The taxpayer is president of a company. He is very wealthy and has a good deal of assets. He went to Bank 1 in January Yr. 1 to borrow $1,000,000. He used the proceeds of the loan to purchase stock. The loan was secured by the stock purchased. The terms of the loan are that it is an interest only loan, with interest to be paid annually on the anniversary of the loan. The rate is 10% of the principal.
In November Yr. 1, the taxpayer realized that he did not have the liquid funds to pay the $100,000 of interest due in January. He had sufficient assets, but due to the business environment, he determined that the smartest economic move to make would be to borrow the $100,000 rather than to liquidate one of his investments. So he went to Bank 2 and borrowed $100,000. This loan was secured by assets other than his stock and was a regular amortizing loan. Interest was 9%. Upon receipt of the loan proceeds on December 1, Yr. 1, taxpayer deposited the proceeds into his regular checking account in Bank 3. The proceeds remained in the checking account for the entire month of December. The balance of the checking account during the month of December ranged from $100,000 to $115,000.
On January 2, Yr. 2, taxpayer wrote a check from his Bank 3 checking account to Bank 1 in full payment of the interest due. On his tax return for Yr. 2, taxpayer took a deduction of $100,000 as an investment interest expense under Section 163. He had sufficient investment income to cover the deduction.
In your research, you discover that Bank 1 owns 90% of the stock of Bank 2. You are able to talk with the client and learn that he was unaware of the relationship. In fact, the loan documents were entirely different and did not make any reference to any relationship. The IRS has indicated it plans to disallow the interest deduction because the IRS believes it has never actually been paid as is required by the Code. The taxpayer would like you to see what the IRS is talking about and whether it has any ground for its position.
a. Write a memo to your supervisor communicating your research results.
b. Write a letter to the taxpayer communicating your research results.
c. Write a letter to the IRS protesting its findings.