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Interest Deductible or Not

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    Interest Deductible or Not

    I have a client who has a partnership as well as a sole proprietorship. Last year he had a huge personal income tax liability (resulting from sole proprietorship). He got a loan that was put through the partnership account and then the IRS payment was written directly from the partnership account to the IRS. I'm thinking this interest shouldn't be deductible but thought I'd check.

    He has injected lots of capital in the partnership and his capital account more than covers the draw (IRS payment), and is still positive at year end. I got to thinking perhaps this loan interest is deductible since it was used to repay a partners capital investment? Doubt it, but thought I'd check.

    Aggressive Position

    I'm going to create a furor of discontent among "purists", but I try to push the envelope as far as I can in favor of clients reducing their tax liability.

    As you have presented it, interest would be not deductible. Before the 1986 Tax Act, nearly all interest was deductible somewhere, but nowadays the correct approach is to measure the use of the proceeds as to how and whether interest can be deductible.

    Normally, a bigger question would be whether this action creates a problem with the other partners, as he made a huge draw against partnership funds which were already so low that they the partnership had to borrow money to accommodate the draw. I believe you answered this question when you said the partner contributed more than enough during the year to eclipse the effect of this draw. So we may assume the other partners are happy with the events that occurred.

    However, why were partnership funds so low that they couldn't accommodate a draw by a partner? Had the partnership needed operational money and borrowed it, the interest would be fully deductible and unquestioned. This would then be money to cover "ordinary and necessary" expenses.

    For partnerships, S corps, proprietorships, there is normally enough cash flow to pay owners for the resulting taxes on profits. In cases where cash runs short, the entity borrows money. In your example, if the proprietorship is the culprit creating the tax liability, the loan would have been more proper to the proprietorship with a personal guarantee (effectively loaned to the owner) and placed in the proprietorship for operations.

    As you can tell, I am averse to ANY interest created because of small businesses being classified as "personal" interest. The IRS wants us to go to great lengths to sift out personal interest, but I believe nondeductible interest should be for truly personal stuff like the wife's credit card and the husband's pickup truck.

    Color me a radical rebel if you please, but I would DEDUCT this interest on the partnership return, where it will flow as a reduction in income to all partners. However, you may receive a firestorm of disagreement.
    Last edited by Corduroy Frog; 07-05-2007, 01:03 AM.


      Original post contains: "Last year he had a huge personal income tax liability (resulting from sole proprietorship). "

      I think the TC will agree with your observation that the interest is NOT deductible. At one time, a TC case called Redlark allowed for such a deduction. But the TC reversed itself (after a number of the CA circuits said Redlark was wrong). I don't agree with C.F. - this is personal interest.

      I've pasted the beginning of Robinson 119 TC 44 (2002) which reverses Redlark. Bullet #3 says it all.

      Official Tax Court Syllabus

      P-H operated a law practice as a sole proprietorship at all relevant times. R audited Ps' 1987 joint tax return and made several adjustments to the Schedules A and C attached to this tax return. Ps agreed to R's adjustments and the resulting deficiencies and additions to tax. In 1994, R seized real property that Ps owned; in 1995, R sold the property and applied the proceeds to Ps' underpayment of their 1987 income tax liability and interest thereon. On Schedule C of their 1995 joint tax return, Ps deducted the 1987 underpayment interest that had been thus paid
      1. Held: Insofar as sec. 1.163-8T, Temporary Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987), and sec. 1.163-9T(b)(2)(i)(A), Temporary Income Tax Regs., 52 Fed. Reg. 48409 (Dec. 22, 1987), apply under the circumstances herein to characterize the 1987 underpayment interest thus paid in 1995 as not being “interest *** on indebtedness properly [pg. 45] allocable to a trade or business” within the meaning of sec. 163(h)(2)(A), I.R.C. 1986, and therefore as not being deductible under ch. 1, I.R.C. 1986, these regulations are valid.
      2. Held, further, Redlark v. Commissioner, 106 T.C. 31 (1996), revd. and remanded 141 F.3d 936 [81 AFTR 2d 98- 1483] (9th Cir. 1998), will no longer be followed.
      3. Held, further, Ps are not entitled to deduct the interest they paid in 1995 on account of the underpayment of their 1987 income tax liability.


        Purpose of Loan

        Yes, NYEA if it is determined that the purpose of the loan is to pay someone's income tax liabilities, I think Equine's client is a "cooked goose" on the issue. I think that would be the correct interpretation of the regulations as well as the court case.

        However, a cash-stripped entity often encounters the "straw that breaks the camels' back."
        A single large cash requirement that creates a trip to the bank. However, the REAL reason may be that the entity is simply in need of operating funds, and the single requirement is just another in a long list of cash needs.

        At the risk of dragging out a long post, I'll share a very vivid example. A young married couple opened a cabinet shop, and borrowed $20,000 with a loan guaranteed by one of the parents. In a few weeks, their house filled with new furniture, a newer model car, and new wardrobes for the missus.

        In about 60 days they called me and said they couldn't meet payroll for their two employees. When I asked them why, they said that a local builder was delinquent paying their bill for some woodworking. I asked them further how much the builder owed, and he apparently owed them $800.

        Yes, $800 would have met their payroll, and it afforded them a convenient excuse. But it was only the "straw that broke the camel's back" and not the underlying problem.