## Facts

- Wisconsin Cheeseman, Inc. operated a highly seasonal cheese-gift business, with major annual expenses and sales activity concentrated in the last quarter of each year.
- To fund seasonal inventory and operations, the company regularly obtained short-term bank loans each fall and repaid them from Christmas-season receipts in late November through January.
- After repaying seasonal loans, the company invested remaining funds in tax-exempt municipal bonds and in Treasury bills used for off-season liquidity; Treasury bills were typically liquidated by mid-July.
- The municipal bonds were pledged as collateral for the company’s short-term borrowing, permitting it to borrow close to the bonds’ full value.
- The company’s municipal bond holdings grew substantially during the years at issue.
- In one year, the company also borrowed funds secured by a mortgage on its real estate to finance construction of a new plant; the loan proceeds were used for construction.
- The IRS disallowed deductions for interest paid on (i) certain short-term loans and (ii) the mortgage, asserting the debts were incurred or continued to purchase or carry tax-exempt obligations under I.R.C. § 265(2).
- The district court upheld the disallowance as to both categories of interest; the taxpayer sought a refund and appealed.

## Issues

1. Whether interest on short-term working-capital loans, secured by municipal bonds, is nondeductible under I.R.C. § 265(2) as indebtedness incurred or continued to “carry” tax-exempt obligations.
2. Whether interest on a mortgage loan used to construct a new plant is nondeductible under I.R.C. § 265(2) because the taxpayer could have sold its municipal bonds instead of borrowing.

## Decision

- The Seventh Circuit affirmed the disallowance of interest deductions for the short-term loans.
- The court reversed the disallowance of interest deductions for the mortgage loan.
- The judgment was affirmed in part and reversed in part, requiring allowance of the mortgage interest deduction while sustaining disallowance for the short-term loan interest.

## Legal Principles

- I.R.C. § 265(2) disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations whose interest is wholly exempt from federal income tax.
- Section 265(2) applies when there is a sufficiently direct relationship between the indebtedness and the taxpayer’s acquisition or retention (“carrying”) of tax-exempt obligations.
- Short-term borrowing that economically permits the taxpayer to retain tax-exempt bonds—particularly where the bonds serve as collateral and could otherwise be liquidated to meet cash needs—may be treated as indebtedness incurred or continued to “carry” the bonds, rendering related interest nondeductible.
- A loan undertaken for an independent, legitimate business purpose (e.g., financing a major, nonrecurring capital project) is not disqualified under § 265(2) absent a direct nexus to purchasing or carrying tax-exempt obligations; a purely hypothetical “could have sold the bonds instead” connection is insufficient.

## Conclusion

The court applied § 265(2) to disallow interest deductions on short-term loans that functioned to maintain the taxpayer’s tax-exempt municipal bond portfolio while financing seasonal operations with borrowed funds, but allowed the mortgage interest deduction because the mortgage financed construction of a new plant and lacked a direct relationship to purchasing or carrying tax-exempt bonds.


Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (7th Cir. 1968)