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, Yr.1, to borrow $1,000,000. The taxpayer used the loan proceeds 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% per annum (simple) interest on the original loan face amount.
In November of 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. The 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 of Yr. 2, the 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, the taxpayer took a deduction of $100,000 as an investment interest expense under Section 163. He had sufficient investment income to cover the deduction. 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 grounds for its position.
a. Are there any additional questions you should ask the client before you begin?
b. What additional potential sources of information might you want to ask for?
c. Which of the preceding facts are relevant? Which are irrelevant?
d. Is there a chance that you will need to ask more questions at a later point? Why or why not?
e. What is the first question you will try to answer in your research? Are there any additional issues that you can identify at this time?
f. What is the taxpayer's desired result? Why is this important? How does it affect your role as tax advisor?
g. Is this a planning research type of situation? How do you know?
h. Do you have an initial belief regarding the tax treatment in this circumstance?