The IRS Tests Deductibility Of Business Interest

You may be aware that the new tax law changed the deductibility of your mortgage interest. It used to be that you could borrow and deduct the interest on up to a million-dollar mortgage. That amount has now been further reduced to $750,000, although there is a grandfather exception for loans existing when the law changed.

COMMENT: I have never lived in a part of the country where a million-dollar mortgage would be considered routine. There was a chance years ago to relocate the CTG family near San Francisco, which might have gotten me to that rarified level. I continue to be thankful I passed on the opportunity.

There is also business interest. Let’s say you have a general contracting business. This would be the interest incurred inside the business. Maybe you have a line of credit to smooth out cash flows, or maybe you buy equipment using a payment plan. The business itself is borrowing money.

Business interest has traditionally avoided most of the revenue-rigging shenanigans of the politicians, but business interest got caught this last time. There is now a limit on the percentage-of-income that a business can deduct, and that amount is scheduled to decline as the years go by. You might see the limit referred to as the “163(j)” limitation, which is the Code section that houses it. Fortunately, you do not have to worry about “163(j)” if your sales are under $25 million. If you are over that limit (BTW related companies have to be added together to test the limit), you probably are already using a tax pro.    

Then there is investment interest. In its simplest form, it is interest on money you borrowed to buy stock in that general contracting business. The distinction can be slight but significant: it is interest on monies borrowed to own (as opposed to operate) the business.

There is a limit on the deductibility of investment interest: the income paid you as a return on investment. If the business is a corporation, as an example, that would be dividends paid you. If you do not have dividends (or some other variation of investment income), you are not deducting any investment interest expense. It will carry-over to next year when you get to try again.

I am looking at a case involving an electrical engineer and his sole-proprietor software development company. He was kicking-it out of the park, so he borrowed money to purchase two vacant lots. He also bought two steel buildings, with the intent of locating the buildings on his vacant lots and establishing headquarters for his company.

The business lost a major customer. Employees fled. He sold the steel buildings for scrap.

But he kept paying interest on the loan to buy the lots.

He deducted the interest as business interest, meaning he deducted it in full.

Oh nay-nay, said the IRS. You have investment interest and – guess what – you have no investment income. No deduction for you!

OBSERVATION: The business was still limping along, and as a proprietorship all its numbers were reported on his individual tax return.

The IRS had one principal argument: the buildings were never moved; the headquarters was never established; the land never used for its intended purpose. The “business” of business interest never happened. What he had was either investment interest or personal interest.

Let’s look at the definition of investment interest:

163(d)(5)  Property held for investment.

For purposes of this subsection –

(A)  In general. The term "property held for investment" shall include-

(i)  any property which produces income of a type described in section 469(e)(1) , and

(ii)  any interest held by a taxpayer in an activity involving the conduct of a trade or business-

(I)  which is not a passive activity, and

(II)  with respect to which the taxpayer does not materially participate.

I say we immediately throw out 163(d)(5)(A)(ii), as the taxpayer is and has been working there. I say that he is materially participating in what is left of the software company.

That leaves 163(d)(5)(A)(i) and its reference to 469(e)(1):

     469(e)  Special rules for determining income or loss from a passive activity.

For purposes of this section -

(1)  Certain income not treated as income from passive activity.

In determining the income or loss from any activity-

(A)  In general. There shall not be taken into account-

(i)  any-

(I)  gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business,

(II)  expenses (other than interest) which are clearly and directly allocable to such gross income, and

(III)  interest expense properly allocable to such gross income, and

(ii)  gain or loss not derived in the ordinary course of a trade or business which is attributable to the disposition of property-

 (I)  producing income of a type described in clause (i) , or

(II)  held for investment.

I am not clear what the IRS is dredging here, other than a circular argument that the interest was not incurred in a trade or business and was therefore held for investment.

The Court said that was an argument too far.

The Court could accept that the properties were not “used” in the trade or business, but it also accepted that the properties happened (the Court used the term “allocable”) because of the trade or business.

The Court allowed the interest as a business deduction.

Our case this time was Pugh v Commissioner.