IRS rules favorably on significant effect below-market loan.

• Author: Orbach, Kenneth N.

Sec. 7872 generally treats certain below-market loans as if they bear interest at the applicable Federal rate and require the lender to make a payment to the borrower sufficient to fund the borrower's payment of interest. For this purpose, the term "loan" is interpreted broadly to include any transfer of money providing the transferor with a right to repayment.

Sec. 7872 generally applies to below-market gift loans, compensation-related loans, corporation-shareholder loans, tax avoidance loans and loans to qualified continuing care facilities. In addition, Sec. 7872 applies to significant effect loans (i.e., loans with an interest arrangement that has a significant effect on any Federal tax liability of the lender or borrower) to the extent provided in regulations. No such regulations have been promulgated.

The legislative history of Sec. 7872 states that any loan that results in the conversion of a nondeductible expense into the equivalent of a deductible expense has an effect on the Federal tax liability of the lender or borrower (Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1984 (hereinafter, the "Blue Book"), p. 531). For example, without Sec. 7872, a member of a club who makes a noninterest-bearing refundable deposit to the club in lieu of all or part of a membership fee has paid the fee with earnings that have not been included in the member's gross income; the member effectively has changed a nondeductible expenditure into one that is deductible.

Another example of a significant effect loan, and its current tax consequences, is in Letter Ruling (TAM) 9521001. Taxpayer, a retirement apartment community that was not a qualified continuing care facility as defined in Sec. 7872(g), provided its residents with a variety of services, including meals, group transportation and up to 30 days of nursing home care.

Residents paid Taxpayer under one of three plans. The first provided for a "high" entrance fee (90% to 100% refundable when a resident moves out) and "low" monthly fees. The two other plans provided for a "low" (or no) entrance fee but "high" monthly fees.

The first plan, the best of the three economically, was selected by more than 90% of the residents. The issue considered by the Service was whether the "high" refundable entrance fee of the first plan was subject to Sec. 7872.

As a preliminary matter, the IRS ruled that the entrance fee was a "loan" under the broad definition of the term for purposes of...