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of its shareholders. Sec. 7872(a), (c)(1)(C). We described the
general effect of section 7872 in KTA-Tator, Inc. v.
Commissioner, 108 T.C. 100, 101-102 (1997), as follows:
Section 7872 recharacterizes a below-market loan 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 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.
The forgone interest on a loan by a corporation to its
shareholder is treated as a distribution to the shareholder and
generally taxed as a dividend. Id. at 106; secs. 61(a)(7),
301(c)(1); H. Conf. Rept. 98-861, 1013 (1984), 1984-3 C.B. (Vol.
2) 267. The forgone interest on a loan by a shareholder to a
corporation is treated as a capital contribution. Sec. 1.7872-
4(d), Proposed Income Tax Regs., 50 Fed. Reg. 33561 (Aug. 20,
1985); see also KTA-Tator, Inc. v. Commissioner, supra at 102
(“The transfer to the borrower is treated as a * * * contribution
of capital * * * depending on the substance of the
transaction.”). Under section 1.7872-2(a)(1), Proposed Income
Tax Regs., 50 Fed. Reg. 33557 (Aug. 20, 1985): “each extension
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