T.C. Memo. 1999-395
UNITED STATES TAX COURT
ESTATE OF FREDERICK R. HOFFMAN, DECEASED,
MARILYN C. HOFFMAN, EXECUTOR,
AND MARILYN C. HOFFMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9952-98. Filed December 6, 1999.
Frank Agostino, Susan M. Flynn, and Andrew D. Engel, for
petitioners.
Craig Connell and Francis J. Strapp, Jr., for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: By notice dated April 3, 1998, respondent
determined deficiencies of $63,322, $76,801, and $60,804 in
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petitioners' 1994, 1995, and 1996 Federal income taxes,
respectively.
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. After concessions,
the issues are whether petitioners: (1) Have interest income,
pursuant to section 7872, from loans made to their controlled
corporation; and (2) are entitled to deduct, on their 1996 tax
return, 1997 real property taxes.
FINDINGS OF FACT
Frederick R. Hoffman died on August 15, 1996, and Marilyn C.
Hoffman was duly appointed executor of his estate. At the time
the petition was filed, Mrs. Hoffman resided in Woodville,
Virginia.
Petitioners were the controlling shareholders of, and
routinely advanced funds to, Hilltop Stud Farm, Inc. (Hilltop).
Petitioners routinely paid Hilltop’s expenses with personal
funds. Corporate and personal records reflected the advances
(including expense payments) as increases in petitioners’
shareholder loan accounts. Petitioners made nine advances in
1994, three in 1995, and four in 1996 (i.e., Hilltop’s fiscal
years ending March 31). Hilltop’s 1994, 1995, and 1996 Federal
income tax returns, signed by Mrs. Hoffman as its president,
reflected “Loans from stockholders” of $2,122,195, $1,613,053,
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and $1,751,372, respectively. Hilltop did not pay interest on
these amounts.
In 1994, Hilltop repaid petitioners $558,000 of the
advances. They did not report any of the $558,000 as income. In
that same year, Hilltop paid $416 to Electronic Keyboard Service
for repair of Mrs. Hoffman’s organ. Hilltop recorded this
transaction as a repayment of petitioners’ advances and reduced
Mrs. Hoffman’s shareholder loan account by $416.
Petitioners prepaid $5,520 of their 1997 real property taxes
and deducted that amount on their 1996 tax return.
Respondent determined that petitioners, pursuant to section
7872, had unreported interest income of $97,589, $106,483, and
$100,076 in 1994, 1995, and 1996, respectively. In addition,
respondent disallowed petitioners’ $5,520 prepaid real property
tax deduction.
OPINION
I. Interest Income From Loans
Section 7872 recharacterizes a below-market loan (i.e., loan
subject to a below-market interest rate) as 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 made a transfer of funds to the borrower, and the borrower
used these funds to pay interest to the lender. The transfer to
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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 KTA-Tator, Inc. v. Commissioner, 108 T.C. 100,
102 (1997).
Section 7872 applies to a transaction that is: (1) A “below-
market” loan, and (2) not described in any of certain enumerated
categories. See sec. 7872(c)(1), (e)(1), (f)(8). We discuss the
requirements in turn.
A. Below-Market Loan Requirement
To determine if the below-market loan requirement is
satisfied, we must ascertain whether a transaction is: (1) A
loan, (2) a demand or term loan, and (3) subject to a below-
market interest rate. See sec. 7872(e)(1).
1. Loan Requirement
Respondent contends that petitioners’ advances to Hilltop
were loans. Petitioners contend their advances were capital
contributions.
For purposes of section 7872, any transfer of money that
provides the transferor with a right to repayment, including an
advance, may be a loan. See KTA-Tator, Inc. v. Commissioner,
supra at 103. Petitioners transferred money to Hilltop,
recording the transfers as loans in their personal and corporate
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records and received repayments during the years in issue.
Contrary testimony offered by Mrs. Hoffman was vague,
contradictory, and unpersuasive. Therefore, we conclude that the
advances were loans for purposes of section 7872, and the loan
requirement is satisfied.
2. Demand or Term Loan
Below-market loans fit into one of two categories: Demand
loans and term loans. See sec. 7872(e)(1). 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. See
Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1339 (1971),
affd. without published opinion 496 F.2d 876 (5th Cir. 1974).
Petitioners made loans, without written repayment terms, to their
controlled corporation, and they determined when the loans would
be repaid. Therefore, we conclude that the loans are demand
loans.
3. 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
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applicable Federal rate (AFR) as determined under section
1274(d). See sec. 7872(e)(1)(A). Petitioners made loans to
Hilltop, and Hilltop did not pay interest on these loans.
Therefore, we conclude that the loans are below-market demand
loans.
B. Enumerated Category Requirement
Section 7872(f)(8) provides that section 7872 shall not
apply to any loan to which any of certain enumerated sections
applies. None of the enumerated sections applies to petitioners’
loans. Therefore, we conclude that the enumerated category
requirement is met, and section 7872 applies to petitioners’
loans.
Accordingly, we hold that petitioners, pursuant to section
7872, have interest income from below-market loans they made to
Hilltop. Petitioners contend, but have not established, that the
loans should be deducted, pursuant to section 166, as bad debts.
II. Deductibility of Prepaid Taxes
Section 164(a)(1) allows a deduction for real property
taxes. Deduction of prepaid real property taxes has been
disallowed where a cash basis taxpayer failed to establish that
the prepayment represented assessed, rather than estimated,
taxes, and that such taxes were due in the year they were paid.
See Hradesky v. Commissioner, 540 F.2d 821 (5th Cir. 1976), affg.
per curiam 65 T.C. 87 (1975). Petitioners have not established
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that their $5,520 prepayment represented assessed, rather than
estimated, taxes. In addition, they have conceded that the
$5,520 was not due in 1996. Accordingly, petitioners may not
deduct the $5,520 from their 1996 income.
Any other contention made by the parties is irrelevant,
moot, or meritless.
To reflect the foregoing,
Decision will be entered
under Rule 155.