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would have been at the applicable Federal rate (AFR) under
section 7872(e)(2) for 1987 and 1988. Of petitioners' repayments
to RSI, KPMG calculated that $728,098 and $214,065 ought to have
been applied to reduce the outstanding principal on the loans for
1987 and 1988, respectively, and $111,604 and $167,569 should
have been allocated to interest at the AFR for those same years.
Respondent timely issued a statutory notice of deficiency on
February 16, 1996. Among other things, respondent adjusted
petitioners' income for the relevant tax years to reflect
dividend income from RSI pursuant to section 7872. (Respondent
adjusted RSI's income on its Forms 1120 for 1987 and 1988 to
reflect interest income in the amounts calculated by KPMG.)
Respondent further adjusted petitioners' itemized deductions to
allow for a partial deduction for the interest respondent deemed
paid to RSI by petitioners for the years in question. Respondent
allowed petitioners a full deduction for interest expenses
identified from "investment sources" in the KPMG analysis, and a
partial deduction for interest expenses identified from "personal
sources", in accordance with section 163.
Discussion
We must decide whether respondent properly imputed dividends
to petitioners in 1987 and 1988 under section 7872 where no
evidence indicates that interest had accrued or was otherwise
paid on the loans in those years. (Petitioners concede that
respondent's adjustments to RSI's income and to petitioners'
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