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individual income tax returns, plaintiffs fully deducted these
interest payments from gross income as a business expense. The
IRS disallowed these "above the line" deductions, but allowed
plaintiffs to deduct the interest "below the line" from their
adjusted gross incomes. The IRS's treatment of the 1986 interest
payments did not change plaintiffs' regular tax liability but
created alternative minimum tax liability which plaintiffs
believed they did not owe. Plaintiffs paid the disputed
alternative minimum tax and associated interest. They sought a
refund of this money from the IRS, which denied the claim, and
then filed this action in the district court. On cross-motions
for summary judgment, the district court granted judgment to the
government.
The district court determined the tax code classifies the
1986 interest payments as a personal rather than a business
expense. The court asserted a sole proprietor could deduct this
interest as a personal business expense. However, unlike the
situation with sole proprietorships, partnerships and S
corporations are separate entities from partners and shareholders
for the purpose of characterizing income and deducting business
expenses. Therefore, if the interest payments are a business
expense, the deduction would occur on the partnership or
corporate level before the determination of the distributive
shares of the businesses' incomes.2 Plaintiffs must endure the
consequences of their choice of business form. Because they own
shares of partnerships and S corporations, their 1986 interest
payments are personal deductions.
Plaintiffs argue they have no alternative minimum tax
liability. They claim the interest payments represent a business
expense because the complexity of income tax laws creates
legitimate disputes about the amount of tax owed, and, thus,
deficiency interest is an ordinary and necessary expense of
operating a business. They argue when deficiency interest is
deducted as a business expense from gross income to arrive at
adjusted gross income, the staring point for calculating
alternative minimum tax, no alternative minimum tax liability
occurs. To support their contention the interest constitutes a
business expense, plaintiffs argue a sole proprietor could deduct
this interest as a business expense; therefore, equity demands
partners and S corporation shareholders receive the same tax
treatment. Pointing to cases involving legal fees and employee
benefits, plaintiffs assert partners may deduct personally-paid
partnership-related expenses as business expenses. Furthermore,
because partnerships and S corporations pass their tax liability
2 The court noted the irony that the corporations and
partnerships cannot deduct the 1986 interest payments because
they have no obligation to pay taxes or interest on tax
deficiencies.
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