1 Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the tax years. All Rule

(continued...)

T.C. Memo. 1997-172

UNITED STATES TAX COURT

DWIGHT E. AND LESLIE E. LEE, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 8043-84, 43467-85, Filed April 7, 1997.

 32625-88.

Thomas R. Moore, for petitioner.

Wilton A. Baker, for respondent.

MEMORANDUM OPINION

DAWSON, Judge: These consolidated cases were assigned to

Chief Special Trial Judge Peter J. Panuthos pursuant to the

provisions of section 7443A(b)(4) and Rules 180, 181, and 183.1
- 2 -

(...continued)

references are to the Tax Court Rules of Practice and Procedure.

The Court agrees with and adopts the opinion of the Special Trial

Judge, which is set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

PANUTHOS, Chief Special Trial Judge: Respondent determined

deficiencies in petitioners' Federal income taxes for the taxable

years 1976 through 1980 as follows:

Docket No. Year Deficiency

8043-84 1978 $26,811.00

43467-85 1977 33,278.26

32625-88 1976 133.00

1979 4,046.00

1980 622.00

These cases were submitted by the parties fully stipulated.

The three dockets have a long history which we will briefly

review. One of the issues in all three dockets relates to

petitioners' participation in transactions with Futures Trading,

Inc. ((FTI)/Merit Securities, Inc. (Merit)). In four

consolidated cases, Seykota v. Commissioner, T.C. Memo. 1991-234,

supplemented by T.C. Memo. 1991-541, we addressed issues

concerning the various FTI/Merit transactions. Petitioners were

not parties to those cases. The decisions in those cases are

final.

On January 11, 1993, a stipulation of settled issues was

filed in all three dockets. The parties stipulated to all issues

except one which was described as follows:
- 3 -

 2 Other investors also disputed the terms of apparent

agreements with respect to transactions with FTI/Merit. See, for

example, Lamborn v. Commissioner, T.C. Memo. 1994-515.

The only issue remaining in dispute between the

parties is whether petitioners are entitled to interest

expense deductions claimed in connection with Peng

Partners. This issue relates to the Merit project and

either will be resolved by the parties or submitted to

the Court for resolution.

As a result of a continuing dispute as to the proper

interpretation of terms of the stipulation, a number of motions

were filed and resolved by the Court.2 When cross-motions for

orders to show cause were filed in March and April 1996, the

Court set these cases for hearing at a session scheduled to take

place in New York, New York. The cases were ultimately submitted

fully stipulated.

Background

At the time the petitions were filed, petitioners resided in

New York, New York. During 1977 through 1980, petitioner Dwight

E. Lee (petitioner) was a partner in an entity known as Peng

Partners. During those years, Peng Partners participated in

"Arbitrage and Carry" (A/C) transactions promoted by FTI. In

1979 and 1980, Peng Partners also participated in T-Bill options

transactions through Merit. This Court has considered both the

FTI A/C transactions and the Merit T-Bill options transactions in

cases involving Merit Securities. See Seykota v. Commissioner,

T.C. Memo. 1991-234, supplemented by T.C. Memo. 1991-541.
- 4 -

Although the record in these cases is sketchy and not

entirely clear, it appears that the parties agree that the

transactions at issue here are factually the same as those we

addressed in the Seykota opinions.

In those opinions, we found that the FTI transactions were,

fundamentally, cash and carry tax shelters. In simplified terms,

an investor would borrow large sums of money. He would acquire

gold with the loan proceeds. He would also enter into contracts

to sell that gold at a specified time in the future. In the gold

markets, the price which the investor paid for the gold was lower

than the price at which he agreed to sell that gold in the

future. The difference between these two prices largely

reflected the amounts of interest and other carrying charges that

the investor would incur while he owned the gold. The A/C

customer would deduct the interest charges plus other carrying

charges--such as charges for management, insurance, and storage--

in the year he borrowed the money. These deductions offset other

ordinary income for that year. When he sold the gold in the next

year, the investor would report the gain at favorable capital

gains rates. The net gain approximately equaled the costs of the

interest and other carrying charges. In effect, the investor

could defer the taxation of income, at rates as high as 70

percent, for a year. He could also convert that income into

capital gains taxable at maximum rates no higher than 28 percent. 

As an integral part of the FTI A/C transactions, the investors
- 5 -

were placed in a number of alleged trades involving options in

U.S. Treasury obligations. These trades were to function as

alleged "hedges" against losses in the gold trades.

In the present cases, the stipulation of settled issues

resolved all the issues before the Court except whether

petitioners are entitled to investment interest expense

deductions resulting from Peng Partners' participation in the FTI

A/C transactions. The investment interest expense deductions in

issue are as follows:

Year Amount

1977 $6,618

1978 29,957

1979 18,037

1980 17,771

Discussion

Respondent's determination that the claimed interest expense

deductions are not deductible is presumptively correct, and

petitioners bear the burden of proving that respondent's

determination is erroneous. Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, 290

U.S. 111, 115 (1933). The fact that these cases are fully

stipulated does not relieve petitioners of that burden. Borchers

v. Commissioner, 95 T.C. 82, 91 (1990), affd. 943 F.2d 22 (8th

Cir. 1991).

Section 163(a) generally permits the deduction of "all

interest paid or accrued within the taxable year on
- 6 -

indebtedness". The deductibility of interest, however, is

subject to an important exception. Interest is not deductible

where the underlying indebtedness lacks economic substance beyond

the taxpayer's desire to obtain an interest deduction. Goldstein

v. Commissioner, 364 F.2d 734, 741-742 (2d Cir. 1966), affg. 44

T.C. 284 (1965).

In Goldstein, the taxpayer sought to reduce the income taxes

that she would owe on sweepstakes winnings. Accordingly, in

prearranged transactions, she borrowed $945,000 from commercial

banks at 4 percent interest and purchased $1,000,000 in Treasury

notes paying 1-1/2 percent interest. The Treasury notes secured

her loans. She then prepaid the interest on the bank loans and

sought to deduct the amount of the interest as an offset against

the sweepstakes income. The net effect of these transactions was

to produce an economic loss that was more than offset by tax

savings from the deduction of the prepaid interest. We sustained

the Commissioner's disallowance of the deduction, and the Court

of Appeals for the Second Circuit affirmed. The Court of Appeals

for the Second Circuit explained that section 163(a) "does not

permit a deduction for interest paid or accrued in loan

arrangements * * * that cannot with reason be said to have

purpose, substance, or utility apart from their anticipated tax

consequences". Goldstein v. Commissioner, 364 F.2d at 740.

We applied the reasoning of Goldstein in Julien v.

Commissioner, 82 T.C. 492 (1984). In Julien, we denied most of
- 7 -

the claimed interest deductions at issue because the taxpayer had

failed to prove that the transactions giving rise to such

deductions had actually taken place. In one instance, however,

we accepted the taxpayer's representation that he had purchased

silver worth $1,033,280 on October 31, 1975, and simultaneously

agreed to sell the same amount of silver at a price of $1,058,776

on January 6, 1976. There was thus an indicated gain of $25,496. 

The taxpayer borrowed the purchase price from an affiliate of the

promoter. The taxpayer paid $24,996.81 as interest on that

amount on December 19, 1975. He paid commissions of another

$662. The terms of his loan agreement effectively precluded him

from further disposition of either the silver he had purchased or

his contract to sell that silver. There was thus no way for the

taxpayer to profit from that transaction; his indicated gain of

$25,496 was more than offset by his interest and commission

expenses. We disallowed the deduction of the interest expense

for 1975. Quoting Goldstein v. Commissioner, supra at 742, we

stated: "Section 163(a) does not 'intend' that taxpayers should

be permitted deductions for interest paid on debts that were

entered into solely in order to obtain a deduction." Julien v.

Commissioner, supra at 509.

We applied the same principle in Sheldon v. Commissioner, 94

T.C. 738, 760-762 (1990). There the issue was whether certain

repurchase agreements, called "repos", generated interest

deductions. A repo is an agreement to finance the purchase of a
- 8 -

3 In Sheldon v. Commissioner, 94 T.C. 738, 767 (1990), we

noted that some of the transactions at issue presented "a small

potential for gain". We nonetheless found Goldstein v.

Commissioner, 364 F.2d 734 (2d Cir. 1966), affg. 44 T.C. 284

(1965), dispositive, stating: "The principle of that case would

not * * * permit deductions merely because a taxpayer had or

experienced some de minimis gain." Sheldon v. Commissioner,

supra at 767; see Lifschultz v. Commissioner, 393 F.2d 232 (2d

Cir. 1968), affg. T.C. Memo. 1966-225.

Treasury bill (or T-Bill) by selling the T-Bill to another party

with an agreement to repurchase the T-Bill, for the original

selling price plus interest, on or before the T-Bill's maturity

date. We observed that the transactions were designed so that

the interest that the taxpayer paid in repurchasing the T-Bill

was greater than the interest actually paid by the T-Bill during

the period the repo was in effect. We found that the repo

transactions were without substance beyond the anticipated tax

consequences of generating interest deductions. Citing

Goldstein, we explained that "loans or other financing

transactions will merit respect and give rise to deductible

interest only if there is some tax-independent purpose for the

transactions." Sheldon v. Commissioner, supra at 759.3

These cases present the issue of the deductibility of

interest in FTI A/C transactions. In these transactions, the

investors borrowed money which was used to buy gold. Their

investments were "hedged" by alleged trades in options for U.S.

Treasury obligations. The transactions generated interest and

other deductions. The investors recovered their investment in
- 9 -

the next taxable year when the gold was sold. We earlier

addressed the deductibility of interest arising from these

transactions in Seykota v. Commissioner, T.C. Memo. 1991-234

(Seykota I), supplemented by T.C. Memo. 1991-541 (Seykota II).

In Seykota I, we found that the FTI A/C transactions lacked

economic substance. We therefore disallowed the taxpayers'

claimed deduction of losses incurred as a result of their

participation in that program. We made an exception for the

deduction of interest paid in connection with borrowing funds to

participate in the program. On the Commissioner's motion for

reconsideration, however, we modified that opinion. Citing

Goldstein, Julien, and Sheldon, we held in Seykota II that the

taxpayer could not deduct interest expenses paid to borrow funds

to acquire gold in connection with FTI A/C transactions. Based

on the record before us in Seykota II, the interest payments

appeared to be integral parts of transactions that "Seen as a

whole * * * lacked economic substance or any purpose other than

generating tax deductions". Id. The taxpayers had the burden of

persuading us otherwise, and, when they failed to do so, we

sustained the Commissioner's disallowance of the claimed interest

deductions.

Respondent maintains that the interest deductions at issue

here are factually indistinguishable from those we addressed in

Seykota II. Respondent accordingly concludes that the reasoning
- 10 -

we applied in Seykota II controls here and that the interest

deductions are not allowable.

Petitioners, however, argue that our holding in Seykota II

has been vitiated by our subsequent opinion in Lieber v.

Commissioner, T.C. Memo. 1993-424. In Lieber, the Commissioner

disallowed deductions relating to a computer leasing tax shelter. 

The Court held that the majority of the deductions at issue were

not allowable. The Court, however, permitted the taxpayers to

deduct interest paid upon indebtedness they incurred in order to

invest in the computer leasing transaction. In so holding, the

Court quoted, as dispositive precedent, the following language

from Jacobson v. Commissioner, 915 F.2d 832, 840 (2d Cir. 1990),

revg. on other grounds T.C. Memo. 1988-341:

Even if the motive for a transaction is to avoid taxes,

interest incurred therein may still be deductible if it

relates to economically substantive indebtedness. 

Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89,

96 (4th Cir. 1985). * * *

Both Lieber and Jacobson explicitly adopt the holding in

Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 96 (4th

Cir. 1985), affg. in part and revg. in part 81 T.C. 184 (1983). 

Rice's Toyota World, Inc., addressed the case of a taxpayer who

borrowed money to invest in a tax shelter. Part of the

indebtedness was secured by a short-term recourse note. The

Court of Appeals for the Fourth Circuit affirmed our disallowance

of most of the deductions at issue. With respect to the

taxpayer's loan transaction, however, the Court of Appeals found
- 11 -

that the debt secured by the short-term recourse note was valid

and that the taxpayer could deduct interest paid on that note to

the lender.

We adopted the reasoning of Rice's Toyota World, Inc. in

Rose v. Commissioner, 88 T.C. 386, 423 (1987), affd. 868 F.2d 851

(6th Cir. 1989). Accordingly, our opinions in Lieber and

Jacobson conclude that, in situations such as that presented in

Rice's Toyota World, Inc., the interest is deductible.

The situation in the Rice's Toyota World, Inc. line of

cases, which allows interest deductions, is, however,

distinguishable from the situation in the Goldstein v.

Commissioner, 364 F.2d 734 (2d Cir. 1966), line of cases, wherein

the courts have disallowed the claimed interest deductions. The

Court of Appeals for the Third Circuit has provided a detailed

discussion of that distinction in United States v. Wexler, 31

F.3d 117, 125-127 (3d Cir. 1994). There the Court of Appeals had

before it a repo transaction, virtually identical to that

addressed in Sheldon v. Commissioner, 94 T.C. 738 (1989), and

similar in concept to the situations in Goldstein, Julien v.

Commissioner, 82 T.C. 492 (1984), and Seykota.

Addressing first the transaction that yielded deductible

interest in Rice's Toyota World, Inc., the Court of Appeals for

the Third Circuit explained:

[The] transaction was unusual because the interest

payments on the recourse note were separable from the

interest payments and depreciation that would have
- 12 -

created the principal benefits of the transaction. 

* * * [Wexler v. Commissioner, supra at 125.]

In contrast, in the repo situation--

[Taxpayer's] case differs in a critical respect. There

is no debt obligation that can be separated from the

underlying * * * scheme or that was undertaken for some

reason other than the tax benefits of deducting

interest on that obligation itself. * * * [Id. at 125-

126.]

The Court of Appeals for the Third Circuit noted that in the

repo situation, "the loan * * * is the very obligation that will

generate the interest payments constituting the tax benefits of

the entire transaction." Id. at 126. It accordingly rejected

the taxpayer's argument that the debt was "an economically

substantive 'genuine indebtedness'". Id.

We have applied a distinction similar to that described by

the Court of Appeals for the Third Circuit in Wexler to cases

involving the FTI A/C program. In Seykota II, we determined that

the interest payments were not separable from the underlying

scheme; instead, as we explained, the "interest payments merely

functioned as the first part of a scheme for the mismatching of

deductions and income". We concluded that the FTI A/C

transactions "lacked economic substance or any purpose other than

generating tax deductions". We accordingly denied the interest

deductions at issue.

We returned to that issue in Alessandra v. Commissioner,

T.C. Memo. 1995-238, an opinion issued after Lieber v.

Commissioner, supra. In Alessandra, the issue was whether the
- 13 -

taxpayer was taxable upon interest income generated by

participation in FTI A/C transactions. There we concluded that

the transactions giving rise to the indebtedness possessed

economic substance and were separable from those aspects of the

program that lacked economic substance. We cited Lieber and

Jacobson v. Commissioner, supra, as well as the other pertinent

authorities, in holding that the evidence of record, as developed

in Alessandra, demonstrated that "Each of the transactions 

* * * had distinct economic utility other than any anticipated

tax benefits". Allesandra v. Commissioner, supra. We

distinguished the situation in Seykota II, where "the disallowed

interest deductions were the tax benefit to be obtained". Id.

An appeal in these cases would be to the Court of Appeals

for the Second Circuit. The Court of Appeals for the Second

Circuit explained, in Jacobson, that the deductibility of

interest in sham situations is limited to "economically

substantive indebtedness." Jacobson v. Commissioner, 915 F.2d at

840. Neither Jacobson nor Lieber (which relied on Jacobson)

suggests that interest is deductible where--

There is no debt obligation that can be separated from

the underlying * * * scheme or that was undertaken for

some reason other than the tax benefits of deducting

interest on that obligations itself. * * * [United

States v. Wexler, supra at 125-126.]

The Second Circuit's earlier opinion in Goldstein stated:

We here decide that Section 163(a) does not "intend"

that taxpayers should be permitted deductions for

interest paid on debts that were entered into solely in
- 14 -

 

4 Indeed, in United States v. Wexler, 31 F.3d 117, 127 (3d

Cir. 1994) the Court of Appeals for the Third Circuit explained:

Rice's Toyota, Jacobson and Lieber indicate that, in

some circumstances, a sham transaction may have

separable, economically substantive, elements that give

rise to deductible interest obligations. * * * [Fn.

ref. omitted.]

The court continued, however, "Yet in each of those cases a key

requirement is that the interest obligation be economically

substantive". Id.

order to obtain a deduction. * * * [Goldstein v.

Commissioner, 364 F.2d at 742.]

In Lieber v. Commissioner, T.C. Memo. 1993-424, we quoted this

sentence and posed the question whether Goldstein v.

Commissioner, supra, conflicted with the Second Circuit's later

opinion allowing interest deductions in Jacobson v. Commissioner,

supra. Clearly, Jacobson (which did not mention Goldstein)

supports the principle that interest deductions are not rendered

nondeductible merely because the proceeds are used to invest in a

sham tax shelter transaction; in some cases the underlying

indebtedness might still be "economically substantive".4

Jacobson v. Commissioner, 915 F.2d at 840. Jacobson thus

indicates that the language of Goldstein would not apply so

broadly that it would deny all interest deductions that are

related to sham transactions. We believe, however, that

Goldstein continues to apply to the narrower situation where a

taxpayer enters into a borrowing transaction for no purpose other

than to claim the deductions generated by that transaction
- 15 -

 

5 In the Goldstein line of cases--Julien, Sheldon, Wexler,

and, as we held in Seykota II, in the FTI A/C transactions--the

taxpayers borrowed large sums of money and simultaneously entered

into offsetting transactions. These transactions lacked economic

substance. Instead, the effect was that of a taxpayer "actually

borrowing his own money to create interest expense". Muserlian

v. Commissioner, 932 F.2d 109, 113 (2d Cir. 1991), affg. T.C.

Memo. 1989-493.

 

6 Apparently, the deductions generated by the FTI A/C

transactions included not only the interest deductions at issue,

(continued...)

itself; such a transaction is not economically substantive. Both

Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 at 96, and

Rose v. Commissioner, 88 T.C. at 423, specifically distinguish

Goldstein from situations in which interest deductions were

allowable. See Muserlian v. Commissioner, 932 F.2d 109, 113 (2d

Cir. 1991) (decided after Jacobson), affg. T.C. Memo. 1989-493;

see also United States v. Wexler, 31 F.3d at 126 n.11.5

In these cases, as in Seykota II, petitioners have not shown

that interest payments in the FTI A/C transactions were separable

from the interest payments and other deductions "that would have

created the principal tax benefits of the transaction." United

States v. Wexler, supra at 125. The latter type of sham

transactions are those presented in Wexler, Goldstein, Julien,

Sheldon, and, as we held in Seykota II, in the FTI A/C

transactions. In those cases the taxpayers paid no interest on

economically substantive indebtedness that was separable from the

sham transaction itself. Accordingly, we sustain respondent's

disallowance of the interest deductions at issue.6
- 16 -

(...continued)

but also other deductions for items such as management fees or

storage charges. However, neither here, nor in Seykota, have

taxpayers proven that the existence of such other deductions make

the underlying obligation one of economic substance "that can be

separated from the underlying * * * scheme". United States v.

Wexler, 31 F.3d 117, 125-126 (3d Cir. 1994).

We are not persuaded otherwise by petitioners' further

argument that respondent has made a number of "concessions" in

the stipulations of settled issues. Petitioners claim that these

concessions require respondent to concede that the interest

expenses at issue are deductible. Respondent counters that the

alleged "concessions" merely reflect this Court's holdings in the

Seykota opinions. The record before us in these fully stipulated

cases does not support petitioners' assertions. Suffice it to

say that petitioners have not shown that the claimed concessions

operate to confer economic substance upon the transactions at

issue. On this record, those transactions are indistinguishable

from those we found to lack economic substance in Seykota II. 

Accordingly, the interest generated by those transactions is not

deductible.

To reflect the foregoing,

Decisions will be entered

under Rule 155.