Kirchman v. C.I.R.

• Decision Date: 11 January 1989
• Docket Number: No. 87-3585,87-3585
• Parties: -588, 89-1 USTC P 9130 Kenneth P. KIRCHMAN and Budagail S. Kirchman, Leo P. Ayotte and Nancy C. Ayotte, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1486

862 F.2d 1486

63 A.F.T.R.2d 89-588, 89-1 USTC P 9130

Kenneth P. KIRCHMAN and Budagail S. Kirchman, Leo P. Ayotte and Nancy C. Ayotte, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 87-3585.

United States Court of Appeals Eleventh Circuit.

Jan. 11, 1989.

Martin M. Ruken, Vedder, Price, Kaufman & Kammholz, Chicago, Ill., for petitioners-appellants.

Richard Farber, Tax Div., Dept. of Justice, Kenneth L. Greene, Washington, D.C., for respondent-appellee.

Appeal from a Decision of the United States Tax Court.

Before JOHNSON and CLARK, Circuit Judges, and ZLOCH ^*, District Judge.

JOHNSON, Circuit Judge:

This case arises on appeal from a United States Tax Court decision affirming the Commissioner of the I.R.S. in assessing a deficiency against appellant taxpayers. The Commissioner assessed a deficiency against approximately 1400 taxpayers for loss deductions taken for years 1975 through 1980 incurred in connection with commodity transactions entered into on the London Metals Exchange. Taxpayers' challenges were consolidated in a single case before the tax court. The tax court held that these transactions were shams with no legitimate economic substance because taxpayers had no profit motive, and upheld the Commissioner. Glass v. Commissioner, 87 T.C. 1087 (1986). ¹ Petitioners, four individual taxpayers, appealed. We affirm.

I. FACTS

The taxpayers involved in this dispute engaged in commodity option and futures transactions on the London Metals Exchange in the years 1975 to 1980. Taxpayers deducted as ordinary losses under I.R.C. Sec. 165(c)(2), 26 U.S.C.A. Sec. 165(c)(2), ² losses incurred in the first year of a two-year series of transactions involving commodities. Each taxpayer incurred significant first-year losses, and many realized approximately offsetting second-year capital gains.

The majority of these commodity transactions took the form of an option straddle transaction. An "option straddle transaction" is a commodity trading strategy involving both option and futures contracts. An option contract gives the holder of the option the right to purchase a particular commodity for a particular price on or before a certain date in the future. A futures contract is a contract that "requires the buyer to receive and the seller to deliver a specified quantity of a given commodity at some future date." Glass, 87 T.C. at 1101. A straddle is the simultaneous holding of contracts to buy and to sell the same commodity. Each contract is called a "leg" of the straddle.

The option straddle transactions occurred over two years. In the first year, a dealer in London executed a series of transactions on behalf of the taxpayer. The first step would be simultaneously to purchase an option to purchase a particular commodity (a "call option") and to sell a call option for the same quantity of the same commodity with different delivery dates. ³ In the second step, the dealer simultaneously purchased and sold futures contracts for identical quantities of the same commodity but with different delivery dates. This is called a futures straddle. At this point, in the simplest transaction, the taxpayer would have purchased a call option and a futures contract, and would have sold a call option and a futures contract on one particular commodity (typically silver). Each leg of the option and futures straddles would have a unique delivery date.

The dealer would then "close out" the legs of the option straddle by purchasing and selling identical offsetting positions. For the call option purchased, the dealer would sell an identical put option, and vice versa for the put option. Because this second set of option contracts would be purchased and sold on a different date than the original option contracts, the prices of the second contracts would differ. The result would be that in closing out one leg of the option straddle, the taxpayer would incur a loss, and in closing out the other leg, the taxpayer would incur an approximately equal gain. The loss realized would be deductible as ordinary loss under I.R.C. Sec. 165(c)(2), and could be used to offset income from other, unrelated sources. The gain would be a short-term capital gain.

To defer recognition of this gain, the taxpayer would close out the loss leg of the futures straddle ⁴ by purchasing an identical offsetting position and replacing it with a new position with a different delivery date. This is known as a "switch transaction." The loss incurred by closing out this leg of the futures straddle would be short-term capital loss and typically would approximately equal the short term capital gain realized by closing out the option straddle. This capital loss, then, would offset that capital gain.

The final step of the option straddle transaction would occur in the next year, although always at least six months after closing out the loss leg of the futures straddle. Both legs of the futures straddle would be closed out by offsetting trades, resulting in a gain approximately equal to the loss realized by closing out the loss leg of the futures straddle in the first year. The gain realized would be either long or short-term capital gain. In a second series of similar transactions, recognition of that gain could be deferred for another year.

A minority of the taxpayers involved in these transactions achieved similar tax results using an "option-hedge" trading strategy. The option-hedge transactions were similar to the option straddle transactions. The tax court provided a good summary of the transactions:

In an option-hedge transaction, the sale of a call and/or put option was hedged by the purchase of a futures contract (to hedge the call) and/or the sale of a futures contract (to hedge the put). Shortly thereafter, the option positions would be closed out at a net loss through the purchase of an identical offsetting call and/or put option. Simultaneously with the purchase of the closing option positions, futures contracts would be executed to hedge the previously purchased and/or sold futures, thus forming one or more futures straddles. Finally, in the following year, the futures straddles would be closed out at a gain approximately equal in amount to the loss incurred on the sold options.

Glass, 87 T.C. at 1106.

The tax results of these transactions would be that in the first year, the taxpayer would have realized an ordinary loss, a short-term capital gain, and an approximately offsetting capital loss. In the second year, the taxpayer would have realized a capital gain approximately equal to the capital loss (and, by extension, the ordinary loss) realized and reported in the first year. The petitioners in this case followed this pattern.

Almost all of these option-straddle or option-hedge transactions were conducted through one of six major commodity dealers: Competex, Rudolf Wolff, Gardner Lohmann, Amalgamated, Commodity Analysis, and Rothmetal. Eleven other broker/dealers were involved. The tax court analyzed the transactions done by these six dealers as representative of all transactions, with the understanding that taxpayers dealing through one of the smaller dealers would subsequently have the opportunity to demonstrate how their transactions differed from these. The petitioners in this case each dealt with one of the major brokers. ⁵

In a normal commodity straddle trading strategy, profit results from changes in the price differential ("spread") between the legs of the straddle. ⁶ In the transactions at issue in this case, all dealers minimized the risks of changes in the spread to minimize the risks of actual loss, and thereby greatly reduced or eliminated any chance of profit. Additionally, promotional materials for five of the six major dealers focused on the tax advantages of these commodity straddle trading strategies and either failed to mention or downplayed the profit potential. Finally, each of the brokerage companies engaged in abnormal trading practices in connection with these transactions, such as not laying off trades, not requiring adequate margins, executing trades before receiving initial margins, using prices that diverged substantially from market prices, manipulating commissions, and artificially adjusting contangos to achieve desired results. ⁷

The taxpayers deducted the first-year losses under I.R.C. Sec. 165(c)(2), claiming these were losses incurred in transactions entered into for profit. The Commissioner disallowed the deductions, and the tax court affirmed. The tax court found that these transactions were substantive shams because the petitioners did not enter into them with a profit motive. Id. at 1162. The court found that this "was a prearranged sequence of trading calculated to achieve a tax-avoidance objective--not investments held for non-tax profit objectives." Id. at 1163. The court concluded that because these transactions were shams, the losses incurred were not deductible under I.R.C. Sec. 165(c)(2).

II. DISCUSSION

A. Standard of Review

Petitioners have the burden of showing that the transactions were not a sham. Brown v. Commissioner, 85 T.C. 968, 998 (1985) (taxpayers challenging assessment of deficiency have burden of proof). Decisions about whether transactions are shams are normally reviewable under a clearly erroneous standard. See, e.g., Enrici v. Commissioner, 813 F.2d 293, 295 (9th Cir.1987) ("The clearly erroneous standard of review would govern even if the finding that the transactions were shams was inferred from undisputed basic facts concerning the transactions because the inference is still essentially factual."). Nevertheless, we review the tax court's conclusions de novo.

In this case, the tax court assumed as true the facts alleged for purposes of its analysis. The court itself stated that it was focusing on an issue of law, i.e., whether taxpayers' allegations, if proven, would be sufficient to achieve the tax results desired. Glass, 87 T.C. at...