Investment Interest Expense Election Correction

Taxes (Photo credit: Tax Credits)

The deduction for Investment Interest Expense is limited by IRC §163(d) to the amount of a taxpayer’s net investment income. Net investment income does not include qualified dividends and long-term capital gains because this type of income is subject to preferentially low tax rates.

Taxpayers may elect to treat this preferential income as investment income; this election will subject such income to ordinary rates, and the additional investment income should allow additional investment interest expense. When done correctly, the election should reduce the taxpayer’s tax liability; when done incorrectly, the election could increase the taxpayer’s tax liability.

The IRS recently addressed in PLR 201217004 an incorrect election: a trust elected to treat too much income as ordinary, and this election resulted in excess income tax. The election was made by the accountants who prepared the trust’s tax return; basically the accountants blamed their computer software for the error.

For two years, the accountants entered some amount into their tax software which resulted in too much income being treated as ordinary. The software for individual income tax returns would have adjusted the amount subject to the election to an ideal amount: the amount that results in a reduction in the taxpayer’s income tax, but no more. However, the tax software did not have a similar control built into the module for fiduciary income tax returns. Whatever amount was entered by the accountants was used, even though it resulted in an increase in the trust’s tax.

The PLR mentions that the tax returns were reviewed “in accordance with the Firm’s quality control policies and procedures.” The reviewer noted at all of the investment interest expense was allowed and deducted, but did not notice that the amount of income subject to ordinary tax rates was in excess of the ideal amount.

The PLR was filed to request permission from the IRS Commissioner to change the election. Permission from the Commissioner for this change is required by Reg. §1.163(d)-1(c):

(c) Revocability of elections. — The elections described in this section are revocable with the consent of the Commissioner.

Fortunately for the taxpayer, the Commissioner granted the request.

See also PLR 201003006, in which case a taxpayers requested permission to revoke an election. The facts here are similar and the excess election resulted from an accountant entering an amount into tax software above what was ideal. The Commissioner granted the request.

Lessons learned:

  • The IRS can be reasonable in allowing a taxpayer to correct an excess election;
  • Tis a poor workman who blames his tools. – A good accountant should review a tax return and be comfortable with all the amounts; don’t assume that the software is smart enough to make elections for you.

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