Sheldon v. Comm'r of Internal Revenue
| Decision Date | 29 May 1990 |
| Docket Number | Docket No. 18208-85. |
| Citation | 94 T.C. 738,94 T.C. No. 46 |
| Parties | STEVEN R. SHELDON AND ELLEN G. SHELDON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
In November and December 1981, G, a limited partnership, purchased Treasury Bills (‘T-Bills‘) maturing in January 1982. G simultaneously entered into repurchase agreements (‘repos‘) involving the same T-Bills, with the same dealers who sold G the T-Bills. Under the terms of the repos, G sold the T-Bills to the dealers and promised to repurchase the T-Bills at future dates for the same prices plus stated interest. One of the repos, from its inception, was to close on the maturity date of the corresponding T-Bills (a ‘repo to maturity ‘). On the dates other repos were to close, G entered into new repos. Some of the new repos were repos to maturity, while other repos were for shorter terms. G, however, eventually entered into repos to maturity on the closing dates of those repos. HELD: The T-Bill acquisitions and repos were not fictitious, but real. HELD FURTHER: The repos lacked tax-independent purpose and economic substance. Accordingly, interest accruing on the repos may not be deducted. Goldstein v. Commissioner, 44 T.C. 284 (1965), affd. 364 F.2d 734 (2d Cir. 1966), followed. Morton A. Smith, Vincent R. Barrella, Alice Yaker, and Steven D. Goldberg, for the petitioners.
Edward J. Roepsch and James Hardaker, for the respondent.
Respondent determined a deficiency in petitioners' Federal income tax in the amount of $56,133 and liability for the increased rate of interest under section 6621(c) 1 for taxable year 1981. In an amended answer, respondent also asserted that petitioners are liable for the section 6653(a)(1) and (2) additions to tax for negligence or intentional disregard of rules and regulations. The issues for our consideration are (1) whether purchases of United States Treasury Bills financed by repurchase agreements were fictitious, (2) whether the transactions lacked economic substance, (3) whether the transactions should be characterized for Federal income tax purposes as forward contracts for purchases at future dates, and (4) whether petitioners are liable for the section 6653(a)(1) and (2) additions to tax and the section 6621(c) increased rate of interest because of those transactions.
The parties have entered into a stipulation of facts, along with attached exhibits, all of which are incorporated herein by this reference.
Petitioners resided in Englewood, New Jersey, when they filed their petition. On May 6, 1981, Government Securities Dealers II (‘GSDII‘) was formed as a limited partnership under New York law. At all relevant times, the general partners of GSDII were Joseph Blumstein and petitioner Steven Sheldon (‘petitioner‘ -- Ellen G. Sheldon is a petitioner due to her filing a joint Federal income tax return with her husband for 1981).
According to its Limited Partnership Agreement, GSDII was formed ‘to act as a broker, dealer and market maker in United States Government securities, * * * [in] other interest bearing and interest oriented instruments and in metals. ‘ Before forming GSDII, petitioner and Mr. Blumstein each had several years of experience in the trading and selling of United States Government securities and other financial investments.
The general partners of GSDII, petitioner, and Mr. Blumstein, contributed initial partnership capital in the amounts of $26,000 and $34,000, respectively. GSDII's 28 limited partners collectively contributed initial capital in the total amount of $1,356,250. Besides the above-indicated initial cash contributions, each GSDII limited partner also agreed to be personally liable for recourse obligations of the partnership up to the amount of three times the initial cash contribution.
GSDII began general operations on November 24, 1981, and reported its income for Federal tax purposes using the accrual method of accounting and a calendar year end. For the 1981 taxable year, GSDII reported income and expenses on its U.S. Partnership Return of Income, as follows:
+-----------------------------------------------------------------------------+
¦Interest income from securities purchased under agreement to ¦$13,447 ¦
¦resell ¦ ¦
+-----------------------------------------------------------------+-----------¦
¦Interest expense from securities sold under agreement to ¦(5,675,708)¦
¦repurchase ¦ ¦
+-----------------------------------------------------------------+-----------¦
¦Trading gain from U.S. Treasury note ¦283 ¦
+-----------------------------------------------------------------+-----------¦
¦Guaranteed payments to general partners ($40,000 each) ¦(80,000) ¦
+-----------------------------------------------------------------+-----------¦
¦Other expenses ¦(35,715) ¦
+-----------------------------------------------------------------+-----------¦
¦Net loss ¦(5,777,693)¦
+-----------------------------------------------------------------------------+
On its 1982 partnership return, GSDII claimed an additional $3,776,829 2 as interest on the above-described 1981 repo transactions. Additionally, GSDII entered into similar repo transactions at the end of 1982 and claimed $5,490,533 of repo interest for its 1982 taxable year regarding T-Bills purchased late in 1982 and maturing in January 1983.
In summary, the timing of the transactions here was critical and of overriding importance. The transactions were intentionally and cleverly structured to be and are real, 21 but are without substance within the meaning of established case precedent. The transactions occurred at year end to create deferral for tax purposes irrespective of whether they resulted in gain or loss, which, as structured, were destined to be de minimis in amount.
As demonstrated by the foregoing calculations, small changes in interest rates can cause a transaction to be profitable or unprofitable. This representative transaction also demonstrates that net profit or loss from a transaction ($5,175 in this example) is small compared to the par amount of the T-Bills involved ($60 million) and to the $761,175 interest expense claimed and $756,000 interest income eventually reported.
Ten of the 11 transactions in issue, including the J&L transaction, each: (1) Involved the purchase of T-Bills in late 1981 (between November 30 and December 18) simultaneous with the entry into a repo for T-Bills of the same par amount; (2) involved T- Bills maturing in January 1982; (3) involved an up-front cash payment by GSDII ($6,000 in the example) equal to the difference between the price of the T-Bills purchased ($59.244 million) and the principal price of the repo ($59.238 million), i.e., the so-called ‘haircut‘; (4) ended with a repo to maturity entered into during December 1981; and (5) showed a net loss for GSDII because the average interest rate under the repos was between .02 percent and .10 percent higher than the yield to maturity on the T-Bills. In addition, none of the transactions was cleared over the Fedwire; all were cleared via pairoff, with no actual delivery of T-Bills to GSDII or to the contra-parties pursuant to the repos. Four of the 10 transactions utilized a third, intermediary repo in addition to the initial repo and the repo to maturity, but those transactions were like the other 10 in all other respects.
The eleventh of the transactions in issue varied somewhat from the others. On December 16, 1981, GSDII purchased T-Bills with a par value of $10 million from New York Hanseatic (‘NYH‘). GSDII was to pay for the T-Bills on December 17, 1981, by entering into a one-day repo with R.M. Hobson (‘HOB‘). On December 17, 1981, however, NYH failed to deliver the T-Bills to GSDII. GSDII, as a result, was unable to deliver the T-Bills to HOB, as required under the one-day repo. The market refers to a party's failure to deliver securities as a ‘fail.‘ On December 18, 1981, GSDII paid HOB $3,367.73, which petitioners characterize as interest under the one-day repo and respondent characterizes as a fee for GSDII's fail. Also on December 18, 1981, GSDII entered into a repo to maturity with NYH in order to finance the T-Bills purchase from them. The repo rate was 10.88 percent, while the T-Bills had a yield to maturity of 10.42 percent. GSDII also paid NYH $1,376.84, an amount equal to GSDII's net loss on the transaction (without regard to the amount paid to HOB). The net result of GSDII's transaction with NYH is calculated as follows:
+--------------------------------------------------+
¦Interest on repo due to NYH ¦$101,710.17¦
+--------------------------------------+-----------¦
¦Discount on T-BIlls purchased 12/17/81¦100,333.33 ¦
+--------------------------------------+-----------¦
¦GSDII net loss ¦1,376.84 ¦
+--------------------------------------------------+
GSDII dealt with six contra-parties on the transactions in issue: J&L, Stuart Bros. (‘STU‘), Newcomb Securities Corp. (‘NSC‘), Cowen & Co. (‘COW‘), NYH, and HOB. Balance sheets from certain of those entities show their total assets as of specific dates, as follows:
+--------------------------------------------+
¦Entity¦Date ¦Total assets¦
+------+------------------------+------------¦
¦NSC ¦Jan. 31, 1981 (audited) ¦$5,102.512 ¦
+------+------------------------+------------¦
¦NSC ¦Jan. 31, 1982 (audited) ¦158,684,897 ¦
+------+------------------------+------------¦
¦J&L ¦May 31, 1981 (unaudited)¦22,720,406 ¦
+------+------------------------+------------¦
¦J&L ¦Sept. 24, 1982 (audited)¦84,941,000 ¦...To continue reading
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