On Appeal from the Decision of the United States Tax Court
Before Sprecher and Wood, Circuit Judges, and Van Pelt, Senior District Judge.*fn*
The primary question presented in this appeal is whether a taxpayer who lends money to his children and other close family members in the form of no-interest loans and open accounts payable on demand must include in the computation of gifts taxable during a particular tax year the value of the interest foregone on the indebtedness outstanding during that year. The tax court ruled in favor of the taxpayer's argument that no taxable gift occurred. We affirm.
As the relevant facts have been set out in the Tax Court's opinion in this case reported at 67 T.C. 1060 (1977), we need only briefly summarize them here. Appellee is an equal partner along with his two brothers in Areljay Company, Not Incorporated ("Areljay"). Prior to and during 1967, Areljay made loans totaling approximately $18 million to a series of 24 trusts that had been established for the benefit of the children and other close relatives of the three brothers. The loans were made to enable the trusts to acquire interests in another investment partnership known as Henry Crown and Company (Not Incorporated) ("HC Not Inc."). Approximately 13% Of the trusts' indebtedness to Areljay was represented by notes payable on demand. The remaining 87% Consisted of loans on open account. Neither the open accounts nor the demand notes contained any provision for the payment of interest except after demand. Nor was any interest paid on the outstanding balances of the loans during the tax year in question.
In the notice of deficiency sent to the appellee on November 30, 1973, the Commissioner of Internal Revenue determined that the loans to the trusts resulted in gifts from the Areljay partners in 1967 in the amount of $1,086,407.75, one-third of which was allocated to the appellee. In calculating the amount of the gifts the Commissioner applied an interest rate of 6% Per annum to the daily balance of the loans outstanding during the year. The Commissioner theorized that the loans involved the transfer of a valuable property right to the trusts equal to the market rate of interest charged on similar loans. After the matter was heard by the Tax Court, a decision was filed on March 31, 1977, holding that the appellee could not be subject to the gift tax on his proportionate share of the partnership's outstanding loans because the making of non-interest-bearing loans under these circumstances is not a taxable event. There were three dissenters. This court has jurisdiction over the Commissioner's appeal under Section 7482(a) of the Internal Revenue Code of 1954, 26 U.S.C. § 7482(a).
The Commissioner begins his argument for finding a gift in these loans with the proposition that the granting of a loan over a period of time at less than the true economic rate of interest bestows an economic benefit on the recipient. As with any productive asset the ability to employ that asset in productive activity gives rise to "income" in an economic sense.*fn1 When money is loaned at zero interest over a period of time the recipient is enriched by the amount of income that the money generates for him. At the same time, the person who lends the money is poorer by the amount of interest foregone. His nominal wealth may not decline, but he misses out on a chance to increase his net worth. This is the "opportunity cost" of his loan. In order for an economic benefit to be transferred to the recipient, it is not necessary that the interest rate be set at zero, but only that the interest rate on the loan be less than the appropriate market rate of interest at the time.
The Commissioner argues that this transfer of economic benefit by means of interest-free loans is inimical to the two major purposes of the gift tax statute protection of the income tax and the estate tax.*fn2 The argument is clearly correct with respect to the income tax, a fact which the Tax Court majority failed to note. The concern here is that people will use gifts of income producing property to split up an income taxable in a high tax bracket into smaller incomes taxable in lower brackets. No-interest loans do just that.*fn3 Moreover, where the loans are payable on demand, the maker of the loans is able to achieve this result without the inconvenience of losing access to the principal should the need arise. The situation with regard to the estate tax is more complex. Because of the time-value of money, when a no-interest loan is made for a definite term, the estate of the person making the loans is reduced in that the economic value of the promise to pay off the loan in the future is less than the value of the money which was loaned out.*fn4 The Commissioner suggests that the same thing is true of the loans in the case at bar. However, as the appellee points out, since the estate could require the loans to be repaid on demand, there is no reason to expect that the fair value of the promise to repay would be substantially less than the face amount of the loans.*fn5 This fact led the Tax Court below and the district court in Johnson v. United States, 254 F. Supp. 73 (N.D.Tex.1966) the only reported decision on all fours with the case at bar to conclude that the government's interest in taxing the estate of the lender had not been affected. But the Commissioner goes on to argue that if the lender had retained the money loaned out and invested it in income-producing assets, his taxable estate would have grown larger by the amount of income earned. See Note Gift Taxation of Interest-Free Loans, 19 Stan.L.Rev. 870, 874 (1967). Appellee's counter-argument, which was accepted by the majority in the Tax Court, is that
our income tax system does not recognize unrealized earnings or accumulations of wealth and no taxpayer is under any obligation to continuously invest his money for a profit. The opportunity cost of either letting one's money remain idle or suffering a loss from an unwise investment is not taxable merely because a profit Could have been made from a wise investment.
67 T.C. 1060, 1067 (1977) (emphasis in the original).
It is true that under our system a taxpayer is not under any duty to cultivate the fruits of his capital (or labor) and will not be taxed as if he had when he hasn't. However, by actively placing others in a position to enjoy the fruits of his capital, the taxpayer in a sense vicariously "realizes" the economic potential thereof.*fn6 Permitting others to enjoy the economic benefits of an asset can be seen as one means of exerting control over the asset's economic potential. This might serve as a theoretical basis for distinguishing gifts such as those involved here from situations where the taxpayer lets his productive properties lie totally fallow. However, whatever the value of this consideration as a policy factor favoring the gift taxation of loans such as those present in the instant case, the Commissioner has not been able to point to any authority suggesting that the congressional purpose of protecting the estate tax was concerned with the use of gifts to diminish a taxpayer's potential estate as well as his actual one.
The Commissioner also points out that a failure to tax the use of interest-free demand loans would be inconsistent with the tax treatment of other practical alternatives for the transfer of an economic benefit to another. The appellee has conceded that had the interest-free loans been made for a definite term, a taxable gift might have occurred.*fn7 Similarly, if the taxpayer had contributed the money to a trust made irrevocable for a certain duration, then the present discounted value of the income interest payable to the beneficiaries would have been considered a gift taxable to the taxpayer at the time that the trust was established. See Treasury Regulations on Gift Tax (1954 Code), § 25.2511-1(e) (26 C.F.R.). More analogous to the situation of no-interest loans repayable on demand is the establishment of a revocable trust. There the income payments to the beneficiary are considered gifts from the grantor during the calendar years received. If the power to revoke terminates, a gift of the corpus is considered to occur.*fn8 See H.Rep.No. 708, 72d Cong., 1st Sess., 28 (1932); Treasury Regulations on Gift Tax (1954 Code), §§ 25.2511-1(e), 2(f), 25.2512-5(c).
It is not enough for the Commissioner to demonstrate that there are good policy reasons for taxing interest-free demand loans and that to fail to do so will lead to inconsistent tax treatment of transactions constituting practical alternatives. He must also show that the taxation of such loans is within the contemplation of the gift tax statute. The Commissioner attempts to carry his burden in this respect by relying on Sections 2501 and 2512(b) of the Code, 26 U.S.C. §§ 2501 and 2512(b). No statutory language or statements in the legislative history have been cited dealing specifically with interest-free loans.*fn9 Instead, reliance is placed on the broad general sweep of these statutory sections. Section 2501 imposes a gift tax on any "transfer of property by gift" made by a taxpayer during the taxable year. Section 2512(b) provides:
§ 2512. Valuation of gifts.
(b) Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift, and shall be included ...