## Facts

- Peerless Industries, Inc. (Peerless) manufactured boilers.
- Lebanon Valley College (LVC) was a small, private, tax-exempt educational institution.
- Eugene Fish, Peerless’s president, also served on LVC’s board of trustees and its finance committee.
- After learning of a similar arrangement involving a for-profit company and a tax-exempt school, Fish arranged for Peerless to issue a bond to LVC.
- Peerless issued LVC a $20 million bond with a 50-year term.
- LVC paid Peerless $23,066 for the bond, described as the expected present value of $20 million due in 50 years.
- The bond gave Peerless the right to retire (call) the bond early at a steep discount at any time after August 1986.
- For example, Peerless could retire the bond in August 1986 for $45,377—meaning Peerless’s net cash outlay, compared with the purchase price, would have been only $22,311 ($45,377 minus $23,066).
- Peerless claimed corporate income tax deductions for accrued interest on the bond for tax years 1985–1987 totaling $399,539.
- The structure created a large mismatch between the potential tax benefits and Peerless’s actual economic cost: if Peerless retired the bond in August 1986, it would have paid roughly $22,311 net but (based on the claimed annual accruals) could have generated deductions on the order of $2 million over several years.
- The IRS disallowed the claimed interest deductions and assessed a 25% addition to tax under I.R.C. § 6661 for substantial understatement, calculated at $129,771.
- Peerless filed a refund suit against the United States in federal district court, challenging both the disallowance of the interest deductions and the § 6661 penalty.

## Issues

1. Whether the Peerless–LVC bond was genuine indebtedness with economic substance such that Peerless could deduct accrued “interest,” or whether the transaction was a sham whose form should be disregarded for federal income tax purposes.
2. Whether, even if the deductions were properly disallowed, Peerless had “substantial authority” for its position under I.R.C. § 6661(b)(2)(B) so that the § 6661 penalty should not apply.

## Decision

- Judgment for the United States.
- The court held that the purported bond transaction lacked economic substance and did not create genuine indebtedness corresponding to the stated $20 million face amount for purposes of interest deductions.
- The court sustained the IRS’s disallowance of Peerless’s accrued interest deductions for tax years 1985–1987.
- The court sustained the 25% addition to tax under I.R.C. § 6661, concluding that Peerless did not have substantial authority for the deductions.
- The decision was later affirmed on appeal by the Third Circuit.  

## Legal Principles

- A taxpayer may deduct interest only if it arises from bona fide indebtedness—an enforceable obligation that has real economic consequences.
- Tax law looks to the substance of a transaction rather than labels or formal paperwork; when objective facts show a deal has no meaningful economic effect apart from tax savings, courts may treat it as a sham and deny the claimed tax benefits.
- A stated principal amount in a purported debt instrument may be disregarded when the taxpayer’s actual economic exposure is minimal compared with the amount used to compute interest deductions.
- Under I.R.C. § 6661, a substantial understatement penalty applies unless the taxpayer shows (among other statutory paths) that there was substantial authority supporting the reported treatment; authority that does not fit the taxpayer’s facts, or that is outweighed by contrary law applying the sham-transaction doctrine, will not avoid the penalty.

## Conclusion

Peerless’s bond transaction with LVC, though styled as a 50-year $20 million debt instrument, was treated as an economically empty arrangement designed to create large interest deductions at little real cost. The court therefore denied the interest deductions and upheld the § 6661 substantial understatement penalty because Peerless lacked substantial authority for claiming the deductions on these facts.


Peerless Industries, Inc. v. United States, 1994 WL 13837 (1994)