KTA-Tator Inc. v. Commissioner

108 T.C. No.8

UNITED STATES TAX COURT

KTA-TATOR, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21013-95. Filed March 11, 1997.

P, a closely held corporation, advanced funds to
its shareholders. The advances were used to pay
expenses relating to construction projects and were not
subject to written repayment terms. After each project
was completed, amortization schedules were prepared and
the shareholders began repaying the advances. Prior to
the shareholder's repayments, P did not report interest
income from the advances. Held: P, pursuant to sec.
7872, I.R.C., has interest income from below-market
demand loans it made to its shareholders.

Kenneth B. Tator (an officer), for petitioner.

Michael A. Yost, Jr., for respondent.
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OPINION

FOLEY, Judge: By notice dated September 27, 1995,

respondent determined deficiencies in petitioner's Federal income

taxes as follows:

Year Deficiency

1992 $10,443
1993 1,828

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure. The issue for decision is whether petitioner,

pursuant to section 7872, has interest income from loans it made

to its shareholders. We hold that it does.

Background

The facts have been fully stipulated under Rule 122 and are

so found. At the time the petition was filed, petitioner's

principal place of business was in Pittsburgh, Pennsylvania.

During the years in issue, petitioner provided various

services within the coatings industry, including consulting,

engineering, inspection, and lab analysis. Kenneth B. Tator is

the president of petitioner, and he and his wife (the Tators) are

its sole shareholders.

In 1991, the Tators began two construction projects. The

first project involved the expansion of petitioner's Pittsburgh
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headquarters, which the Tators owned and leased to petitioner.

The second project involved the construction of a new office

building in Houston, Texas, which the Tators would own and lease

to petitioner. Petitioner was authorized by its board of

directors to loan funds to the Tators for construction, the

purchase of land, and other business purposes. During the

construction phase of the two projects, petitioner made over 100

advances of funds to the Tators. Each advance was executed by

issuing a separate corporate check, and the Tators used the

advances to pay contractors and meet other expenses. The

advances were not subject to written repayment terms. On the

corporate balance sheets, petitioner reported the advances as

loans to shareholders. Monthly and year-to-date totals were

recorded in two accounts entitled "Mortgage Receivable -

Pittsburgh" and "Mortgage Receivable - Houston".

The Houston project was completed in October of 1992, and

the Pittsburgh project was completed in October of 1993. Upon

the completion of each project, the Tators prepared an

amortization schedule and began repaying the advances. The

amortization schedule for each project delineated monthly

payments over 20 years at an interest rate of 8 percent. The

amortization schedule for the Houston project had a beginning

principal balance of $400,218, while the amortization schedule

for the Pittsburgh project had a beginning principal balance of

$225,777.60.
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On its 1992 and 1993 Federal income tax returns, petitioner

did not report interest income from the advances. On September

27, 1995, respondent issued a notice of deficiency to petitioner.

Respondent determined that petitioner, pursuant to section 7872,

had unreported interest income of $30,718 for 1992 and $5,225 for

1993. Based on these amounts, respondent determined that

petitioner was liable for deficiencies of $10,443 for 1992 and

$1,828 for 1993.

Discussion

Section 7872 was enacted as part of the Deficit Reduction

Act of 1984 (DEFRA), Pub. L. 98-369, sec. 172(a), 98 Stat. 699.

Section 7872 sets forth the income and gift tax treatment for

certain categories of "below-market" loans (i.e., loans subject

to a below-market interest rate). Section 7872 recharacterizes a

below-market loan as an arms-length transaction in which the

lender made a loan to the borrower in exchange for a note

requiring the payment of interest at a statutory rate. As a

result, the parties are treated as if the lender made a transfer

of funds to the borrower, and the borrower used these funds to

pay interest to the lender. The transfer to the borrower is

treated as a gift, dividend, contribution of capital, payment of

compensation, or other payment depending on the substance of the

transaction. The interest payment is included in the lender's

income and generally may be deducted by the borrower. See H.

Conf. Rept. 98-861, at 1015 (1984), 1984-3 C.B. (Vol. 2), 1, 269;
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Staff of Joint Comm. on Taxation, General Explanation of the

Revenue Provisions of the Deficit Reduction Act of 1984, at 528-

529 (J. Comm. Print 1984).

Section 7872 applies to a transaction that is: (1) A loan;

(2) subject to a "below-market" interest rate; and (3) described

in one of several enumerated categories. Sec. 7872(c)(1),

(e)(1), (f)(8). The parties agree that the third requirement has

been met. We discuss the remaining requirements in turn.

I. Loan Requirement

Respondent contends that each advance petitioner made to the

Tators should be treated as a separate loan. Petitioner contends

that the corporation was authorized to fund both projects with a

single loan and that the advances were analogous to "draw downs"

on an open line of credit. Petitioner further contends that, for

purposes of section 7872, a loan did not exist until petitioner

advanced all the funds necessary to complete the Pittsburgh and

Houston projects. Petitioner relies on section 1.7872-2(a)(1),

Proposed Income Tax Regs., 50 Fed. Reg. 33557 (Aug. 20, 1985),

which states: "An integrated series of transactions which is the

equivalent of a loan is treated as a loan."

While proposed regulations do constitute "'a body of

informed judgment * * * which courts may draw on for guidance'",

Frazee v. Commissioner, 98 T.C. 554, 582 (1992) (quoting Bolton

v. Commissioner, 694 F.2d 556, 560 n.10 (9th Cir. 1982), affg. 77

T.C. 104 (1981)), we accord them no more weight than a litigation
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position, F. W. Woolworth Co. v. Commissioner, 54 T.C. 1233,

1265-1266 (1970). Even if we were inclined to seek guidance from

the proposed regulations, petitioner's reliance on section

1.7872-2(a)(1), Proposed Income Tax Regs., supra, is misplaced.

That section is an antiabuse provision intended to address a

series of transactions where each individual transaction may not

be a loan, but collectively the series of transactions has the

same effect as a loan. Contrary to petitioner's contention,

section 1.7872-2(a)(3), Proposed Income Tax Regs., 50 Fed. Reg.

33557 (Aug. 20, 1985), rather than section 1.7872-2(a)(1),

Proposed Income Tax Regs., supra, is the relevant section of the

proposed regulations. Section 1.7872-2(a)(3), Proposed Income

Tax Regs., supra, provides that "each extension or [sic] credit

or transfer of money by a lender to a borrower is treated as a

separate loan." Thus, the proposed regulations upon which

petitioner relies provide that each advance should be treated as

a separate loan. Indeed, petitioner reported, on its corporate

balance sheets, each advance as a separate loan.

For authoritative guidance on whether a series of advances

may be treated as individual loans, we turn to the legislative

history of section 7872. The House conference report to DEFRA

states that "any transfer of money that provides the transferor

with a right to repayment may be a loan. For example, advances

or deposits of all kinds may be treated as loans." H. Conf.
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Rept. 98-861, supra at 1018, 1984-3 C.B. at 272 (emphasis added).

Each of petitioner's advances was a transfer resulting in a right

to repayment. In essence, each transfer was an extension of

credit and therefore a loan. See Frazee v. Commissioner, supra

at 589 (stating that "The term 'loan' under section 7872 is

interpreted broadly to include any extension of credit.").

Accordingly, we conclude that the loan requirement is

satisfied and that each advance is a separate loan for purposes

of section 7872.

II. Below-Market Loan Requirement

To determine if the below-market loan requirement is

satisfied, we must ascertain whether the loan is (1) a demand or

term loan and (2) subject to a below-market interest rate. See

sec. 7872(e)(1).

A. Demand or Term Loan

Below-market loans fit into one of two categories: Demand

loans and term loans. Sec. 7872(e)(1); H. Conf. Rept. 98-861,

supra at 1018, 1984-3 C.B. at 272. A demand loan includes "any

loan which is payable in full at any time on the demand of the

lender." Sec. 7872(f)(5). A term loan is "any loan which is not

a demand loan." Sec. 7872(f)(6).

The determination of whether a loan is payable in full at

any time on the demand of the lender is a factual one. Loans

between closely held corporations and their controlling

shareholders are to be examined with special scrutiny. Electric
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& Neon, Inc. v. Commissioner, 56 T.C. 1324, 1339 (1971), affd.

without published opinion 496 F.2d 876 (5th Cir. 1974).

Petitioner made loans, without written repayment terms, to its

only shareholders and had unfettered discretion to determine when

the loans would be repaid. Therefore, the loans are demand

loans.

We note that a technical correction in the Tax Reform Act of

1986 amended section 7872(f)(5) and expanded the definition of

demand loan to include, "To the extent provided in regulations,

* * * any loan with an indefinite maturity." Tax Reform Act of

1986, Pub. L. 99-514, sec. 1812(b)(3), 100 Stat. 2834. The

legislative history accompanying the technical correction

provides the following justification for the amendment:

The definitions of term loan and demand loan in
section 7872 appear to treat loans with an indefinite
maturity as term loans. However, it often is
impractical to treat a loan with an indefinite maturity
as a term loan, since section 7872 requires the
computation of the present value of the payments due
under such a loan. Accordingly, the bill grants the
Treasury Department authority to treat loans with
indefinite maturities as demand loans rather than term
loans. [S. Rept. 99-313, at 958 (1986), 1986-3 C.B.
(Vol. 3) 1, 958; emphasis added.]

The Department of the Treasury, however, has not promulgated

final regulations for section 7872, and the proposed regulations

fail to address the treatment of loans that have indefinite

maturities and are not payable on the demand of the lender. As a

result, such loans are not demand loans and, pursuant to section

7872(f)(6), are term loans.
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The technical correction is not applicable to petitioner's

transactions. This amendment to the statute was intended to give

the Department of the Treasury authority to expand the category

of demand loans to include loans that have indefinite maturities

and are not payable on the demand of the lender. We note that

all demand loans by their very nature have indefinite maturities.

See Dickman v. Commissioner, 465 U.S. 330, 337 (1984) (analyzing

the "uncertain tenure of a demand loan"). If all loans with

indefinite maturities were classified as term loans under the

statute, no loan would meet the definition of a demand loan.

"[W]e have employed the rule that statutes are to be construed so

as to give effect to their plain and ordinary meaning unless to

do so would produce absurd or futile results * * *. Furthermore,

all parts of a statute must be read together, and each part

should be given its full effect." Phillips Petroleum Co. v.

Commissioner, 101 T.C. 78, 97 (1993), affd. without published

opinion 70 F.3d 1282 (10th Cir. 1995). Petitioner's loans,

payable on demand and having indefinite maturities, are demand,

rather than term, loans. Next, we must determine whether

petitioner's loans are subject to a below-market interest rate.

B. Below-Market Interest Rate

A demand loan is a below-market loan if it is interest free

or if interest is provided at a rate that is lower than the

applicable Federal rate (AFR) as determined under section
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1274(d). Sec. 7872(e)(1)(A). If a demand loan is classified as

a below-market loan, the lender has interest income (foregone

interest) equal to the difference between (1) the interest that

would have accrued on the loan using the AFR as the interest rate

and (2) any actual interest payable on the loan. Sec.

7872(e)(2). The parties are treated as though, on the last day

of each calendar year, the lender transferred an amount equal to

the foregone interest to the borrower and the borrower repaid

this amount as interest to the lender. Sec. 7872(a).

During the construction phase of each project, petitioner

made loans to the Tators. Prior to the completion of

construction and the preparation of the amortization schedules,

the Tators did not pay interest on these loans. Therefore, we

conclude that the loans are below-market demand loans.

Petitioner contends that even if the requirements of section

7872 are met, a temporary regulation provides that section 7872

is not applicable, because the loans' interest arrangements have

no significant effect on any Federal tax liability of the lender

or the borrower. See sec. 7872(h)(1)(C); sec. 1.7872-5T(b)(14),

Temporary Income Tax Regs., 50 Fed. Reg. 33521 (Aug. 20, 1985).

To determine whether a loan lacks a significant tax effect, all

facts and circumstances should be considered including the

following factors: (1) Whether the items of income and deduction

generated by the loan offset each other; (2) the amount of such

items; (3) the cost to the taxpayer of complying with the
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provisions of section 7872 if such section were applied; and

(4) any nontax reasons for deciding to structure the transaction

as a below-market loan rather than a loan with interest at a rate

equal to or greater than the applicable Federal rate and a

payment by the lender to the borrower. Sec. 1.7872-5T(c)(3),

Temporary Income Tax Regs., 50 Fed. Reg. 33521 (Aug. 20, 1985);

see also H. Conf. Rept. 98-861, supra at 1020, 1984-3 C.B. at

274.

Petitioner contends that if section 7872 applies, the Tators

would be entitled to claim an interest expense deduction equal to

the interest they are deemed to have paid petitioner, and as a

result, the items of income and deduction offset each other.

Implicit in this contention is the assumption that the temporary

regulation permits the borrower's reduction in tax from the

interest deduction to offset the lender's increase in tax from

the interest income. Petitioner has misinterpreted the scope of

the exception. Because section 7872(h)(1)(C) and the temporary

regulation refer to the tax liability of the "lender or the

borrower", the factors must be applied separately to each

taxpayer.

The following example illustrates this point. In the case

of a below-market demand loan from a corporation to a

shareholder, the corporation is treated as transferring to the

shareholder, and the shareholder is treated as paying to the

corporation, an amount equal to the foregone interest. The
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deemed transfer from the corporation to the shareholder is

treated as a distribution, which generally is taxed as a dividend

to the shareholder. Secs. 61(a)(7), 301(c)(1); H. Conf. Rept.

98-861, supra at 1013, 1984-3 C.B. at 267. The shareholder

generally may deduct the deemed interest payment to the

corporation. H. Conf. Rept. 98-861, supra at 1013, 1984-3 C.B.

at 266. The shareholder's income from the deemed dividend and

the shareholder's deduction for the deemed payment of interest

may offset each other within the meaning of the temporary

regulation. The corporation, on the other hand, is subject to

tax on the foregone interest but is not entitled to a deduction

for the deemed distribution it made to the shareholder.

Therefore, it has no deduction to offset the interest income from

the loan. Similarly, petitioner has interest income but is not

entitled to a deduction for the deemed distribution it made to

the Tators. As a result, petitioner's reliance on the exception

is misplaced.

Accordingly, we hold that petitioner, pursuant to section

7872, has interest income from below-market loans it made to its

shareholders.

To reflect the foregoing,

Decision will be entered

for respondent.