Interest expense may or may not be deductible. Generally speaking, whether you can deduct interest, how you can deduct it and in what year you can deduct it is determined by how you spent the money that you borrowed. One category of potentially deductible interest is investment interest. A common way to get investment interest is to buy stocks on margin. Investment interest expense is deductible in a given year to the extent of “investment income”. Investment interest expense that exceeds “investment income” is carried forward indefinitely.
It would seem that someone who is investing profitably will not have much problem deducting all their investment interest expense. Such is not the case. Long term capital gains and dividend income subject to the 15% rate are not included in “investment income”. If they were there would be a tax arbitrage opportunity, since the investment interest expense is an itemized deduction that might have a 35% benefit. There is relief, though. You can elect to have dividends and long term capital gain taxed at the ordinary rate, which allows them to be included in “investment income”. If you are not generating other types of investment income, it is probably a good idea. How much of your dividends and capital gains should you elect to be included in investment income ?
If you think you will have other types of investment income in the future, that becomes a judgment call, but if you are of the bird in the hand school and want to minimize the current years tax, you will elect to have enough of your 15% income converted so that you can deduct all the investment interest expense that you have. You certainly do not want to convert more than that. All you would be doing then is increasing your tax. That would be stupid. If I was desiging tax software, I would make it so you couldn’t even do that, which brings us to the sad story of Private Letter Ruling 201217004. Now pay attention, because there will be an assignment at the end.
The PLR concerns a trust. Trusts are taxed in a similar manner to individuals, at least as far as investment interest is concerned:
For Year 1 and Year 2, Trust hired an accounting firm (Firm) to prepare its Form 1041, U.S. Income Tax Return for Estates and Trusts (“Return”). The Firm prepared the Return by entering the relevant data into a tax software computer program (“Software”) but a keying error was made on line 4g of Form 4952, Investment Interest Expense Deduction, that resulted in an inadvertent election to include the entire amount of qualified dividend income and net capital gain in each year. For Year 1 $a was treated as investment income for purposes of the deduction for investment interest expense. The actual amount of investment interest in Year 1 was $b , an amount significantly less than $a. .
Based on my made up numbers, the preparer converted $15,000 of 15% income into ordinary income without getting any benefit. Apparently they made a similar error in the following year. How did this happen ?
The Firm uses the Software to prepare many Forms 1040 during filing season. For Forms 1040, the Software automatically limits an election to include qualified dividend income and net capital gain as investment income for purposes of calculating the deduction for investment interest expense to the amount of investment interest. The Firm relied on the software to calculate investment interest expense in the same manner for the taxpayer’s Return, however the Software does not do this automatically for a Form 1041. The Firm was unaware of the differences in the computer tax software in identifying this type of error.
To err is human. To really screw things up you need a computer. That cackling sound you hear is coming from Jersey City, where Robert Flach, The Wandering Tax Pro, who only does returns by hand, scorning the expensive and unreliable software the rest of us use, is gleefully laughing at another comeuppance of an accounting firm. It gets worse.
The error was discovered by the beneficiary’s business manager. The Firm was contacted by the business manager on Date 1 and was advised of the Form 4952 elections.
Ouch.
The election to treat 15% income as ordinary is revocable, but only with the consent of the IRS. The Service analogized the situation to other rulings that they have made, where taxpayers did not make the election, because their preparers had not informed them about it. So thanks to the astuteness of the business manager, the taxpayer must have gotten a refund. Likely the accounting firm ate the cost of the ruling.
So here is your assignment. If you have margin interest or other investment interest expense, perhaps from a partnership, dig out your returns for the last three years. See if there is a Form 4952 attached. Take a look at Line 4g. If there is nothing there and there is a positive amount on Line 7 (Disallowed Investment Interest) and you had long term capital gains and dividends, you might have benefited from making the election. On the other hand if there is a positive amount on Line 4g and Line 6 (Net Investment Income) is greater than Line 8 (Investment Interest Expense Deduction), you may have been the victim of the same error described in the Private Letter Ruling. I would particularly recommend this exercise if you are responsible for filing a return (Form 1041) for a trust. Good luck and good hunting.
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Originally published on Forbes.com on May 22nd, 2012