                         T.C. Memo. 1999-395



                       UNITED STATES TAX COURT



           ESTATE OF FREDERICK R. HOFFMAN, DECEASED,
                 MARILYN C. HOFFMAN, EXECUTOR,
             AND MARILYN C. HOFFMAN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 9952-98.                   Filed December 6, 1999.




     Frank Agostino, Susan M. Flynn, and Andrew D. Engel, for

petitioners.

     Craig Connell and Francis J. Strapp, Jr., for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     FOLEY, Judge:    By notice dated April 3, 1998, respondent

determined deficiencies of $63,322, $76,801, and $60,804 in
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petitioners' 1994, 1995, and 1996 Federal income taxes,

respectively.

     All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.    After concessions,

the issues are whether petitioners:    (1) Have interest income,

pursuant to section 7872, from loans made to their controlled

corporation; and (2) are entitled to deduct, on their 1996 tax

return, 1997 real property taxes.

                          FINDINGS OF FACT

     Frederick R. Hoffman died on August 15, 1996, and Marilyn C.

Hoffman was duly appointed executor of his estate.    At the time

the petition was filed, Mrs. Hoffman resided in Woodville,

Virginia.

     Petitioners were the controlling shareholders of, and

routinely advanced funds to, Hilltop Stud Farm, Inc. (Hilltop).

Petitioners routinely paid Hilltop’s expenses with personal

funds.   Corporate and personal records reflected the advances

(including expense payments) as increases in petitioners’

shareholder loan accounts.   Petitioners made nine advances in

1994, three in 1995, and four in 1996 (i.e., Hilltop’s fiscal

years ending March 31).   Hilltop’s 1994, 1995, and 1996 Federal

income tax returns, signed by Mrs. Hoffman as its president,

reflected “Loans from stockholders” of $2,122,195, $1,613,053,
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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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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 KTA-Tator, Inc. v. Commissioner, 108 T.C. 100,

102 (1997).

     Section 7872 applies to a transaction that is: (1) A “below-

market” loan, and (2) not described in any of certain enumerated

categories.     See sec. 7872(c)(1), (e)(1), (f)(8).    We discuss the

requirements in turn.

     A.   Below-Market Loan Requirement

     To determine if the below-market loan requirement is

satisfied, we must ascertain whether a transaction is: (1) A

loan, (2) a demand or term loan, and (3) subject to a below-

market interest rate.     See sec. 7872(e)(1).

           1.    Loan Requirement

     Respondent contends that petitioners’ advances to Hilltop

were loans.     Petitioners contend their advances were capital

contributions.

     For purposes of section 7872, any transfer of money that

provides the transferor with a right to repayment, including an

advance, may be a loan.     See KTA-Tator, Inc. v. Commissioner,

supra at 103.    Petitioners transferred money to Hilltop,

recording the transfers as loans in their personal and corporate
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records and received repayments during the years in issue.

Contrary testimony offered by Mrs. Hoffman was vague,

contradictory, and unpersuasive.     Therefore, we conclude that the

advances were loans for purposes of section 7872, and the loan

requirement is satisfied.

          2.   Demand or Term Loan

     Below-market loans fit into one of two categories:     Demand

loans and term loans.    See sec. 7872(e)(1).   A demand loan

includes “any loan which is payable in full at any time on the

demand of the lender.”    Sec. 7872(f)(5).   A term loan is “any

loan which is not a demand loan.”    Sec. 7872(f)(6).

     The determination of whether a loan is payable in full at

any time on the demand of the lender is a factual one.     Loans

between closely held corporations and their controlling

shareholders are to be examined with special scrutiny.     See

Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1339 (1971),

affd. without published opinion 496 F.2d 876 (5th Cir. 1974).

Petitioners made loans, without written repayment terms, to their

controlled corporation, and they determined when the loans would

be repaid.   Therefore, we conclude that the loans are demand

loans.

          3.   Below-Market Interest Rate

     A demand loan is a below-market loan if it is interest free

or if interest is provided at a rate that is lower than the
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applicable Federal rate (AFR) as determined under section

1274(d).     See sec. 7872(e)(1)(A).     Petitioners made loans to

Hilltop, and Hilltop did not pay interest on these loans.

Therefore, we conclude that the loans are below-market demand

loans.

      B.    Enumerated Category Requirement

      Section 7872(f)(8) provides that section 7872 shall not

apply to any loan to which any of certain enumerated sections

applies.     None of the enumerated sections applies to petitioners’

loans.     Therefore, we conclude that the enumerated category

requirement is met, and section 7872 applies to petitioners’

loans.

      Accordingly, we hold that petitioners, pursuant to section

7872, have interest income from below-market loans they made to

Hilltop.     Petitioners contend, but have not established, that the

loans should be deducted, pursuant to section 166, as bad debts.

II.   Deductibility of Prepaid Taxes

      Section 164(a)(1) allows a deduction for real property

taxes.     Deduction of prepaid real property taxes has been

disallowed where a cash basis taxpayer failed to establish that

the prepayment represented assessed, rather than estimated,

taxes, and that such taxes were due in the year they were paid.

See Hradesky v. Commissioner, 540 F.2d 821 (5th Cir. 1976), affg.

per curiam 65 T.C. 87 (1975).     Petitioners have not established
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that their $5,520 prepayment represented assessed, rather than

estimated, taxes.   In addition, they have conceded that the

$5,520 was not due in 1996.   Accordingly, petitioners may not

deduct the $5,520 from their 1996 income.

     Any other contention made by the parties is irrelevant,

moot, or meritless.

          To reflect the foregoing,



                                            Decision will be entered

                                       under Rule 155.
