- 6 -
itemized deductions were correct.) We must also decide whether
petitioners are liable for additions to tax under section 6661
for a substantial underpayment of tax for 1987 and 1988.
I. Were Dividends Properly Imputed to Petitioners Under Section
7872 for 1987 and 1988?
Section 7872 was enacted as part of the Deficit Reduction
Act of 1984, Pub. L. 98-369, sec. 172(a), 98 Stat. 699. Section
7872 sets forth the appropriate income and gift tax treatment for
certain categories of "below-market" loans; i.e., loans that are
interest free or that provide for interest that is lower than the
AFR. Sec. 7872(e)(1); KTA-Tator, Inc. v. Commissioner, 108 T.C.
100, 105 (1997). Section 7872 recharacterizes a below-market
loan, as defined in section 7872(e)(1), so that the loan becomes
the equivalent of 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 had made a transfer of funds
to the borrower, and the borrower then used these funds to pay
interest to the lender. The deemed transfer to the borrower is
treated either as a gift, dividend, contribution of capital,
payment of compensation, or other payment depending on the
substance of the transaction. The deemed interest payment is
included in the lender's income and generally may be deducted by
the borrower, subject to the rules governing the deductibility of
interest. KTA-Tator, Inc. v. Commissioner, supra at 102; see H.
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