113 T.C. No. 28
UNITED STATES TAX COURT
ROUNTREE COTTON CO., INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24014-97. Filed December 16, 1999.
R determined that C made below-market-interest loans directly and indirectly to C’s shareholders within the meaning of sec. 7872, I.R.C. The “indirect” loans were to entities owned in part by C’s shareholders. C contends that sec. 7872, I.R.C., was not intended to apply to a loan by C to a shareholder of C who does not have a majority or controlling interest in C. C also contends that sec. 7872, I.R.C., does not apply to a loan by C to an entity in which no shareholder of C individually holds a controlling or majority interest. R contends that the below-market- interest loans to entities were all made indirectly to C’s shareholders. All of C’s shareholders were members of the same family, and each of the entities was owned entirely by members of that family, although some of them were not shareholders of C. R argues that sec. 7872, I.R.C., does not require that C’s shareholders have a majority or controlling interest in the entities - 2 -
to which the “indirect” loans were made in these circumstances. C also contends that R cannot make determinations with respect to it without making corresponding adjustments to the income taxes of its shareholders. R argues that such adjustments are not a prerequisite to the making of a determination with respect to one of the parties to a sec. 7872, I.R.C., below-market- interest loan. Held: Sec. 7872(c)(1)(C), I.R.C., applies to C’s loans to each of its shareholders and to C’s loans to each of the family-owned entities in which C’s shareholders held an interest. Held, further: Sec. 7872, I.R.C., requires “consistent” treatment but does not require that R make both adjustments concurrently or determine one before determining the other.
Towner Leeper, for petitioner.
Gerald L. Brantley, for respondent.
OPINION
GERBER, Judge: Respondent determined income tax
deficiencies in petitioner’s taxable years ended August 31, 1994
and 1995, in the amounts of $19,094 and $16,944, respectively.
The deficiencies are attributable to respondent’s determination
that petitioner made “below-market loans” within the meaning of
section 7872.1 More particularly, we consider a question of
first impression of whether the provisions of section 7872 apply
1 All section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to this Court’s Rules of Practice and Procedure, unless otherwise indicated. - 3 -
where petitioner makes loans to its shareholders and to entities
owned in part by its shareholders and in part by other members of
the same family.
Background
Petitioner is a corporation that, at all pertinent times,
had its principal place of business in Las Cruces, New Mexico.
Petitioner was engaged in cotton brokerage and, for Federal
income tax purposes, reported gross income of $1,276,431 and
$1,913,962 for its fiscal 1994 and 1995 tax years, respectively.
At all pertinent times, the shares of stock of petitioner were
owned by family members related by blood or marriage as follows:
Ownership Shareholders (%) William Tharp 16.8 Est. of Glenda Tharp 16.7 Charles Tharp 33.5 Claudia Keith 33.0 Total 100.0
William and Charles Tharp and Claudia Keith are all children of
Claud Tharp, who did not own any shares of petitioner. Glenda
Tharp, now deceased, was the wife of William Tharp.
During the fiscal years in issue, shareholders of petitioner
and related family members owned or had an interest in certain
entities as follows: (1) Charles Tharp and his son, Craig Tharp,
each owned a 50-percent interest in the capital and profits of
the Buena Vista Partnership; (2) the Dona Ana Land Corp.’s shares
of stock were owned in the following percentages: William - 4 -
Tharp--14.5 percent, Charles Tharp--29 percent, Claudia Keith--9
percent, Claud Tharp--33 percent, and the Estate of Glenda
Tharp--14.5 percent; (3) capital and profit interests in the
Tharp Family Partnership were owned, as follows: William Tharp--
10 percent, Charles Tharp--10 percent, Claudia Keith--10 percent,
and each child of William, Charles, and Claudia owned a 10-
percent interest, accounting for the remaining 70 percent; (4)
capital and profit interests in the Tharp Farms Partnership were
owned as follows: William Tharp--30 percent, Charles Tharp--30
percent, Claudia Keith--20 percent, Claud Tharp--20 percent; and
(5) capital and profit interests in the Tharp Enterprises
Partnership were owned as follows: William Tharp--25 percent,
Charles Tharp--25 percent, Claudia Keith--25 percent, and Claud
Tharp--25 percent. The various interests of petitioner’s
shareholders and of other family members in the entities to which
indirect loans were made are reflected in a chart attached to
this opinion as an appendix.
The following interest-free loans were made by petitioner
directly to shareholders:
Demand Note Borrower Dated Amount Charles Tharp Aug. 31, 1994 $29,978.74 William Tharp Aug. 31, 1994 11,100.00 William Tharp Aug. 31, 1994 28,113.21
Respondent’s agent computed interest at the applicable Federal
rate on the loans directly to shareholders in the aggregate - 5 -
amounts of $3,143 and $3,416 for petitioner’s fiscal tax years
ended August 31, 1994 and 1995, respectively.
The following interest-free loans, evidenced by promissory
notes, were made by petitioner to entities that were, in some
part, owned by petitioner’s shareholders:
Demand Note Borrower Dated Amount Buena Vista Partnership Aug. 31, 1994 $27,575.14 Dona Ana Land Corp. Aug. 31, 1994 50,412.27 Tharp Family Partnership Aug. 31, 1994 2,599.12 Tharp Farms Partnership Aug. 31, 1994 581,889.39 Tharp Enterprises--Farms1 Aug. 31, 1994 401,855.24 Tharp Enterprises--Equipment1 Aug. 31, 1994 16,200.00 1 It appears that these two loans were both made to Tharp Enterprises Partnership and that the “Farms” and “Equipment” designations reflected the bank accounts into which they were to be deposited.
During the taxable years under consideration, an additional
$111,707.20 interest-free loan was extended by petitioner to
Tharp Enterprises Partnership that was not evidenced by a
promissory note.
Respondent’s agent computed interest at the “applicable
federal rate” on the indirect loans (not directly to
shareholders) in the aggregate amounts of $45,816 and $46,447 for
the fiscal tax years ended August 31, 1994, 1995, respectively.
The total amounts of imputed interest determined by respondent
for petitioner’s 1994 and 1995 fiscal years were $48,959 and - 6 -
$49,836.2 Respondent’s agent’s initial computation and the
amounts set forth in the notice of deficiency were computed on a
fiscal year basis. A second computation by respondent, submitted
for trial purposes, was based on imputed interest for the 1994
and 1995 calendar years in the aggregate amounts (including
direct and indirect loans) of $19,476 and $59,832, respectively.
Discussion
I. Procedural/Evidentiary Matter
This case was submitted fully stipulated by the parties
under Rule 122. Respondent, however, reserved an objection to
the admissibility (relevance) of Exhibit 17-P, which is
respondent’s revenue agent’s report that was prepared and given
to petitioner before issuance of the notice of deficiency.
Respondent contends that the revenue agent’s report is not
admissible (relevant) in this instance. In support of his
position, respondent points out that the Court considers the
parties’ positions de novo and the pre-deficiency-notice
administrative record is therefore irrelevant. See Greenberg’s
Express, Inc. v. Commissioner, 62 T.C. 324 (1974). Respondent
acknowledges, however, that in certain limited circumstances, the
Court will “look behind the deficiency notice”. Such instances
2 In the notice of deficiency, respondent determined $49,836 of 1995 interest. The correct amount, however, should have been $49,863. The transposition of the numbers 3 and 6 caused a $27 difference. - 7 -
include unconstitutional conduct by respondent’s employees, see,
e.g., Riland v. Commissioner, 79 T.C. 185 (1982), and certain
types of illegal income cases, see, e.g., Shriver v.
Commissioner, 85 T.C. 1 (1985). Petitioner does not contend that
respondent’s determination is arbitrary or that unconstitutional
conduct occurred. We agree with respondent and find no reason to
consider respondent’s agent’s pre-deficiency-notice report in
reaching our decision. Respondent’s objection is sustained with
respect to proposed Exhibit 17-P.
II. Section 7872
The primary question for our consideration concerns whether
petitioner must include interest, pursuant to section 7872,
attributable to interest-free loans made to entities (a
corporation and three partnerships) owned in whole or part by its
shareholders. Before the enactment of section 7872, the
Commissioner was generally unsuccessful in attempting to
attribute or impute income from interest-free or below-market
loans.3 See Dean v. Commissioner, 35 T.C. 1083 (1961); Greenspun
v. Commissioner, 72 T.C. 931 (1979), affd. 670 F.2d 123 (9th Cir.
1982); Suttle v. Commissioner, 625 F.2d 1127 (4th Cir. 1980),
affg. T.C. Memo. 1978-393; Martin v. Commissioner, 649 F.2d 1133
3 Respondent, however, was ultimately successful, in a gift tax context, in situations where below-market loans were made between family members. See Dickman v. Commissioner, 465 U.S. 330 (1984). - 8 -
(5th Cir. 1981); Beaton v. Commissioner, 664 F.2d 315 (1st Cir.
1981), affg. T.C. Memo. 1980-413.
Congress, in 1984, addressed these and other related
concepts by enacting section 7872. See Deficit Reduction Act of
1984, Pub. L. 98-369, sec. 172(a), 98 Stat. 699. That section
concerns the subject of “below-market loans” in several contexts,
including those between family members, partnership/partner,
employer/employee, corporation/shareholder, and other related-
party categories. We described the general effect of section
7872 in KTA-Tator, Inc. v. Commissioner, 108 T.C. 100, 101-102
(1997), as follows:
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 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 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; 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).
Petitioner advances several arguments in support of its
overall contention that the loans it made do not come within the
provisions of section 7872. Petitioner contends that it has - 9 -
suffered by the Government’s 15-year failure to issue final
regulations, although Congress, in the 1984 statute, mandated
that certain legislative regulations be promulgated. Petitioner
also contends that case precedent, before the 1984 enactment of
section 7872, established that imputed interest should apply to a
loan by a corporation only if the loan is to a sole or
controlling shareholder. In addition, petitioner contends that
section 7872 legislative history supports its contention that the
section is limited to situations involving controlling
shareholders.
The below-market loan provisions of section 7872 apply,
among other circumstances, to “Any below-market loan directly or
indirectly between a corporation and any shareholder of such
corporation.” Sec. 7872(c)(1)(C). In that respect, petitioner
reads section 7872 as referring to a loan by a corporation to its
majority or controlling shareholder or to a loan by a corporation
to an entity in which one of the lending corporation’s
shareholders owns a majority interest. Petitioner relies on the
fact, in this case, that there is no one individual with a
majority of its shares or who is a controlling shareholder of
petitioner. Petitioner also relies on the fact that no
individual shareholder of petitioner had a majority or
controlling interest in any of the entities to which “indirect” - 10 -
loans were made. We consider each of petitioner’s contentions
separately.
The Failure To Issue Final Regulations--Petitioner contends
that the Government’s failure, for almost 15 years, to issue
final or permanent regulations as mandated by Congress in section
7872(h)(1) was to petitioner’s detriment.4 That section contains
the requirement that the Secretary prescribe regulations in
several broad areas, including for the
purpose of assuring that the positions of the borrower and lender are consistent as to the application (or nonapplication) of * * * [section 7872] and * * * exempting * * * transactions the interest arrangements of which have no significant effect on any Federal tax liability of the lender or the borrower.
Sec. 7872(h)(1)(B) and (C). Petitioner contends that if final
regulations had been promulgated, it would have been to its
benefit. Petitioner, however, has not identified any particular
benefit that would have been conferred, the substance of any
regulations envisioned by petitioner, or the reason(s) for such
regulations.
The Commissioner, during 1985 and before the time the loans
herein were made, published proposed regulations. See secs.
4 Petitioner’s argument is obscure in that no explanation is provided as to how the issuance of the final regulations would have provided a better situation for petitioner or changed the outcome of this case. It is more likely than not that respondent’s litigating position and regulation(s) would have been equivalents. Petitioner’s concern about the absence of final regulations is also less compelling where, as here, some guidance was provided by the issuance of proposed regulations. - 11 -
1.7872-1 through 1.7872-13, Proposed Income Tax Regs., 50 Fed.
Reg. 33556-33569 (Aug. 20, 1985). The Commissioner also
published one temporary regulation. See sec. 1.7872-5T,
Temporary Income Tax Regs., 50 Fed. Reg. 33521 (Aug. 20, 1985).
Petitioner contends that the proposed regulations do not have the
force and effect of law and are not to be given any more
deference than respondent’s litigating position, citing KTA-
Tator, Inc. v. Commissioner, supra at 102-103.
The proposed regulations did provide taxpayers with guidance
as to the Commissioner’s section 7872 position regarding certain
aspects of the issues in this case and the broad areas Congress
mandated for legislative regulations. We note that the proposed
and temporary regulations were published substantially in advance
of the making of the loans in question. In that regard, the
Commissioner’s proposed and temporary regulations contain
exemptions from section 7872, de minimis rules, and
interpretations and rules regarding below-market loans. The
proposed and temporary regulations are generally unfavorable to
petitioner’s position. Accordingly, if the Commissioner had
converted the proposed regulations to final or permanent status,
it would not have been beneficial to petitioner or its
Respondent has scrupulously avoided reliance upon or
reference to the proposed regulations. In response to - 12 -
petitioner’s complaint about the absence of final regulations,
respondent argues that the statute is clear and unambiguous
concerning the issues before the Court and that there is no need
to seek interpretation or guidance from any regulation. In
addition, respondent contends that the section 7872(h) areas for
which regulations were mandated and which were referenced by
petitioner have no bearing on the questions before the Court.
We first consider the statutory language in our search for
an answer. See United States v. American Trucking Associations,
Inc., 310 U.S. 534, 542-543 (1940); Hospital Corp. of Am. v.
Commissioner, 107 T.C. 116, 128 (1996). If the language of the
statute is clear, we need look no further in deciding its
meaning. See Sullivan v. Stroop, 496 U.S. 478, 482 (1990).
Petitioner’s Controlling Shareholder Argument--Below-market
loans between corporations and shareholders may come within the
provision of section 7872. In particular, section 7872(c)(1)(C)
makes section 7872 applicable to “Any below-market loan directly
or indirectly between a corporation and any shareholder of such
corporation.” The loans in question were without interest, and,
if the other threshold requirements are met, the loans would be
subject to section 7872.
Petitioner’s primary attack on respondent’s determination is
based on the fact that each of its shareholders has less than a
majority or controlling interest in petitioner and that the - 13 -
entities to which petitioner made (indirect) loans were not owned
entirely by petitioner’s shareholders. In support of its
approach, petitioner first focuses on the statutory language.
Petitioner argues that the singular use of the term “shareholder”
in the phrase “between a corporation and any shareholder” is
intended to reflect that attribution rules do not apply.
Respondent’s counsel, for the record, states that there was no
reliance on the attribution rules of sections 267 and 318 in this
case. Section 7872 does not require that a corporate loan be
made to a controlling or majority shareholder. The statutory use
of the term “any” preceding the term “shareholder” would obviate
the need for respondent to rely on attribution rules for
application of section 7872 in connection with a transaction with
a minority shareholder. Petitioner’s argument concerning the
loans made directly to its shareholders is refuted by the plain
language of the statute.
As to the “indirect” loans, respondent’s argument is that
petitioner’s shareholders are members of the same family and that
they, along with other family members, own the entities to which
indirect loans were made. In that regard, Claud Tharp (father of
three of petitioner’s shareholders and father-in-law of the
fourth) is the only nonshareholder with a substantial interest in
the two entities to which the vast majority of the indirect loans
were extended. - 14 -
Petitioner also argues that court holdings addressing
“below-market loans” fact patterns, both before and after the
enactment of section 7872, concerned majority or controlling
shareholders. Petitioner concludes that these cases, therefore,
stand for the proposition that without control by a shareholder
there can be no imputed interest. On that point, however,
insofar as it pertains to the loans made directly to petitioner’s
shareholders, the terms of section 7872(c)(1)(C) are clear; i.e.,
it applies to loans “between a corporation and any shareholder”
(emphasis added). Again, there is no ambiguity or room for
interpretation of the statutory language regarding its
application to shareholders who are not controlling or majority
shareholders. It appears, to some extent, that section 7872 was
enacted in response to the cases that petitioner has relied upon
and in which the Commissioner was generally unsuccessful in
pursuing below-market loan situations.
In addition, the pre- and post-enactment opinions, although
they involve controlling shareholder fact patterns, do not
reflect any consideration of a threshold requirement that below-
market loans be made to a majority shareholder.5 Finally,
5 To the contrary, the Commissioner was unsuccessful in the corporation/shareholder cases for reasons that had no relationship to the number of shares held by the taxpayer. Although share ownership may have some relationship to dividend and constructive dividend situations, that aspect was not focused upon in the line of cases referenced by petitioner. - 15 -
petitioner did not provide a reason why Congress would have
intended that the provisions of section 7872 be limited to loans
made to a majority shareholder. To the contrary, it appears that
Congress did not intend to limit the focus of section 7872 to
loan transactions between controlled entities. Section 7872
addresses below-market loans in several settings where there is
no ownership or control factor whatsoever; i.e., employer/
employee and independent contractor/client. The intent and
context of section 7872 is not limited to situations where there
is control between the lender and the borrower or control over
the ultimate borrowing entity in “indirect” loan situations.
This general absence of a control requirement is bolstered by the
specific language of section 7872(c)(1)(C) causing the statute to
apply to “any shareholder”.
Petitioner also refers to a portion of H. Conf. Rept. 98-861
(1984), 1984-3 C.B. (Vol. 2) 1 (legislative history for section
7872), in support of its position that Congress intended to limit
corporate section 7872 loans to situations involving controlling
shareholders. As part of a paragraph explaining “Family loans
and non-family demand loans”, the House report contains the
following statement:
In the case of a demand loan from a closely held corporation to a controlling shareholder, the transfer would be treated as a distribution with respect to the stock of the distributing corporation and be taxed to the shareholder as a dividend to the extent of the - 16 -
distributing corporation’s earnings and profits under section 301.
H. Conf. Rept. 98-861, supra at 1013, 1984-3 C.B. (Vol. 2) at
267.
Petitioner’s quotation from the House report is not
compelling because it is taken out of context and appears to be
an example of the application of section 7872 in a corporate
setting involving a demand note. The above-quoted House report
language is not designed to limit the application of section 7872
to situations involving controlling shareholders. The reference
to “a controlling shareholder” may also relate to the
corresponding “dividend” mentioned later in the quoted sentence.
More importantly, the statutory language “any shareholder” is
clear, without limitation, and unambiguous, and there is no need
to seek out the legislative intent in the underlying legislative
history. The portion of the legislative history relied on by
petitioner is also far from being directly on point or probative
in support of petitioner’s position. Accordingly, we hold that
section 7872 may apply to a loan to a majority or a minority
shareholder.
Petitioner’s Indirect Loan Argument--We next consider
petitioner’s arguments that section 7872 should not apply to the
“indirect loan” situations. Petitioner declares that 7 of the 10
loans in question were “indirect” (not made directly to
shareholders) and do not come within the purview of section 7872. - 17 -
More particularly, petitioner contends that the “indirect loans”
were made by petitioner to partnerships or entities in which none
of petitioner’s shareholders individually held a controlling
interest. Finally, petitioner points out that some of the
partners or owners of the entities that received loans were not
shareholders of petitioner.
The specific concern raised by petitioner’s arguments
focuses upon petitioner’s shareholders’ partial interest in the
entity that receives the benefit of the below-market loan and in
the receiving entity. Although the borrowing entity receives the
full benefit of the indirect loan, petitioner’s shareholder(s)
are each only partially benefited by the loan because of their
less than complete ownership of the borrowing entity. An adjunct
question concerns the treatment of a nonshareholder of petitioner
who may be benefited because of his ownership interest in the
borrowing entity.
The statute includes “Any below-market loan directly or
corporation.” Sec. 7872(c)(1)(C). Indirect loans are
includable, but the statute does not specifically address the
possibility that indirect loans may ultimately benefit a person
or entity other than a shareholder or that the shareholder may
ultimately receive less benefit than the full amount lent. The
proposed regulations generally address indirect loans by - 18 -
[restructuring them] as two or more successive below- market loans (“deemed loans”) * * *, as follows:
(i) A deemed below-market loan made by the named lender to the indirect participant [e.g., a shareholder of the lender]; and
(ii) A deemed below-market loan made by the indirect participant to the borrower [third party or nonshareholder].
Sec. 1.7872-4(g)(1)(i) and (ii), Proposed Income Tax Regs., 50
Fed. Reg. 33561 (Aug. 20, 1985). Where one corporation makes a
loan to another under common control, the proposed regulations
restructure it as a loan from the lending corporation to its
parent followed by a loan from the parent to the borrowing
entity. Thus the proposed regulations treat the entire loan as
being made first to the shareholder(s) of the lender.
The proposed regulations do not directly address the
questions, raised by petitioner, concerning whether a
nonshareholder would be subject to section 7872 under the facts
before us or how the nonshareholder would be treated in
connection with any benefit received from the receipt of a below-
market loan by the borrowing entity.6 Although those questions
are raised and argued by petitioner, we do not have before us
6 The remainder of the proposed regulations concerning indirect loans contains some examples and focuses on the following situations: (1) Applying sec. 7872 separately to each deemed loan, and (2) dealing with circumstances where intermediaries are used to “avoid the application of section 7872(c)(1)(A), (B), or (C)”. Sec. 1.7872-4g(2), Proposed Income Tax Regs., 50 Fed. Reg. 35561 (Aug. 20, 1985). - 19 -
questions about how the shareholders or nonshareholders are
individually taxed. Here, we have jurisdiction solely over
whether petitioner, a corporation, is subject to section 7872 and
whether imputed interest arises from the interest-free loans it
made to its shareholders and the related entities.
Petitioner, however, is contending that distortion is caused
by the application of section 7872 to situations where a
corporation makes loans to an entity in which both shareholders
and nonshareholders of the lending corporation have ownership
interests. Petitioner explains that Claud Tharp, who owned no
shares in the lending corporation (petitioner), did own 20
percent of the Tharp Farms Partnership and 25 percent of Tharp
Enterprises Partnership, entities that received most of the
proceeds of the indirect below-market loans. Petitioner’s
argument contains the implication that respondent would be unable
to make dividend income adjustments to all participants in the
entity to which indirect loans are made. Petitioner theorizes
that respondent’s alleged inability should preclude respondent
from determining that the lending corporation had income
attributable to the below-market interest. Petitioner’s position
is somewhat myopic because section 7872 is not limited to
transactions between corporations and shareholders. It may
result in below-market loans being treated in part as gifts,
dividends, contributions of capital, payments of compensation, or - 20 -
some other type of payment, depending on the substance of the
transaction. Accordingly, there would be no lack of continuity
where an indirect below-market loan was made by a corporation to
an entity that was owned by the lender’s shareholders and
nonshareholders of the borrowing corporation.
In that same vein, respondent contends that there is no
statutory prerequisite that a corresponding or correlative
adjustment be made to the tax of a hypothetical borrower before
making an adjustment to the tax of the lender. Although
respondent states that he is able to determine an adjustment with
respect to petitioner’s shareholders, he contends that his
failure to do so would not necessarily preclude a determination
with respect to petitioner’s taxes. In support of this
contention, respondent relies on an explanation in KTA-Tator,
Inc. v. Commissioner, 108 T.C. at 106-107, that dividend income
determined by the Commissioner may be offset by the shareholder’s
interest deductions, but the lending corporation would not be
entitled to a corresponding deduction attributable to the deemed
dividend distribution against its imputed interest income.
Although the holding of KTA-Tator, Inc. has no direct bearing on
the questions involving “indirect” loans, the discussion in that
case illustrates that one party to a below-market loan may end up
with a tax liability, and the other may incur no net tax effect.
That, however, does not specifically focus on the question of - 21 -
what is meant by “consistency” between the lender and the
borrower.
In section 7872(h)(1)(B), the Secretary was mandated to
prescribe “regulations for the purpose of assuring that the
positions of the borrower and lender are consistent as to the
application (or nonapplication) of this section”. We do not read
that language as requiring regulations that provide for
correlative or numerically corresponding adjustments between a
lender and a borrower. We understand that language to call for
regulations that ensure that both parties to the transaction
would or would not be subject to the effect of section 7872. So,
for example, if it were determined that an employer made a below-
market loan to a nonshareholder employee under section 7872, to
be consistent, the Commissioner would be required to consistently
treat both the employee and the employer as subject to the
provisions of section 7872. Treating them consistently may
require the Commissioner to permit appropriate deductions to a
party to a loan transaction as though the interest had actually
been paid. If, however, the Commissioner was barred from
treating one of the parties to the loan consistently because of
the expiration of the period for assessment, that would not - 22 -
preclude the determination of appropriate income or deductions
for a taxpayer whose period for assessment remained open.7
Petitioner’s argument also raises the adjunct question of
whether respondent’s inability to make adjustments to
nonshareholders of the borrowing entities has any effect on the
application of section 7872. With respect to these questions,
the statutory language applying section 7872 directly or
indirectly to loans or to any shareholder does appear to answer
questions of whether the statute applies to indirect loans
involving nonshareholders. This is a situation where the
issuance of final regulations might have been helpful to address
the tax effect of the below-market loans on the recipients, but
the taxability with respect to the lender is adequately set out
in the statute.
Because section 7872 is to be applied to a loan made
“directly or indirectly” between a corporation and any
shareholder of the corporation, we find the ordering approach
used in the proposed regulations to be an effective way to
address the issue we consider here. Under the proposed
7 The record does not reveal whether respondent made “consistent” or any determinations with respect to shareholders or nonshareholders or whether respondent is currently limited in his ability to do so. Petitioner merely argues, in the abstract, that respondent should not be permitted to make the determination in this case without making one for the shareholders or perhaps others. If respondent has not already done so, we do not believe that petitioner’s shareholders are inviting respondent to make deficiency determinations against them under sec. 7872. - 23 -
regulations, indirect loans are treated as from the lender to the
indirect participant and then to the borrower.8 That is one
logical method to determine the effect of the below-market loans
on all the participants and to treat direct and indirect loans
similarly. In this setting, the loans are being made by a
family-owned corporation indirectly to shareholders through
family-owned entities. The ability to make such loans depends on
petitioner’s shareholder(s), and so the whole amount of the loan
is first attributable to the shareholders’ relationship with the
lender. After that point, the flow from the lender’s
shareholders to others, whether partners, nonshareholders, or
some other relationship, would be subject to section 7872 only if
that transaction came within the statutory ambit. The effect and
handling of any separately hypothecated loans after those
considered to the lender’s shareholders present a more complex
question that would be better addressed in regulations and is one
we need not address here.
We recognize that there could be some questions about the
amount of any dividend to the shareholder(s) in an indirect loan
situation, especially where the borrowing entity does not
8 The proposed regulation restructures indirect loans into separate loans as follows: “(i) A deemed below-market loan made by the named lender to the indirect participant; and (ii) A deemed below-market loan made by the indirect participant to the borrower.” Sec. 1.7872-4(g)(1)(i) and (ii), Proposed Income Tax Regs., 50 Fed. Reg. 35561 (Aug. 20, 1985). - 24 -
comprise solely shareholders. We need not answer those questions
in this setting, however, because we are able to deal with the
entire loan from the corporation to the shareholder within the
statutory framework and without reference to any regulation. To
the extent that Tharp family members who were not shareholders
received some benefit from the below-market loans, they did so
only because the lender’s shareholders (who were also Tharp
family members) made the decision or choice that they so benefit.
Also, because of our holding on the ordering of the indirect
loans, any benefit received by nonshareholders would have been
received from petitioner’s shareholders.
Parts of section 7872 (other than the one addressing
corporations and shareholders) concern below-market loans in
several types of situations. None of the various section 7872
applications addressing below-market loans require that each
dollar lent benefit the intended borrower directly or fully. We
know this because the statute applies to indirect loans, and, by
definition, such loans can be to a person or entity other than
the shareholder or corporation referenced in section
7872(c)(1)(C).
Respondent, on brief, argues that “the interest-free demand
loans were made by petitioner to the borrowing entities solely to - 25 -
confer an economic benefit * * * to petitioner’s shareholders,
who also owned and controlled the borrowing entities.”9
We agree with respondent that the circumstances in this case
are such as Congress intended would trigger the lender’s
recognition of forgone interest under section 7872(c)(1)(C).
Petitioner would have us focus on the fact that no shareholder of
petitioner individually held a majority of petitioner’s stock
and, as to indirect loans, that persons who were not shareholders
of petitioner owned interests in the entities that received the
below-market loans. Petitioner’s focus, however, overlooks the
fact that all of the shareholders of petitioner were part of the
same family and, of necessity, collectively agreed to make or
permit the making of below-market loans both directly to
themselves and indirectly to their family-controlled entities.
In the same vein, the “indirect borrowing entities” were
exclusively composed of family members, including petitioner’s
shareholders and in some instances the shareholders’ father or
children.
The below-market loans were being made within a tightly
controlled conglomeration of Tharp family members and entities
9 Respondent does not rely on the attribution provisions of sec. 267 or 318 for his interpretation of the language of sec. 7872. Respondent does, however, ask us to focus on the fact that petitioner and the entities to which it made loans were all owned and controlled by persons having a close family relationship. No ownership interest in any of those entities was held by an individual outside of the family. - 26 -
for the benefit of Tharp family members, most of whom were
shareholders of petitioner. This is the type of situation that
section 7872 was intended to address. In the setting of this
case, if there had been significant ownership of the borrowing
entities by anyone who did not belong to the Tharp family, we do
not think it likely that interest-free loans to those entities
would have been made by petitioner. In view of the foregoing, we
hold that the direct and indirect loans made by petitioner come
within the provisions of section 7872(c)(1)(C) and that interest
should be imputed to petitioner.
That does not end our inquiry, however, because respondent,
in the notice of deficiency, computed the amount of interest to
be imputed to petitioner on the basis of the loans outstanding
during each of petitioner’s taxable years. For tax purposes,
petitioner used a fiscal year ending on August 31. Petitioner,
however, argues that section 7872 requires an interest
computation based on a calendar year. Section 7872(a)(2)
provides that
Except as otherwise provided in regulations prescribed by the Secretary, any foregone interest attributable to periods during any calendar year shall be treated as transferred (and retransferred) under paragraph (1) on the last day of such calendar year.
The Commissioner did not publish any final or temporary
regulations that vary from the rule stated in section 7872(a)(2). - 27 -
The total amounts of imputed interest determined by
respondent for petitioner’s 1994 and 1995 fiscal years were
$48,959 and $49,836, respectively. In his reply brief,
respondent provides a second computation of imputed interest for
the 1994 and 1995 calendar years in the aggregate amounts
(including interest on both direct and indirect loans) of $19,476
and $59,832, respectively. In that regard, respondent concedes
in his reply brief that “Forgone interest is treated as
transferred by the borrower to the lender as interest on the last
day of the calendar year. I.R.C. § 7872(a)(2)”.
Accordingly, respondent concedes that his notice
determination amounts were not correctly computed. The proposed
corrected computations result in a substantially reduced interest
amount for petitioner’s 1994 tax year from $48,959 to $19,476 and
an increased interest amount for petitioner’s 1995 tax year from
$49,836 to $59,832. With respect to respondent’s concessions, - 28 -
which we accept, we leave the parties to compute the revised
deficiencies, if any, under Rule 155.10
To reflect the foregoing,
Decision will be entered under
Rule 155.
10 To the extent that respondent’s revised 1995 computation of interest is greater than the amount determined in the notice of deficiency, respondent is limited by the amount of corporate income tax deficiency determined in the notice because of the timing of the concession (by means of reply brief) and because respondent has not sought to amend his answer and to assert an increased deficiency under sec. 6214. - 29 -
APPENDIX Summary of Ownership Interests
Ownership Interests in Rountree Cotton Co., Inc.
William Tharp Charles Tharp Claudia Keith Estate of Glenda Tharp
Rountree Cotton 16.8% 33.5% 33.0% 16.7% Co., Inc.
Ownership Interests in Other Entities Estate of William Tharp Charles Tharp Claudia Keith Claud Tharp Glenda Tharp Others 1 Buena Vista –- 50% –- –- –- 50% Partnership Dona Ana Land 14.5% 29 9% 33% 14.5% –- Corp. 2 Tharp Family 10.0 10 10 –- –- 70 Partnership Tharp Farms 30.0 30 20 20 -- -- Partnership Tharp Enters. 12.5 25 25 25 12.5 -- Partnership 1 Craig Tharp, the son of Charles Tharp. 2 Each of the following persons owned 10 percent: William “Glenn” Tharp and John Tharp (the children of William Tharp); Craig Tharp and Laura Kendrick (the children of Charles Tharp); and Michael Keith, Stanley Keith, and Michelle Gardette (the children of Claudia Keith).