Estate of Frederick R. Hoffman - Page 3




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          and $1,751,372, respectively.  Hilltop did not pay interest on               
          these amounts.                                                               
               In 1994, Hilltop repaid petitioners $558,000 of the                     
          advances.  They did not report any of the $558,000 as income.  In            
          that same year, Hilltop paid $416 to Electronic Keyboard Service             
          for repair of Mrs. Hoffman’s organ.  Hilltop recorded this                   
          transaction as a repayment of petitioners’ advances and reduced              
          Mrs. Hoffman’s shareholder loan account by $416.                             
               Petitioners prepaid $5,520 of their 1997 real property taxes            
          and deducted that amount on their 1996 tax return.                           
               Respondent determined that petitioners, pursuant to section             
          7872, had unreported interest income of $97,589, $106,483, and               
          $100,076 in 1994, 1995, and 1996, respectively.  In addition,                
          respondent disallowed petitioners’ $5,520 prepaid real property              
          tax deduction.                                                               
                                       OPINION                                         
          I.  Interest Income From Loans                                               
               Section 7872 recharacterizes a below-market loan (i.e., loan            
          subject to a below-market interest rate) 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             





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