Taxing Lessons Case Summaries

Case — Interest Income and Expense Offsetting

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TL Case Summ

THE QUESTION

Can interest paid and interest received be offset against each other?

THE DISPUTE

Taxpayer Says: Interest received on an amended state income tax return can be offset against interest paid on an amended return for another state because the same tax item is at issue.

Internal Revenue Service Says: The two amounts stand alone. Interest received is taxable income. Personal interest paid is not deductible.

THE LAW

From Internal Revenue Code Section 61(a): Defines gross income very broadly–“all income from whatever source derived.”

From Internal Revenue Code Section 163(h): Disallowance of Deduction for Personal Interest.– (1) In general.–In the case of a taxpayer other than a corporation, no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year.

From Alfaro v. Commissioner, T.C. Memo. 2002-309, aff’d, 349 F.3d 225 (5th Cir. 2003): Interest paid on individual tax deficiencies is nondeductible personal interest.

From Am. Viscose Corp. v. Commissioner, 19 B.T.A. 937 (1930), aff’d, 56 F.2d 1033 (3d Cir. 1932): It has long been held that interest received on a tax refund is includible in gross income.

From S.C. Nat’l Bank, Greenville v. Hammond, 198 S.E.2d 123, 127 (S.C. 1973): It is essential to the establishment of a set off that the claims or debts be mutual, that is, they must subsist or be owing, between the same parties. 

THE CAUSE OF THE DISPUTE

With certain exceptions, interest you receive is taxable on your federal income tax return. The same inclusiveness does not apply to interest deductions.

Current tax law specifically excludes a deduction for some types of interest expense. For example, personal interest, such as amounts you pay on income tax underpayments, credit card or vehicle loans, is not deductible.

In this case, the taxpayers amended tax returns for two states after learning the capital gains from the sale of a stock had been reported to the wrong state. The effect of the amended returns was to increase the taxable income on one state return, and reduce it on the other. Consequently, the taxpayers paid interest to the state where they now owed additional tax, and received interest on the tax refunded from the other state.

The state paying the interest to the taxpayers reported the payment to the IRS, but the taxpayers did not report the amount on their return. Their argument: because the interest received and the interest owed were generated by the same transaction, the two amounts could be offset. Since the interest paid was more than the interest owed, they had no gain to report.

The taxpayers did agree the interest paid was nondeductible personal interest, and took no deduction for the amount remaining after the offset.

The IRS says the taxpayers have no right of offset, since the amounts were a payment of a debt to one entity and the receipt of an entitlement from another. The interest received is income and is taxable, while the interest paid is personal interest and is not deductible.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 18KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. The code does not allow the taxpayers to deduct interest paid on the state tax underpayments, so there is no valid mechanism for the “setoff” that they assert. The interest received is income and is taxable and the  interest payment is not deductible.
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