Cohen v. Commissioner

92 T.C. No. 65, 92 T.C. 1039, 1989 U.S. Tax Ct. LEXIS 67

Opinion

OPINION

WILLIAMS, Judge:

The Commissioner determined deficiencies in petitioner’s Federal gift tax in the following taxable periods and amounts:

Calendar period ending Deficiency

Sept. 30, 1980. $15,599

Dec. 31, 1980. 19,782

Mar. 31, 1981 . 20,515

Jun. 30, 1981. 30,096

Sept. 30, 1981 . 32,379

Dec. 31, 1982. 75,140

Dec. 31, 1983. 142,033

Dec. 31, 1984. 2,954

Total deficiencies. 338,498

The issue we must decide is the appropriate interest rate to use in valuing the gift that results from an interest-free demand loan pursuant to Dickman v. Commissioner, 465 U.S. 330 (1984).

The facts of this case have been fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure, and are so found. Eileen D. Cohen, petitioner, is an individual who resided in Eau Claire, Wisconsin, during the period involved and when her petition was filed.

The Alyssa Marie Alpine Trust (First Trust) is an irrevocable trust formed by petitioner and Melvin S. Cohen, petitioner’s spouse, pursuant to a trust agreement for the Benefit of Alyssa Marie Alpine dated October 19, 1977, which designates Alyssa Marie Alpine (Alyssa) as its principal beneficiary. Alyssa is petitioner’s granddaughter. The Alyssa Marie Alpine Trust No. 2 (Second Trust) is an irrevocable trust formed by Edith Phillips (Edith), petitioner’s mother, pursuant to a trust agreement dated March 13, 1980, which designates Alyssa as its principal beneficiary. The 1983 Cohen Family Trust (1983 Trust) is an irrevocable trust Edith formed pursuant to a trust agreement creating the 1983 Cohen Family Trust dated June 3, 1983, which designates certain lineal descendants of Edith as its principal beneficiaries. (Hereinafter, the First Trust, the Second Trust, and the 1983 Trust are referred to collectively as the Trusts.) For Federal income tax purposes, petitioner and the Trusts reported on the cash basis method of accounting and used the calendar year as their taxable years.

Subsequent to and in reliance upon the court’s decision in Crown v. Commissioner, 585 F.2d 234 (7th Cir. 1978), affg. 67 T.C. 1060 (1977), petitioner (a resident of the Seventh Circuit) made non-interest-bearing demand loans to the First Trust, the Second Trust, and the 1983 Trust. All of the loans were evidenced by non-interest-bearing demand notes. Petitioner filed a Form 709, United States Quarterly Gift Tax Return, for the calendar periods ended December 31, 1980, and December 31, 1981, reporting certain gifts of cash and property which were excludable from taxable gifts under section 2503(b)² as in effect during the calendar years 1980 through 1984. Petitioner inadvertently filed Form 709, United States Quarterly Gift Tax Return, on an annual basis for the calendar years ended December 31, 1980, and December 31, 1981, instead of on a quarterly basis. Petitioner made no taxable gifts during the calendar year ended December 31, 1982, and December 31, 1983, other than the gifts made by the non-interest-bearing demand loans at issue herein, and petitioner originally filed no gift tax returns for these periods.

Petitioner did not report as taxable gifts the transfer of the value of the non-interest-bearing loans to the Trusts relying on the Crown decision that such non-interest-bearing loans did not give rise to taxable gifts. On August 16, 1984, after the Supreme Court’s decision in Dickman v. Commissioner, supra, petitioner filed an amended Form 709, United States Quarterly Gift Tax Return, for the calendar quarters ended December 31, 1980, and December 31, 1981, and filed an (amended) Form 709, United States Gift Tax Return, for the calendar years ended December 31, 1982, and December 31, 1983, reporting values for the non-interest-bearing demand loans made by petitioner to the Trusts as taxable gifts. After the Supreme Court’s decision in Dickman, petitioner also filed Form 709, United States Gift Tax Return, for the calendar year ended December 31, 1984, reporting a value for the non-interest-bearing demand loans made by petitioner to the Second Trust and the 1983 Trust as taxable gifts. Petitioner determined the value of the gifts by using the interest rates specified in sections 25.2512-5(e) and 25.2512-9(e), Gift Tax Regs. The rates were 6 percent from the beginning of the period at issue until November 30, 1983, and 10 percent from December 1, 1983, until the end of the period at issue. Although the returns for the calendar years ended December 31, 1982, and December 31, 1983, were marked “Amended,” petitioner had not filed original returns for these periods.

For the calendar periods ended September 30, 1980, December 31, 1980, March 31, 1981, June 30, 1981, September 30, 1981, December 31, 1982, December 31, 1983, and December 31, 1984, respondent concedes that petitioner is entitled to treat all gifts made by petitioner as being made one-half by petitioner and one-half by petitioner’s spouse in accordance with section 2513.

In the notice of deficiency, respondent determined that the non-interest-bearing demand loans made by petitioner to the Trusts resulted in taxable gifts. Respondent further determined that the value of each taxable gift is calculated by applying the following interest rates to the loan balances outstanding during each calendar year (simple interest):

Taxable year Interest rate

1979 6.0%

1980 11.5

1981 12.0

1982 10.6

1983 8.6

1984 9.9

These rates are set forth in Rev. Proc. 85-46, 1985-2 C.B. 507.

The statutory interest rates applicable to refunds and deficiencies of tax pursuant to section 6621 for the calendar years ending December 31, 1979, through December 31, 1984, are as follows:

Period Interest rate

Feb. 1, 1978 — Jan. 31, 1980. 6%

Feb. 1, 1980 — Jan. 31, 1982. 12

Feb. 1, 1982-Dec. 31, 1982 . 20

Jan. 1, 1983 — June 30, 1983 . 16

July 1, 1983-Dec. 31, 1984 . 11

The average annual rates of interest for three-month Treasury bills for the calendar years ending December 31, 1979 through December 31, 1983, used by the Treasury Department in developing Rev. Proc. 85-46, supra, are as follows:

Year Interest rate

1979. 10.041%

1980. 11.506

1981 . 14.029

1982. 10.686

1983 . 8.63

Generally, the interest rate on a demand loan does not exceed the interest rate on a term loan that is identical in all other respects.

From January 1, 1980, through December 31, 1984, the trustees of the First Trust invested the proceeds of the non-interest-bearing loans at issue primarily in short-term tax-exempt investments. From March 13, 1980 (the date of formation of the Second Trust), through December 31, 1984, the trustees of the Second Trust invested the proceeds of the non-interest-bearing loans at issue primarily in short-term tax-exempt investments and tax-exempt money market funds. From June 3, 1983 (the date of formation of the 1983 Trust) through December 31, 1984, the trustees of the 1983 Trust invested the proceeds of the non-interest-bearing loans at issue primarily in short-term tax-exempt investments. The weighted average annual percentage returns realized by the First Trust, the Second Trust and the 1983 Trust during the periods at issue are as follows:

First Trust Return

1979 . 3.26%

1/1/80-6/30/80

Footnotes

•

*. 8.29

Total. 5.76

Second Trust

1980 . 4.69

1981. 7.05

1982 . 7.20

1983 . 5.50

1/1/84-3/1/84*. 13.61

Total. 6.45

1983 Trust

1983 . .84

1/1/84 — 3/1/84. 17.89

Total. 5.63

In determining the gift tax deficiencies for the periods involved here, respondent redetermined the total amount of taxable gifts for periods prior to the period at issue here. In this redetermination of prior gifts, respondent included an amount for the taxable gift attributable to non-interest-bearing demand loans made by petitioner prior to the period at issue here. Petitioner concedes that respondent’s valuation of the prior period interest-free loans is consistent with his valuation of the interest-free loans for the periods before the Court.

The parties agree that in determining the value of the gifts petitioner made during the periods at issue here, the applicable interest rate the Court determines shall be applied to the average annualized loan amount of the loans made to the Trusts during the appropriate periods as follows:

Period, Calendar quarter ended: First trust Second trust 1983 trust

6/30/79 $56,017

9/30/79 356,644

12/31/79 423,554

3/31/80 554,643 $57,212

6/30/80 449,311 465,530

9/30/80 972,375

12/31/80 992,875

3/31/81 1,076,823

6/30/81 1,355,664

9/30/81 1,400,937

12/31/81 1,403,713

Year

1982 7,004,174

1983 5,589,432 $2,831,547

1984 322,276 1,116,170

The parties stipulated to the hypothetical rate of return which would have been realized on the loans at issue using the interest rates specified in sections 25.2512-5(e) and 25.2512-9(e), Gift Tax Regs. A summary of the parties’ stipulation is as follows:

Applicable actuarial Return

First trust Total loans rate (rate X loans)

6/15/79-6/30/80 $7,057,471 6% $423,448

Second trust

3/14/80-11/30/83 51,418,822 6% 3,085,129

12/1/83-3/1/84 673,817 10 67,382

1983 trust

6/6/83-11/30/83 5,879,234 6% 352,754

12/1/83-3/1/84 4,003,465 10 400,346

69,032,809 4,329,059

Overall yield for all of the loans: 6.271%

The issue before us is how to value the gift that results from an interest-free demand loan.³ Petitioner loaned money interest-free to trusts created for the benefit of family members. Petitioner loaned the funds to the trusts after the Seventh Circuit Court of Appeals held, in Crown v. Commissioner, 585 F.2d 234 (7th Cir. 1978), affg. 67 T.C. 1060 (1977), that no gift tax liability would result. After the Supreme Court reversed the Crown outcome, Dickman v. Commissioner, supra, petitioner filed gift tax returns on August 14, 1984, reporting the gifts for 1980 through 1983, and timely filed a gift tax return reporting the gifts for 1984. Petitioner valued the gifts relying on Rev. Rul. 73-61, 1973-1 C.B. 408. Respondent used the interest rates in Rev. Proc. 85-46 to determine the deficiencies against petitioner.

Petitioner argues that the appropriate rates are those found in section 25.2512-5 or 25.2512-9, Gift Tax Regs., as applicable to each taxable period pursuant to Rev. Rul. 73-61. Petitioner argues alternatively that the actual yields generated by the funds in the trust should determine the value of the gifts. In any event, petitioner contends that section 483 and the regulations thereunder provide an upper limit for the appropriate interest rate. Respondent contends that the interest rates in Rev. Proc. 85-46 are reasonable in light of the market interest rates and thus satisfy the Dickman requirement.

Interest-free demand loans result in taxable gifts of the reasonable value of the use of the money lent. Dickman v. Commissioner, 465 U.S. 330 (1984). Section 2501 imposes a tax on the transfer of property by gift. The tax applies whether the transfer is in trust or otherwise, direct or indirect. Sec. 2511(a). The amount of a gift of property is the fair market value of the property at the date of the gift. Sec. 2512(a); sec. 25.2512-1, Gift Tax Regs. The value of the interest-free loan is measured by the cost the donee would have incurred in borrowing the same funds.

Dickman v. Commissioner, supra, provides the starting point for determining the value of the gift. Prior to Dickman, respondent had attempted, unsuccessfully, to impose the gift tax on interest-free demand loans. See Crown v. Commissioner, 585 F.2d 234 (7th Cir. 1978), affg. 67 T.C. 1060 (1977); Johnson v. United States, 254 F. Supp. 73 (N.D. Tex. 1966). In Dickman, the Supreme Court held that interest-free demand loans result in “taxable gifts of the reasonable value of the use of the money lent.” (Fn. ref. omitted.) Dickman v. Commissioner, supra at 344. The Court reasoned that the right to use money is a valuable right, “readily measurable by reference to current interest rates * * Dickman v. Commissioner, supra at 337. In Dickman, respondent had determined the value of the gift by utilizing the interest rates applicable to a deficiency pursuant to section 6621.

Valuation, however, was not at issue in the appeal before the Supreme Court. Following the Supreme Court’s decision in Dickman, respondent issued a revenue procedure for determining the interest rate to value the gift resulting from an interest-free demand loan. Rev. Proc. 85-46, 1985-2 C.B. 507.⁴ This revenue procedure sets the interest rate for valuation at the lesser of (1) the statutory interest rate for refunds and deficiencies in section 6621 or (2) the annual average rate for three-month Treasury bills. Respondent used the Rev. Proc. 85-46 rates to value the gifts in the present case.

The Dickman opinion alludes to use of a market rate of interest to value the loans. Three-month Treasury bills and the section 6621 rates both reflect market rates of interest for short-term loans. Treasury bills are auctioned and issued weekly on the public market. Section 6621 provides for an adjustable interest rate based on the prime rate in all of the years before us.

Petitioner argues that Rev. Proc. 85-46 can be justly ignored because Rev. Rul. 73-61 required taxpayers to use sections 25.2512-5 and 25.2512-9, Gift Tax Regs., in valuing the gift resulting from interest-free demand loans. Because petitioners used the rates required by Rev. Rul. 73-61, they argue respondent should not be permitted to apply a different and higher set of rates to their gifts retroactively.

Rev. Rul. 73-61 discusses the gift tax consequences to a parent who lent $250,000 interest-free to his son’s wholly owned corporation, $200,000 payable on demand and $50,000 payable in ten years. The ruling concludes that the parent gave the use of the money to his son. Rev. Rul. 73-61, supra at 409. The 1973 ruling also states that the value of the term gift loan can be ascertained by accepted actuarial methods when the loan is made and is, therefore, subject to the gift tax at that time, citing section 25.2512-5, Gift Tax Regs. 1973-1 C.B. at 409. Section 25.2512-5, Gift Tax Regs., provides for actuarial valuation of annuities, life estates, terms for years, remainders, and reversions. With respect to the demand loan, however, the ruling states that the value of the gift was not ascertainable until the end of each calendar quarter during which the corporation had the use of the money. The valuation method for the demand loan was not specified in the ruling. The revenue ruling, therefore, provides no direct support for petitioner’s argument.

Petitioner, however, points to the Supreme Court’s acknowledgment that a demand loan, because of its inherently uncertain term, will bear a lesser interest rate than a term loan identical in other respects. Dickman v. Commissioner, 465 U.S. at 337. She argues, therefore, that a demand loan cannot bear a rate higher than the rate that respondent approved for the term loan in Rev. Rul. 73-61. Petitioner’s reliance on the interest rate utilized in Rev. Rui. 73-61 is, nevertheless, misplaced.

First, the interest rates prevailing in 1973 may well have been reflected by section 25.2512-5, Gift Tax Regs., but there is no doubt that, in the years before the Court, prevailing interest rates were much higher. Consequently, we can say that the regulation does not apply the market interest rate standard articulated by the Supreme Court in Dickman. Second, respondent applies in this case the lesser of Treasury bill rates or section 6621 rates. As a result, the interest rates applied by respondent in this case are comparable, if not identical, to the rates respondent used in Dickman which were not criticized by the Supreme Court. Finally, because the rates that respondent utilizes in valuing the gifts in this case are market rates extant while the loans were outstanding, there is no “retroactive” application of unforeseeable interest rates to petitioner’s prejudice.

Respondent’s “lesser of” three-month Treasury bills and section 6621 rates standard allows taxpayers to use a relatively low interest rate to compute gift values. The U.S. Government is the debtor with the lowest credit risk; its interest rates, therefore, should be lower than other market interest rates payable by other debtors whose credit worthiness is not so firm as that of the United States. See Goldstein v. Commissioner, 89 T.C. 535 (1987). It is highly improbable that a donee of an interest-free demand gift loan could borrow the funds at a lower interest rate than the one payable by the United States. Respondent, therefore, has selected a fair method of determining the reasonable value of the gifts that result from interest-free demand loans. Rev. Proc. 85-46 is based on a readily ascertainable yield on funds and provides a reliable method to determine the reasonable value of the use of the funds. In short, it satisfies the standards of valuation anticipated in Dickman v. Commissioner, supra at 344 n. 14.

Petitioner also argues that the actual yield of the loan proceeds is the proper measure of the gift if section 25.2512-5, Gift Tax Regs., does not apply. The issue, however, is not what the donee of an interest-free loan could have made if it invested the funds. On this point of valuation, the Supreme Court commented that “the Commissioner need not establish that the funds lent did in fact produce a particular amount of revenue; it is sufficient for the Commissioner to establish that a certain yield could readily be secured and that the reasonable value of the use of the funds can be reliably ascertained.” Dickman v. Commissioner, supra at 344 n. 14. The cost of the use of the funds (i.e., market interest rate), which is the measure of the value of the gift, does not depend on the soundness of the debtor’s use of the loan proceeds. A lender does not usually reduce the rate of interest because the debtor experiences a relatively low rate of return on investing the proceeds. The relevant inquiry is at what interest rate the donee could have borrowed the funds. See Dickman v. Commissioner, supra at 335 and n. 5. Petitioner’s argument, therefore, fails.

Petitioner also contends that, in any event, the interest rates in section 483 provide a cap on the interest rate respondent may impute for gift tax purposes, based on the Seventh Circuit’s decision in Ballard v. Commissioner, 854 F.2d 185 (7th Cir. 1988), revg. a Memorandum Opinion of this Court.⁵ Respondent argues that section 483 is irrelevant because this case does not involve a sale or exchange of property.

Section 483⁶ generally provided in the years at issue that interest would be imputed in installment sales contracts at an “unstated interest” rate if the contract did not provide for a “safe harbor” test rate of interest. The “safe harbor” test rates during the periods at issue were 6-percent simple interest until June, 30, 1981, and 9-percent simple interest thereafter. Sec. 1.483-1(d)(1)(ii), Income Tax Regs. The unstated interest rates during the periods at issue were 7 percent compounded semiannually through June 30, 1981, and 10 percent compounded semiannually thereafter. Sec. 1.483-1(c)(2)(ii), Income Tax Regs.

The Seventh Circuit Court of Appeals, to which an appeal would he in this case, recently considered section 483 in a gift tax context in Ballard v. Commissioner, supra. In Ballard, the taxpayer sold property to her children for a price less than fair market value on the installment method at a 6-percent interest rate. The taxpayer reported the difference between fair market value and the purchase price as a gift. The Commissioner determined that the 6-percent interest rate on the purchase price gave rise to an additional gift. He determined a deficiency in gift tax using an 18-percent market rate of interest to discount the purchase price even though the contract provided for interest at 6 percent, the section 483 “safe harbor rate.”

This Court held that the section 483 “safe harbor” interest rate could not be relied on for gift tax valuation purposes. The Seventh Circuit reversed and held that section 483 applies to the gift tax provisions of the Code as well as to the income tax provisions. Ballard v. Commissioner, supra at 188. The court based its holding on the introductory language of section 483 which states that section 483 applies, “for purposes of this title,” i.e., to all provisions of the Code. The court reasoned that,

although valuation of property, for purposes of gift taxes, is not directly related to the imputation of taxes on installment contracts for purposes of income taxation; a taxpayer who complies with Sec. 483 and charges a “safe harbor” rate of interest on an installment sales contract, should not be penalized if the “safe harbor” rate of interest is below the market rate of interest for purposes of gift tax valuation.

Ballard v. Commissioner, supra at 187.

The taxpayer in Ballard sold property on the installment method. Section 483, therefore, applied by its terms to the taxpayer in Ballard. The Ballard court held that when a taxpayer complies with the section 483 safe harbor rules in an installment sale, respondent cannot impute a higher market rate of interest to find a gift. The section 483 safe harbor protects taxpayers who sell property using the installment method for purposes of the gift tax as well as the income tax.

Section 483 by its terms, however, does not apply to transactions other than contracts for the sale or exchange of property. We look, therefore, to the purpose of section 483 to determine what effect it might have on transactions other than installment sales. Section 483 was designed by Congress to prevent sellers from converting ordinary income into capital gain by agreeing to deferred payment of the purchase price without stating how much of the deferred payments constituted interest. H. Rept. 749, 88th Cong., 1st Sess. (1963), 1964-1 C.B. (Part 2) 196. In the same transaction, buyers of depreciable property were able to depreciate the acquired property using an inflated basis. Section 483 was designed to provide a basis rule for installment sales by recharacterizing part of the stated principal payments as interest. The purposes underlying section 483 had nothing to do with valuation. In promulgating regulations that established “safe-harbor” and “imputed” interest rates, the Treasury Department did not peg the rates to any market interest rate. We conclude that section 483 does not provide appropriate interest rates under the Dickman standard for use in valuing the gift resulting from an interest-free demand loan.

Like section 483, section 482 also provides an imputed interest rate. We consider section 482 because, unlike section 483, it provides a rule specifically for imputing interest rates on interest-free demand loans in transactions between certain related taxpayers.

In general, section 482⁷ provides for the allocation of income and deductions among taxpayers. The purpose of section 482 is to place transactions of controlled taxpayers dealing with each other on a tax parity commensurate with the dealings between uncontrolled taxpayers dealing at arm’s length. Sec. 1.482-1(b)(1), Income Tax Regs. The section 482 regulations require an arm’s-length interest rate to be imputed if a taxpayer loans money to a controlled taxpayer in a business setting and charges no interest. Sec. 1.482-2(a)(1), Income Tax Regs. The regulations provide a safe harbor interest rate that taxpayers may use to avoid imputation of interest on loans between controlled taxpayers.

During the period at issue prior to July 1, 1981, the safe harbor rate was between 6 and 8 percent per annum simple interest. Sec. 1.482-2(a)(2)(iv), Income Tax Regs. For the remaining period at issue, the safe harbor rate was between 11 and 13 percent per annum simple interest. Sec. 1.482-2(a)(2)(iii), Income Tax Regs. These safe harbor rates applied to interest-free loans unless the taxpayer established a more appropriate rate under the circumstances.

The section 482 rates were changed occasionally to reflect market interest rates. The rate changes during the periods at issue, however, lagged considerably behind actual market changes.⁸ Dickman requires us to measure the economic value associated with the use of the money; this value is “readily measurable by reference to current interest rates.” Dickman v. Commissioner, supra at 337. The regulations, which did not provide current interest rates, therefore, do not provide an appropriate rate to determine value for gift tax purposes. Moreover, we note, the rates chosen administratively by respondent in Rev. Proc. 85-46 and applied in this case are more beneficial to petitioner than the section 482 rates for the years at issue.

Petitioner also argues that the rates chosen by respondent in Rev. Proc. 85-46 are not theoretically correct and, consequently, that we should disregard them. Petitioner points out that any interest chargeable to the trusts on their loans would have turned on many factors, including the loan mix of the lender, availability and cost of funds to the lender, prevailing interest rates locally, local economic conditions, the credit status and history of the debtor, the debtor’s reputation in the community, etc.- — i.e., all the variables that go into a financial institution’s decision on what to charge for lending money to a specific borrower on a given day. While respondent’s approach may not have been theoretically pure, we commend respondent for promulgating easily administrable, readily ascertainable, comprehensible standards that, in our view, seem generous in their application to petitioner.

Decision will be entered for the respondent.

2

All section references are to the Internal Revenue Code of 1954 as in effect for the years at issue, unless otherwise indicated.

Date of repayment of all loans.