Jerry always wanted to run his own manufacturing business. Jerry needed a special machine that cost $40,000. After all of the other start- up expenses, Jerry only had $30,000 remaining to purchase this machine. Jerry’s good friend Mike came to the rescue and loaned him $10,000 to help Jerry buy the machine. The loan was a simple loan with a balloon payment of $11,000 at the end of two years. This represents approximately a 5% annual interest rate, which was the going market rate at the time the loan was made.
Jerry’s business was going well, however it required him to put in many long hours. Jerry noticed that an apartment building that was close to his warehouse had a vacancy. Jerry thought it would be nice to drive to work instead of commute through traffic, so he decided to move closer to the warehouse. Before moving, he decided to have a garage sale to get rid of the things at his old place. The garage sale was a hit! Jerry didn’t know he was sitting on such a gold mine. In total, Jerry made $15,000 from selling his items at the garage sale.
With business going well, and the unanticipated cash flow from the garage sale, Jerry decided to pay back his loan in full to Mike, ahead of schedule. When Jerry offered the check to Mike for $11,000, Mike said, “You know what Jerry? You’re my friend. I wasn’t expecting the money back. I know you would help me out if I needed it. I’m just happy that I was blessed to be in a position where I could help you pursue your dreams.”
Jerry was extremely grateful. As a gesture of thanks, and because Jerry had been working so much that he and Mike hadn’t hung out much lately, Jerry took Mike out to a fancy dinner followed by VIP concert to Mike’s favourite band. In all, the night cost Jerry about $1,500, but Jerry didn’t mind. After all, he just saved $11,000 for not having to pay Mike back for the loan, plus, Jerry figured he would just deduct the costs of dinner and the concert as a business expense.
Jerry comes into your office seeking tax advice. Identify any tax issues that arise through Jerry’s story. Also identify any relevant section of the Code, case law, or tax court memorandums that will help you resolve these issues.