Active Media Services, Inc.

Response to Internal Revenue Service Form 5701

Tax Year Ended 6/30/2008

FACTS

For taxable year ended June 30, 2008 Active Media Services, Inc. has claimed a
deduction for accrued interest expense on loans to two of its shareholders. The
loans payable are evidenced by loan agreements, bear a market rate of interest,
and carry scheduled repayment terms which have been amended. The accrued
interest was not paid during the taxable year in question. Active Media Services,
Inc. computes its taxable income under the accrual method of accounting.

ISSUE

May Active Media Services, Inc. treat a liability for interest expense accrued but
unpaid on its contractual borrowings as incurred and deductible in the tax year
ended June 30, 2008.

LAW AND ANALYSIS

Section 163 of the Internal Revenue Code provides that there shall be allowed as
a deduction all interest paid or accrued within the taxable year on indebtedness.
Section 461 provides the general rules for determining the taxable year in which
a deduction may be taken. Section 1.461-1(a) (2)(i) of the Income Tax
Regulations provides that a liability is incurred, and is generally taken into
account for federal income tax purposes, in the taxable year in which: (1) all the
events have occurred that establish the fact of the liability, (2) the amount of the
liability can be determined with reasonable accuracy, and (3) economic
performance has occurred with respect to the liability.

A liability for interest is fixed for purposes of deductibility under Section 163 when
the debtor has a legal obligation to pay it and the obligation is not contingent on
the occurrence of some future event. Central Cuba Sugar Co. v. Commissioner,
198 F.2d 214, 216-7 (2d Cir. 1952), cert. denied, 344 U.S. 874 (1952). Accrued
interest can be deducted only when and to the extent that there exists a legally
binding obligation to pay it, fixed in all its terms within the taxable year. Security
Flour Mills Co. v. C.I.R. 321 U.S. 281, 64 S. Ct. 596, 88 L.Ed. 725. Generally, the
amount of interest to be deducted is based on the loan agreements or similar
lender and borrower contracts that fix both the obligation and determine the
amount of interest to be paid on the borrowing. Economic performance for an
interest liability is satisfied with the passage of time as the interest cost
economically accrues under Section 1.461-4(e).

If an obligation to pay is established, but the ability to pay is uncertain, or even

very remote, generally an accrual basis taxpayer nonetheless may deduct
interest as incurred (Rev Rul. 70-367).

Under case law, there are generally two standards determining the deductibility
of accrued interest. Under one standard, improbability of payment is not a factor
to be considered in determining deductibility. Under the second standard, the
accrued interest is deductible unless it can be demonstrated categorically that
payment is extremely doubtful.

The primary case is Zimmerman Steel Co. v. Commissioner, 130 F. 2d 1011 (8 th

Cir 1942). In Zimmerman, the 8th Circuit court stated:

But where interest actually accrued on a debt of a taxpayer in a tax year the
statue plainly says he may deduct it. That he has no intention or expectation of
paying it, but must go into bankruptcy as this taxpayer was obliged to do, can not
of itself justify denial of deduction in computing the taxpayers net income. It is
true that if a mans gains at the end of the year consist of bad debts he can have
no net income to tax. But neither does he have such net income if the interest on
what he owes amounts to more than his gains.

In Fahs v. Martin, 224 F. 2d 387 (5th Cir. 1955), the court concluded that the
Internal Revenue Code does not preclude the deduction of interest, not even if
the latter is unlikely to be paid.

In Keebeys Inc. v. Paschal, 188 F. 2d (8th Cir 1951), the payment of a creditors
note had been postponed until all other obligations of the debtor had been met,
but the legal duty for payment of the note was not dependent upon the debtors
ability to pay. The obligation to pay was a continuing one and there was
reasonable ground to believe that it would ultimately be paid. The liability was
fixed and certain. The right to deduct the amounts as interest became absolute in
the year when accrued even though actual payment was deferred.

In Cohen v. Commissioner 21 T.C. 855, 857, the rule which emerges from the
decisions of this court is that deductions for accrued interest are proper where it
can not be categorically said at the time these deductions were claimed that the
interest would not be paid, even though the course of conduct of the parties
indicated that the likelihood of payment of any part of the disallowed portion was
extremely doubtful D.J. Jorden, 11 T.C. 914,925.

Under the standards applied under the categorical unlikelihood standard it is

apparent that it would not be categorically unlikely that Active Media Services,
Inc. will not pay interest on its debt to shareholders. In Southeastern Mail T.C.
252, the deduction was allowed even though the taxpayer discontinued business
four days before its fiscal year ended. The fact that there had been an active
operating business up until that time was enough to make the deduction
allowable. In Cohen and Jorden, the fact that the taxpayer had been paying
some principal and interest on the loan sufficed to qualify for the deduction. In
Taube v. Commissioner 88 T.C. 464, the prospect of potential future revenue
qualified the taxpayer for the deduction.

CONCLUSION

Applying these standards to Active Media Services, Inc. there is a taxpayer with
an active business operation, is not in bankruptcy, is solvent in the fact that the
value its assets exceed its debt, has a history of making some principal and
interest payments on its debt to shareholders, and has prospects for future
revenue. Accordingly, it is certainly appropriate and Active Media Services, Inc.
is entitled to the deductions claimed for accrued but unpaid interest on its federal
income tax return.