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By Peter Barton, MBA, CPA, JD, Professor of Accounting, and Alka Arora, PhD, CPA, Assistant Professor of Accounting University of Wisconsin-Whitewater

In KTA-Tator v. Commissioner, a case of first impression, the Tax Court ruled that interest-free advances on building construction loans by a corporation to its sole shareholders resulted in taxable interest income to the corporation during the construction period even though the shareholders began paying interest to the corporation when the buildings were completed. This case is important because the controlling IRC section 7872 affects most below-market loans.

Enacted in 1984, section 7872 defines "below-market loans" as demand or term loans with interest payable at less than the applicable Federal interest rate. "Foregone interest" is the interest at the Federal rate less the interest paid on the loan. The Federal rate is the average rate on U.S. obligations as determined under section 1274(d). Section 7872 treats the foregone interest as being transferred to the borrower and returned to the lender. This treatment results in the foregone interest being taxable interest income to the lender. Depending on the relationship to the lender, the borrower has dividend income, compensation, a contribution to capital, or a gift. Whether the borrower has a corresponding interest expense deduction depends on the purpose of the loan (business, investment, residential, personal, etc.).

Section 7872 applies to most below-market loans, including loans directly or indirectly between the following: employers and employees, independent contractors and persons who hire them, and corporations and their shareholders. Also covered by section 7872 are below-market gift loans where the foregone interest is a gift. These loans typically occur between family members or friends. In addition, section 7872 applies to below-market loans with interest arrangements "having tax avoidance as a principal purpose." This phrase is not defined in the statute. There is an exception to the Section 7872 requirements for most loans that do not exceed $10,000, but this exception does not apply to loans having tax avoidance as a principal purpose unless the loan is a gift loan. [There are also special rules for gift loans that do not exceed $100,000 in Section 7872(d). These rules have created planning opportunities.]

In KTA-Tator, KTA-Tator Corporation made over 100 advances of funds from 1991­1993 to its sole shareholders, the Tutors, to expand KTA's headquarters and construct a new office building. The Tators would own both buildings and lease them to KTA. During the construction period, there was no written agreement concerning these advances, and KTA neither charged nor received any interest. When the buildings were completed, in October of 1992 and 1993 respectively, the Tutors prepared written amortization schedules and began repaying the advances at eight percent annual interest over 20 years.

The IRS claimed that KTA had unreported interest income of $30,718 in 1992 and $5,225 in 1993, arguing that each advance was a separate loan under section 7872. KTA contended that the advances were similar to "draw downs" on an open line of credit and that a loan did not exist under Section 7872 until KTA advanced all the funds needed to complete the buildings. Agreeing with the IRS, the Tax Court ruled that KTA's advances were demand loans and KTA had taxable interest income from the time each advance was made. The court cited the legislative history, which broadly interpreted "loan" as "any transfer of money that provides the transferor with a right to repayment."

The court also pointed out that although the Tator's imputed dividend income was offset by imputed interest expense, no offset is allowed to KTA's imputed interest income for the deemed transfer KTA made to the Tutors.

Clearly the IRS has broad authority under section 7872 to treat most below-market loans as resulting in interest income to the lender at the applicable Federal rate. KTA-Tator strengthens this authority. Therefore, it is important to provide for market rate interest on loans and make sure the interest is paid unless the $10,000 exception noted above applies.

Source: KTA-Tator v. Commissioner, 108 T.C. , No.8 (March 11, 1997)

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