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.