Joseph M. Dodge
(Florida State), Disallowing Deductions Paid with Excluded Income:

The idea advanced herein, as a thought experiment, is the possibility of expanding (by legislation) — or possibly interpreting (by Treasury regulation) — § 265(a)(1) to disallow deductions deemed to have paid out of tax-exempt (i.e., excluded) income. Although § 265(a)(1) already disallows deductions to obtain tax-exempt income (hereinafter referred to as “forward disallowance”), the Treasury has not seriously attempted to systematically disallow deductions paid with tax-exempt income (hereinafter referred to as “backward disallowance”). The reason for this Treasury inattention is undoubtedly a realization that a tracing rule (that would disallow deductions actually paid with tax-exempt income) would, in most cases, be easily avoidable (because cash is fungible) and only serve to unfairly lay a trap for the unsophisticated. This conundrum could be finessed, however, by disallowing that percentage of otherwise-allowable deductions as excluded income bears to total (included and excluded) income – an approach that respects the fungibility of cash.