Goldstein won the Irish
Sweepstakes (a big horserace). When he realized that this would move him
up to a higher tax bracket, he developed a plan to avoid paying a lot of
taxes on his winnings.
Goldstein took out a big loan
and bought government bonds with the money. Then he used the horserace
winnings to prepay the interest on the loan, and used the bonds as
collateral on the loan.
Effectively, this meant that
instead of having one big payday from the horse race, Goldstein would get
smaller payments from the bonds over the course of many years. That
would keep him in a low tax bracket because the taxable gain from the
winnings would be cancelled out by the deductible interest payments.
Goldstein filed his taxes and
claimed a deduction for all the interest he prepaid, based on 26 U.S.C.
§163(a). The IRS denied the
deduction. Goldstein appealed.
The IRS argued that based on
Knetsch v. United States (364
U.S. 361 (1960)), interest payments made solely for tax avoidance
purposes were not deductible. (aka the Sham Transaction Doctrine).
The two basic elements of a
sham transaction are that the
only purposes of the transaction was to create a deduction and that
there were no assets outside of the deal that could be called upon to
satisfy any liability (aka a non-recourse loan).
Goldstein distinguished his
situation from Knetsch since the
loan he made was not a non-recourse loan, and Goldstein's assets were potentially
at risk if the loan went bad.
In Knetsch, if Knetsch defaulted on the loan, the bank
couldn't go after his assets, so he had nothing at risk.
Goldstein was on the hook
for the loan. If for some reason the government defaulted on the bonds,
then the bank could take Goldstein's other assets (like his house).
But in reality, the chance
that the government would default on the bonds was pretty much 0%.
The Tax Court found for the
IRS. Goldstein appealed.
The Appellate Court affirmed
and denied the deduction.
The Appellate Court found
that an interest payment may not be deductible under §163(a) even though the underlying debt is a full
recourse debt.
The Appellate Court found
that the only reason for the transaction was for tax avoidance purposes.
Goldstein's assets were
never at risk unless the government defaulted on their bonds, and the
chance of that was so small that it effectively meant that none of
Goldstein's other assets were at risk.
Therefore, Goldstein's
situation was no different than Knetsch, and the Sham Transaction Doctrine still applies.
