Mason v. Commissioner

T.C. Memo. 1997-352

UNITED STATES TAX COURT

RAYMOND K. AND MINERVA R. MASON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9998-96. Filed July 31, 1997.

Ps, shareholders of a closely held corporation,
received certain advances of funds from the corporation
in 1987 and 1988 which they used for personal and
investment expenses. The loans were not evidenced by a
note or security agreement, and no interest rate was
agreed to or set by the parties during these years. Ps
also made certain repayments on the loans in 1987 and
1988 which were reflected as reductions of principal on
the financial ledgers of both Ps and the corporation.

R determined that Ps were the recipients of below-
market loans from the corporation and, among other
things, adjusted their income to reflect distributions
pursuant to sec. 7872, I.R.C. Held: Ps have dividend
income in an amount equal to the forgone interest from
the below-market demand loans. KTA-Tator, Inc. v.
Commissioner, 108 T.C. 100, 106-107 (1997), applied.
Held, further, additions to tax under sec. 6661,
 - 2 -

I.R.C., are sustained, subject to recomputation under
Rule 155.

Mike E. Jorgensen, for petitioners.

Charles Baer, for respondent.

MEMORANDUM OPINION

NIMS, Judge: Respondent determined the following

deficiencies, additions to tax, and accuracy-related penalty with

respect to the Federal income tax of petitioners, Raymond K. and

Minerva R. Mason, for the taxable years 1987, 1988, and 1989:

Additions to Tax Penalty
Year Deficiency Sec. 6661 Sec. 6662(a)

1987 $38,236 $9,559 --
1988 36,662 9,166 --
1
1989 -- -- $5,927
______________
1
This figure is equal to 20 percent of the underpayment of
tax previously assessed.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years at issue. All

Rule references are to the Tax Court Rules of Practice and

Procedure.

After concessions, the remaining issues for decision are:

(1) Whether petitioners received below-market demand loans from

their closely held corporation such that dividends may be imputed

to them in 1987 and 1988 in the amount of the forgone interest

pursuant to section 7872; and (2) whether petitioners are liable
 - 3 -

for additions to tax pursuant to section 6661(a) for a

substantial understatement of tax for 1987 and 1988.

(Petitioners concede the correctness of the section 6662(a)

accuracy-related penalty for 1989.)

This case was submitted pursuant to Rule 122, on a full

stipulation of facts, and the facts as stipulated are so found.

This reference incorporates herein the stipulation of facts and

attached exhibits. Petitioners resided in Jacksonville, Florida,

at the time they filed their petition in this case. (The term

petitioner will be used henceforth to refer to Raymond K. Mason.)

Background

Petitioners are the only shareholders of Rebuilding Service,

Inc. (RSI), a corporation which makes investments and loans, in

addition to providing consulting services. Petitioner is RSI's

president and director. Petitioners report their income on a

calendar year and cash basis. RSI is also on a calendar year;

RSI reports its income on an accrual basis.

As of the time this case was submitted, a revolving credit

relationship between petitioners and RSI, in which petitioners

periodically borrowed from and repaid advances made by RSI, had

existed for a number of years. During 1987 and 1988, RSI

advanced funds to petitioners in the amounts of $1,128,570 and

$25,648, respectively, for both personal and investment purposes.

The terms of the loans were not reduced to a note or security
 - 4 -

agreement. The loans had no fixed maturity date for repayment,

and RSI could have demanded the outstanding principal balances at

any time. During 1987 and 1988, petitioners and RSI did not

record, set, or otherwise contemplate a rate of interest on these

loans.

Also during 1987 and 1988, petitioners made repayments to

RSI in the total amounts of $839,702 and $381,734, respectively.

(RSI's ending balances in 1987 and 1988 for all of its advances

to petitioners were $2,282,482 and $2,093,993, respectively.) No

interest expense relating to these payments was shown on

petitioners' joint Forms 1040, U.S. Individual Income Tax Return,

nor was interest income reflected on RSI's Forms 1120, U.S.

Corporation Income Tax Return. Whenever petitioner and RSI

exchanged money during this period, RSI's financial ledger simply

reported a debit or credit to "note payable--shareholder", as

appropriate. Likewise, petitioner's financial ledger reported a

credit or debit to "accounts payable/account receivable--RSI", as

appropriate. Neither petitioners' nor RSI's ledger explicitly

characterized the repayments as either principal or interest.

However, the ledgers indicate that all payments by petitioners to

RSI reduced the outstanding principal of the loans dollar-for-

dollar by the amount of the payments.

In 1990, petitioners retained the accounting firm KPMG Peat

Marwick (KPMG) to analyze the ledgers of both petitioners and

RSI. KPMG calculated what RSI's interest income on the loans
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would have been at the applicable Federal rate (AFR) under

section 7872(e)(2) for 1987 and 1988. Of petitioners' repayments

to RSI, KPMG calculated that $728,098 and $214,065 ought to have

been applied to reduce the outstanding principal on the loans for

1987 and 1988, respectively, and $111,604 and $167,569 should

have been allocated to interest at the AFR for those same years.

Respondent timely issued a statutory notice of deficiency on

February 16, 1996. Among other things, respondent adjusted

petitioners' income for the relevant tax years to reflect

dividend income from RSI pursuant to section 7872. (Respondent

adjusted RSI's income on its Forms 1120 for 1987 and 1988 to

reflect interest income in the amounts calculated by KPMG.)

Respondent further adjusted petitioners' itemized deductions to

allow for a partial deduction for the interest respondent deemed

paid to RSI by petitioners for the years in question. Respondent

allowed petitioners a full deduction for interest expenses

identified from "investment sources" in the KPMG analysis, and a

partial deduction for interest expenses identified from "personal

sources", in accordance with section 163.

Discussion

We must decide whether respondent properly imputed dividends

to petitioners in 1987 and 1988 under section 7872 where no

evidence indicates that interest had accrued or was otherwise

paid on the loans in those years. (Petitioners concede that

respondent's adjustments to RSI's income and to petitioners'
 - 6 -

itemized deductions were correct.) We must also decide whether

petitioners are liable for additions to tax under section 6661

for a substantial underpayment of tax for 1987 and 1988.

I. Were Dividends Properly Imputed to Petitioners Under Section
7872 for 1987 and 1988?

Section 7872 was enacted as part of the Deficit Reduction

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

7872 sets forth the appropriate income and gift tax treatment for

certain categories of "below-market" loans; i.e., loans that are

interest free or that provide for interest that is lower than the

AFR. Sec. 7872(e)(1); KTA-Tator, Inc. v. Commissioner, 108 T.C.

100, 105 (1997). Section 7872 recharacterizes a below-market

loan, as defined in section 7872(e)(1), so that the loan becomes

the equivalent of an arm's-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 had made a transfer of funds

to the borrower, and the borrower then used these funds to pay

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

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

payment of compensation, or other payment depending on the

substance of the transaction. The deemed interest payment is

included in the lender's income and generally may be deducted by

the borrower, subject to the rules governing the deductibility of

interest. KTA-Tator, Inc. v. Commissioner, supra at 102; see H.
 - 7 -

Conf. Rept. 98-861, at 1015 (1984), 1984-3 C.B. (Vol. 2) 1, 269;

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). Petitioners do not contest that the advances

from RSI constitute loans, or that the loans were from a

corporation to its shareholders (one of the enumerated categories

under section 7872(c)(1)). Rather, petitioners maintain that the

advances were not made at a below-market rate, and therefore

section 7872 does not apply to impute dividend income to them.

In order to determine whether the below-market loan

requirement is satisfied for purposes of applying section 7872,

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).

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

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

861, at 1018, 1984-3 C.B. (Vol. 2) 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
 - 8 -

the demand of the lender is a factual one. Loans between closely

held corporations and their controlling shareholders are subject

to special scrutiny. Electric & Neon, Inc. v. Commissioner, 56

T.C. 1324, 1339 (1971), affd. without published opinion 496 F.2d

876 (5th Cir. 1974).

In the instant case, RSI made loans without written

repayment terms to its only shareholders and had unfettered

discretion to determine when the loans would be repaid. On that

basis, we conclude that the loans are demand loans. We reached

the same conclusion on similar facts in KTA-Tator, Inc. v.

Commissioner, supra at 104-105.

Next, we must determine whether the loans were subject to a

below-market interest rate. A demand loan is a below-market loan

if it is interest free, or if it provides for interest at a rate

that is lower than the AFR as determined under section 1274(d).

Sec. 7872(e)(1)(A), (f)(2)(B). If a demand loan is classified as

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

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 interest actually payable on the loan. Sec.

7872(e)(2); KTA-Tator, Inc. v. Commissioner, supra at 105. The

parties are treated as though, on the last day of each calendar

year, the lender transferred an amount equal to the forgone

interest to the borrower and the borrower repaid this amount as

interest to the lender. Sec. 7872(a). In the context of a loan
 - 9 -

between a corporation and a shareholder, the deemed transfer of

forgone interest from the corporation to the shareholder is

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

to the shareholder. KTA-Tator, Inc. v. Commissioner, supra at

106; McGinnis v. Commissioner, T.C. Memo. 1993-45; see H. Conf.

Rept. 98-861, at 1012, 1984-3 C.B. (Vol. 2) at 266.

Petitioners contend that section 7872 does not apply to the

instant case, arguing that interest on the loans had accrued at

the AFR in 1987 and 1988 and was in fact paid in those years,

although petitioners admit that interest was not expressly

allocated as such until 1990. Petitioners maintain that proposed

regulations under section 7872 provide support for a post-tax-

yearend partial allocation of a repayment to interest at the AFR.

Petitioners further assert that the adjustments made by

respondent to the returns of RSI and petitioners for the years at

issue shows the propriety of such post-tax-yearend partial

allocations to interest.

Respondent, on the other hand, argues that there was forgone

interest on the loans and therefore section 7872 applies in this

case, since neither petitioners nor RSI had agreed to any

interest liability during 1987 and 1988. Moreover, respondent

avers, no evidence exists that any of petitioners' payments to

RSI in 1987 and 1988 were in fact applied to interest owed on the

loans. Under the circumstances, respondent maintains that a

repayment cannot be partially allocated to interest at the AFR
 - 10 -

after the end of the relevant tax year in order to skirt the

application of section 7872. For the reasons which follow, we

agree with respondent.

Petitioners rely primarily on section 1.7872-13(c), Proposed

Income Tax Regs., 50 Fed. Reg. 33568, 33569 (Aug. 20, 1985), as

support for their position. Petitioners point to language in

section 1.7872-13(c), Proposed Income Tax Regs., that provides:

If a demand loan does not have a constant outstanding
principal amount during a period, the amount of forgone
interest shall be computed according to the principles
set forth in paragraph (b) of this section, with each
increase in the outstanding loan balance being treated
as a new loan and each decrease being treated as first
a repayment of accrued but unpaid interest (if any),
and then a repayment of principal. [Emphasis added.]

We note that, 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), this Court

accords them no more weight than that given to a litigation

position. See KTA-Tator, Inc. v. Commissioner, 108 T.C. at 102-

103. In any case, petitioners' reliance thereon is misplaced.

Most importantly, petitioners ignore the fact that, contrary

to the underscored language of section 1.7872-13(c), Proposed

Income Tax Regs., no interest "accrued" during the years in

question in this case. Petitioners acknowledge that no

obligation to pay interest had been agreed on or contemplated by

the parties to the loan transactions during 1987 and 1988.

Petitioners nonetheless assert that interest need not be stated
 - 11 -

to avoid section 7872. In so arguing, petitioners ignore the

language of section 1.7872-3(c)(1), Proposed Income Tax Regs., 50

Fed. Reg. 33559 (Aug. 20, 1985), which provides that "Section

7872 does not apply to any loan which has sufficient stated

interest." (Emphasis added.) In any event, no evidence

demonstrates that any interest was actually paid in 1987 and

1988. Indeed, all evidence points to the contrary. No interest

income was shown on RSI's Forms 1120, nor was any interest

expense reflected on petitioners' returns for the years at issue.

Also telling is the fact that both petitioners' and RSI's

financial ledgers indicate that all payments by petitioners to

RSI reduced the outstanding principal of the loans dollar-for-

dollar by the amount of the payments.

Furthermore, petitioners ignore the parenthetical language

"if any" emphasized above. Petitioners theorize that the words

"unpaid interest" refer to imputed interest computed at the AFR

under section 7872, and thus assert that all repayments should be

treated first as payments of such interest by the borrower. In

that connection, petitioners posit, without pointing to any

authority, that section 7872 applies only in the narrow

circumstance where a taxpayer learns after the end of the

relevant tax year that his repayments are insufficient to satisfy

first all of the interest owing at the AFR. However, if

petitioners' interpretation were correct, the parenthetical

language "if any" would be superfluous, as there would always be
 - 12 -

interest to be repaid first on a below-market loan under section

7872.

We think that the provision in section 1.7872-13(c),

Proposed Income Tax Regs., is more appropriately viewed as only

applying to payments of below-market stated interest. In this

context, the parenthetical "if any" makes sense, as there may

well be no stated interest (as in the case at hand). Our

interpretation finds support in an example given later in the

proposed regulations. Section 1.7872-13(d), Example (2),

Proposed Income Tax Regs., 50 Fed. Reg. 33569 (Aug. 20, 1985),

treats partial repayments on an interest-free demand loan as

repayments of principal only, thereby requiring a separate

calculation of forgone interest.

Petitioners next attempt to bootstrap respondent's

adjustments to RSI's interest income and petitioners' itemized

deductions for interest expense under section 7872 (which

petitioners do not contest) into evidence that interest equal to

the AFR was paid in 1987 and 1988 on the loans. Petitioners

ignore the fact that, as the adjustments by respondent were made

after the years in question to reflect what petitioners and RSI

should have reported on their returns, the adjustments cannot

conceivably be relied upon to show that interest was in fact paid

in those amounts.

Petitioners posit that "the Commissioner has already enjoyed

the tax benefits of the interest payments and is now [unjustly]
 - 13 -

seeking an imputed dividend from the Petitioners." Petitioners

misconstrue the manner in which the transaction is viewed under

section 7872. As mentioned above, the statute treats a below-

market loan as a transfer from the lender to the borrower of an

amount equal to the forgone interest, and a retransfer of such

amount from the borrower to the lender as interest. Sec.

7872(a)(1). Pursuant to that treatment, petitioners have

received increased itemized deductions for interest to the extent

allowed by rules governing such deductions, and forgone interest

was included in income by RSI. It is integral to the statutory

scheme that petitioners also recognize the amount of forgone

interest as dividend income.

Finally, it is true that, in 1990, KPMG determined the

correct amount of interest that should have accrued on the debt

in order to have avoided the application of section 7872.

However, it is well established that a transaction is to be given

effect in accordance with what actually occurred, not with what

might have taken place under different circumstances.

Commissioner v. National Alfalfa Dehydrating & Milling Co., 417

U.S. 134, 148 (1974). Taxpayers are bound by the form of the

transaction they chose and must accept the tax consequences of

their choice. Id. at 149; Bradley v. United States, 730 F.2d

718, 720 (11th Cir. 1984). Since petitioners structured the

loans without stated interest during 1987 and 1988, they may not
 - 14 -

retroactively decide to make them interest bearing in an amount

equal to the AFR to achieve a more favorable tax result.

Based on the foregoing, we hold that dividend income was

properly imputed to petitioners under the provisions of section

7872 in 1987 and 1988 in the amount of $111,604 and $167,569,

respectively.

II. Are Petitioners Liable for Additions to Tax Under Section
6661 in 1987 and 1988 for a Substantial Understatement of Tax?

Respondent determined that petitioners are liable for

additions to tax for a substantial understatement of tax for 1987

and 1988 under section 6661.

As in effect for 1987 and 1988, section 6661(a) imposed an

addition to tax of 25 percent of the amount of any underpayment

attributable to a substantial understatement of tax. See

Pallottini v. Commissioner, 90 T.C. 498, 503 (1988). An

understatement is the amount by which the correct tax exceeds the

tax reported on the return. Sec. 6661(b)(2)(A). An

understatement is substantial if it exceeds the greater of 10

percent of the correct tax or $5,000 ($10,000 in the case of a

corporation). Sec. 6661(b)(1). Petitioners bear the burden of

proving that respondent's imposition of additions to tax under

section 6661 is erroneous. Rule 142(a); Tweeddale v.

Commissioner, 92 T.C. 501, 506 (1989).

Petitioners have adduced no evidence on this issue, nor did

they advance any reasons why the additions should not apply,
 - 15 -

other than their claim that there is no section 7872 adjustment

producing an understatement. (Petitioners do not contend that

they have substantial authority or that they adequately disclosed

the understatement under sec. 6661(b)(2)(B)(i) and (ii).) Since

we have held otherwise, if the recomputed deficiency under Rule

155 satisfies the statutory percentage or amount, petitioners

will be liable for such additions to tax. See Cluck v.

Commissioner, 105 T.C. 324 (1995). We have considered

petitioners' other arguments, and to the extent that they are not

addressed herein, we find them to be either irrelevant or without

merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.