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On its 1992 and 1993 Federal income tax returns, petitioner
did not report interest income from the advances. On September
27, 1995, respondent issued a notice of deficiency to petitioner.
Respondent determined that petitioner, pursuant to section 7872,
had unreported interest income of $30,718 for 1992 and $5,225 for
1993. Based on these amounts, respondent determined that
petitioner was liable for deficiencies of $10,443 for 1992 and
$1,828 for 1993.
Discussion
Section 7872 was enacted as part of the Deficit Reduction
Act of 1984 (DEFRA), Pub. L. 98-369, sec. 172(a), 98 Stat. 699.
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 arms-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;
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