A taxpayer is president of a company. He is very wealthy and has a good deal of assets. He went to Bank 1 in January of Yr. 1 to borrow $1,000,000. The loan proceeds were used to purchase stock. Pursuant to a certain stock pledge agreement, 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% per annum (simple) interest on the original loan face amount.
In November of Yr. 1, 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% per annum, compounding semiannually on the outstanding principal loan balance. 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 authorizing payment of funds 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 Code Section 163. He had sufficient investment income to cover the deduction.
In the course of conducting your research, you discover that Bank 1 owns 90% of the stock of Bank 2. You discuss this fact with the client and learn that he is unaware of the affiliated relationship. In fact, the loan documents were entirely different and made no reference to any legal relationship between the two banks. The IRS has indicated it plans to disallow the interest deduction because it believes it has never actually been paid as is required by the Code. The taxpayer would like you to consider this development raised by the IRS and analyze and report to him whether the IRS has justifiable grounds for its position.
a. What relevant primary authority did you locate?
b. Does the authority adequately address the research question(s)? If so, what are your conclusions and reasoning upon which they are based?
c. Were there additional questions that required research beyond a reference service?
d. What resources did you use in your research?
e. How much time did you spend on this portion of your research?