## Facts

- Daniel V. Alfaro and Irma L. Alfaro filed joint federal income tax returns; Mr. Alfaro operated a law practice as a sole proprietorship from at least 1982 through 1996.
- The IRS audited the couple’s returns for tax years 1982–1988 and assessed deficiencies attributable entirely to income from Mr. Alfaro’s law practice.
- The taxpayers and the IRS settled the deficiency disputes in 1995.
- In 1996, the taxpayers paid $1,527,695 in accrued statutory interest on the agreed income tax deficiencies.
- On their 1996 return, the taxpayers claimed a deduction for the statutory interest, asserting it was incurred in connection with Mr. Alfaro’s trade or business; the Commissioner disallowed the deduction.
- The Tax Court sustained the deficiency, and the taxpayers appealed.

## Issues

1. Whether statutory interest paid by individual (non-corporate) taxpayers on federal income tax deficiencies is deductible as trade-or-business interest when the deficiencies arose from business income.
2. Whether the Treasury regulation classifying individual income-tax deficiency interest as nondeductible “personal interest” under I.R.C. § 163(h) is a valid interpretation of the statute.

## Decision

- The Fifth Circuit affirmed the Tax Court.
- The court held that statutory interest on an individual’s federal income tax deficiency is nondeductible personal interest under I.R.C. § 163(h), even if the deficiency arose from income generated by the taxpayer’s principal trade or business.
- The court upheld the challenged Treasury regulation as a permissible construction of § 163(h) under Chevron principles.

## Legal Principles

- I.R.C. § 163(h) generally disallows deductions for “personal interest” paid or accrued by non-corporate taxpayers, subject to limited statutory exceptions.
- Treasury may reasonably classify particular categories of interest for purposes of § 163(h) when the statute does not foreclose the classification.
- Under Chevron, a Treasury regulation interpreting the Internal Revenue Code is upheld if it is based on a permissible construction of the statute.
- Statutory interest on an individual’s income tax deficiency may be treated as personal interest because it is tied to the individual’s personal income tax liability, regardless of the business source of the underlying income.

## Conclusion

The Fifth Circuit sustained the Commissioner’s disallowance of the Alfaros’ deduction, holding that individual statutory interest paid on federal income tax deficiencies is nondeductible personal interest under § 163(h) and that Treasury’s regulation adopting that treatment is valid.


Alfaro v. Commissioner, 349 F.3d 225 (5th Cir. 2003)