The purpose of this tax research problem is to solve the following scenario presented by Rupert, Pope, & Anderson: “Mark Hancock is a self-employed attorney who operates his law practice as an unincorporated sole proprietorship. In 2012, the IRS disallowed several business deductions he took in 2010 and 2011. In addition to paying the deficiency and assessed penalties, he also pays $18,000 in interest on the tax owed. Can he deduct that interest in the current year?” (p. 7-45).
This is a highly controversial subject that has been contested many times over the years. “Prior to the Tax Reform Act of 1986, the tax court in several cases had deemed an income tax deficiency to be an ordinary and necessary business expense for purposes of determining a taxpayer's adjusted gross income, net operating loss carryover, and net operating carryback, so long as that deficiency was attributable to the ordinary operation of the taxpayer's business” (Rovner, 2015, para. 6). Therefore, businesses could deduct the interest they paid for IRS penalties from previous years as a business expense before 1986.
The decision of whether or not a business could deduct interest incurred as a result of IRS imposed penalties was brought to the spotlight in the 1990’s. “On their income tax returns for 1992 and 1994, Nick and Helen Kikalos deducted as a business expense the interest they paid on tax deficiencies that had been assessed for prior years. The Internal Revenue Service disallowed the deduction pursuant to a temporary regulation that deems interest owed on tax underpayments to be nondeductible personal interest, even if the income giving rise to the tax liability derives from the taxpayer's business” (Rovner, 2015, para. 1). The temporary regulation that Rovner is referring to is Reg. Sec. 1.163-9T of the Treasury Department. “Following its decision in Redlark v. Commissioner, 106