Sally Jorgenson owns a nail salon with 10 employees. The salon is a sole proprietorship, and Sally uses the accrual meth

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Sally Jorgenson owns a nail salon with 10 employees. Thesalon is a sole proprietorship, and Sally uses the accrual methodof accounting and maintains applicable financial statements. A yearago, Sally decided to sell gift cards to enhance her business. Thegift cards can be used for nail services or nail products. Shereceives payment for the gift cards when she sells them, and thegift cards have no expiration date. They cannot be redeemed forcash. Offering gift cards is new to Sally, and unfortunately, shedid not confer with you, her tax accountant, about how to keeprecords for the gift cards. Therefore, she has only kept records ofwhen the cards are redeemed, not when they are sold. For applicablefinancial statement purposes, Sally has included the payments forthe cards in revenue when they are redeemed.
Can Sally account for the income from the gift cards in thesame way for tax purposes? If not, what would you advise Sally todo to enable her to use the most advantageous method of reportingthe gift card income for tax purposes?

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EXHIBIT 10-2 The Research Memo Sawyers and Gill CPAS San Francisco, CA September 30, 20XX Facts The Browns live in South Dakota. They own their home and hold investments in the debt of several domestic corporations. The interest that they received on this debt was gross income to them. To diver- sify their portfolio, the Browns took out a sizable second mortgage on their home and applied a por- tion of the proceeds to some City of Chandler school bonds. The remainder of the proceeds was used to expand the facilities of Mrs. Brown's dental clinic. Issue(s) How much of the mortgage interest paid can be claimed as an deduction by the Browns? Conclusion That portion of the mortgage proceeds applied to the dental clinic generates an interest deduction to be claimed against clinic income on Schedule C. No other deduction is allowed. Authorities IRC Section 265(a)(2) Rev. Proc. 72-18, 1972-1 CB 740 Wisconsin Cheeseman v. U.S.,388 F. 2d 420 Bradford, 60 T.C.253 Israelson v. U.S., 367 F. Supp. 1104 Mariorenzi v. Comm., 490 F.2d 92, TC Memo 1973-141 Analysis and Summary The IRC disallows the deduction of interest on indebtedness that is incurred or continued to purchase or carry obligations, the interest on which is exempt from the federal income tax. IRC § 265(a)(2). This provision denies the double benefit that would be enjoyed by the taxpayer who would receive tax- exempt income while simultaneously claiming an investment-interest deduction for the interest expense paid, for example, by incurring a bank loan and using the proceeds to purchase municipal bonds.

The IRS examines evidence to infer the intent of the taxpayer who is incurring the indebtedness. Under Rev. Proc. 72-18, 1972-1 CB 740, a taxpayer who purchases exempt bonds can claim an interest deduction if the debt in question has been incurred (1) for personal reasons (e.g., via a mortgage to finance the purchase of residential property), or (2) for valid business reasons, as long as the borrow- ing does not exceed legitimate business needs. Several court decisions have emphasized that the existence of such business motives must be docu- mented clearly, as to both presence and amount. Wisconsin Cheeseman v. U.S., 388 F.2d 420 (CA-7, 1968); Bradford, 60 T.C. 253 (1973); Israelson v. U.S., 367 F. Supp. 1104 (D. Md. 1973).

Mortgage indebtedness is a classic illustration of an investment that will generate deductible interest expenses for the taxpayer who holds exempt bonds. However, the timing of such a mortgage trans- action must be monitored to exhibit the proper motives for the benefit of the IRS. In one case, the taxpayer paid for his home with cash. Only later was an investment program (that included municipal bonds) initiated and a residential mortgage secured. The IRS inferred that the mortgage proceeds were in indirect support of the exempt indebtedness, and the deduction for the mortgage interest was disal- lowed. Mariorenzi v. Comm., 490 F.2d 92 (CA-8, 1974), T.C. Memo 1973-141. Had the taxpayer secured a mortgage before the home was completed, purchasing the exempt bonds out of savings, it appears that the deduction could have been preserved. The IRS has applied this doctrine outside of the Eighth Circuit, in PLR 8631006. Because the Browns live in the Eighth Circuit, the Mariorenzi doctrine prevails, and no itemized deduc- tion is allowed at all, that is, for that portion of the loan that is applied to the school bonds. Rev. Proc. 72-18 is insensitive to portfolio-diversification motives, and no personal motive appears to exist that supports any other possible deduction. According to the logic of these precedents, the Browns should have sold the exempt bonds and then used the proceeds to finance their portfolio acquisitions. Actions to Be Taken Prepare letter, review results with client. Suggest changes in portfolio holdings to regain the deduction. Preparer: Mary H. Polzin Reviewer: Char E. Mano