinary course of business.

The Redlark decision, by its fact situation, is only applicable to sole proprietors. Pass-through entity owners attempting a deduction of interest on adjustments must consider the 1994 pro-IRS decision of the Tenth Circuit (True, 74 AFTR 2d 94-6253).

The pro-taxpayer Tax Court decision only applies where the interest is ordinary and necessary (e.g., where the deficiency results from an error that is typical of, and reasonably expected in, the taxpayer's business). The court, in Michael v. Commr TC Memo 1996-466, held against a self-employed taxpayer who paid interest on a deficiency that arose from his failure to pay self-employment taxes after reclassification as an independent contractor. The court held that these deficiencies were not a normal incident of the business. *

(Source: Redlark (CA9 4/10/98)


By James P. Constantino, CPA, Teahan & Constantino, Counselors at Law

Congressional hearings have recently focused the spotlight on problems with our tax system. Taxpayers and their representatives before the IRS hope that Congress will enact meaningful reforms of the IRS's audit and collection procedures. Congress heard about problems with the IRS computer systems and its failure so far to update them. But the discussion of problems at the collection division was both compelling and anecdotal. This is regrettable, given that the collection division can have a devastating effect on delinquent taxpayers.

Three simple changes to procedures would help those representing taxpayers before the collection division, as well as delinquent taxpayers themselves. They aim at keeping taxpayers informed and allowing them to present their cases before the IRS. They are simple and easy to implement, at little or no additional cost to the IRS. Based on my experience before the collection division, I do not believe they would unduly impede the IRS in fulfilling its mission of collecting delinquent taxes.

Suggestion 1: Notify responsible parties. When a corporation does not pay Federal employment taxes, the IRS conducts an investigation to determine who in the corporation was personally responsible for unpaid corporate taxes withheld from employees. The revenue officer conducts the investigation through interviews with various parties and examination of checking accounts and other documents. Upon completing the investigation, the revenue officer completes a report on IRS Form 4183, which names the persons responsible and the reasons for the determination, as well as naming those officers of the corporation who are not found to be responsible persons. But despite these formalities, no person named in the report receives a copy of the report from the revenue officer.

I suggest that the revenue officer furnish a copy of IRS Form 4183 to each person found responsible, and that investigated persons not found to be responsible also be notified of that determination. Furthermore, under current procedures there is no provision to notify a responsible corporate officer whether there are any other responsible persons involved in the collection matter. In the interest of fairness, this procedural gap should also be closed.

The revised procedures I am proposing would give potentially responsible persons an opportunity to determine whether the revenue officer's report is complete and accurate, and with it, a chance to bring alleged inaccuracies to the attention of the revenue officer. Under better and fairer notification procedures, a potentially responsible person could make a more reasoned decision whether to agree or disagree with the revenue officer's findings. And, in the event of disagreement, that person would be able to prepare an appeal that specifically addresses the arguments in the revenue officer's report.

Suggestion 2: Nonparties of potential Federal tax liens. The IRS sometimes makes use of a procedure whereby it files a Federal tax lien against a party who is not the taxpayer under administrative procedures for determining alter ego, nominee status, or transferee proceedings. A revenue officer conducts an investigation and reports the findings and recommendations to file the lien against the party who is not the taxpayer. No formal procedures exist for notifying a person that he or she is the target of such an investigation. Additionally, the potential target is not notified of the results of the investigation or given any opportunity to examine the basis of the report to address the accuracy or completeness of its information. The collection division is therefore in a position to secure district counsel's approval of the revenue officer's findings and conclusions without any input by the potential target. So how do we know that the revenue officer reported all the facts or that the facts reported are accurate and complete?

I recommend that the revenue officer notify, in writing, both the taxpayer and the third party target that a determination has been made to proceed under alter ego, nominee, or transferee procedures against the third party and the revenue officer's reasons for making the determination. The taxpayer should have a reasonable period (60 days) to reply to the revenue officer's report. This reply should be made part of the file that is sent to district counsel, before it makes its decision on whether to follow the revenue officer's recommendation. District counsel should also be required to notify all parties when its decision is made and a reasonable opportunity for appeal of this decision would be provided.

Suggestion 3: Reform property seizure procedures. The U.S. Supreme Court has held that an entry without warrant onto private areas of a taxpayer's personal or business premises by the IRS for the purpose of seizing property to satisfy a tax liability violates the law unless the IRS has previously obtained a writ of entry from the courts (G.K. Leasing v. United States, 429 U.S. 338, 1977). To obtain a writ, the revenue officer prepares an affidavit and data sheet providing a complete background on the case, including the location and items of property intended to be seized. Under current procedure, the taxpayer does not know the information contained in the affidavit, the court to which it is sent, or the date when the request for the writ will be made before the judge.

I suggest that the revenue officer notify the taxpayer of the location, time, and date that the writ will be requested and provide the taxpayer with the affidavit and data sheet. The taxpayer should be given an opportunity to appear before the court. If this is not practical, the revenue officer should furnish the taxpayer with an opportunity to reply or comment on the writ request before it is forwarded by the revenue officer. Any reply by the taxpayer should be included in the file submitted to the judge considering the writ request.

My office recently became involved in a case in which there was an ongoing dispute between a taxpayer and the IRS as to the ownership of the property to be seized. The IRS proceeded with a writ and seizure before the dispute was settled. We believe that the judge who granted the writ was unaware of the question of ownership that the taxpayer raised. The taxpayer would have benefited by having access to the writ procedure because, we believe, the judge may have required the settlement of the ownership issues before proceeding to issue a writ. *

The author gratefully acknowledges the contributions of John P. Lyons, senior tax consultant to Teahan & Constantino and retired IRS Revenue Officer.

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editors:
Robert L. Goldstein, CPA
Leipziger & Breskin

Joel D. Rothstein, CPA
Own Account

Richard M. Barth, CPA

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