Dewees v. C.I.R., 87-1763

• Citation: 870 F.2d 21
• Decision Date: 04 October 1988
• Docket Number: No. 87-1763,87-1763
• Parties: -934, 89-1 USTC P 9224 David DEWEES and Anne Dewees, Petitioners, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee. . Heard
• Court: United States Courts of Appeals. United States Court of Appeals (1st Circuit)

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870 F.2d 21 63 A.F.T.R.2d 89-934, 89-1 USTC P 9224 David DEWEES and Anne Dewees, Petitioners, Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee. No. 87-1763. United States Court of Appeals,
First Circuit. Heard Oct. 4, 1988.
Decided March 15, 1989.

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Martin M. Ruken with whom Stuart D. Kenney, Vedder, Price, Kaufman & Kammholz, Kenneth C. Shepro and Altheimer & Gray, Chicago, Ill., were on brief, for petitioners.

Kenneth L. Greene, Tax Div., Dept. of Justice, with whom William S. Rose, Jr., Asst. Atty. Gen., Gary R. Allen and Richard Farber, Tax Div., Dept. of Justice, Washington, D.C., were on brief, for respondent.

Before BOWNES and BREYER, Circuit Judges, and BROWN, ^* Senior Circuit Judge.

BREYER, Circuit Judge.

Taxpayers David and Anne Dewees appeal from a Tax Court decision that a 1978 loss they incurred while engaged in "straddle" trading on the London Metals Exchange was not an "ordinary loss" deductible from their income. See Internal Revenue Code, 26 U.S.C. Sec. 165(c)(2) (1982); Deficit Reduction Act of 1984, Pub.L. No. 98-369, Sec. 108, 98 Stat. 494, 630-631 (1984) (a provision enacted specifically to govern deductions of losses from straddle transactions). The Tax Court held that their loss was not deductible because the transactions were shams, without economic substance, see Gregory v. Helvering, 293 U.S. 465, 469-70, 55 S.Ct. 266, 267-68, 79 L.Ed. 596 (1935), or, alternatively, because the transactions were not "entered into for profit" within the meaning of Sec. 108. Consequently, the Deweeses cannot deduct the loss from their ordinary income, though they can use it in calculating the net losses or gains they incurred from the whole series of transactions, under Sec. 108(c). Glass v. Commissioner, 87 T.C. 1087 (1986).

The Deweeses claim that the Tax Court is wrong, that their transactions have economic substance and were entered into "for profit." The issue they raise is important because their transactions typify those at issue in about 1,100 other cases consolidated by the Tax Court (the "London options cases"), involving potential tax revenues of more than $60 million. We have devoted considerable efforts to understanding, in detail, the typical transactions before us. We have concluded that these transaction are not "for profit," and that the Tax Code forbids the deduction that the Deweeses seek. And, we have decided to explain our reasons through the use of a hypothetical example (created with the help of the parties) that both captures the essence of the actual transactions and permits us, by varying certain assumptions, to deal more

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easily with the legal arguments the parties raise.

I.

Background

To understand the trading strategy the Deweeses used, one must keep several background facts in mind. First, dealers on the London Metal Exchange typically sell silver in 10,000 ounce "lots." They sell silver for future delivery up to 7 months away. Thus, in January one can buy current, February, March, April, May, June, July or August silver. The price of a later lot will normally exceed the price of an earlier lot by a small amount of money which reflects the interest on the money that is "tied up" in the silver (plus storage and insurance costs and other minor factors). For example, if March silver sells for 250 pence per ounce, April silver will then likely sell for 255 pence per ounce. This price difference is called the "contango" (a concept that plays an important role in this case).

Second, a buyer or seller of silver for future delivery often does not really expect to deliver, or to receive, the silver in question. Rather, as the time for delivery approaches, he will buy or sell an offsetting amount of silver. Doing so is called "liquidating" or "closing out" a "position."

One can also buy or sell options. When one buys an option on future silver, one does not have to exercise it; one merely has a right to exercise it. Thus, assume that it now is January, January silver is selling for 250 pence per ounce, and July silver is selling for 280 pence per ounce. Assume that Jane wants an option to buy July silver at a price of 280 (an "option to buy" is, of course, an option to buy at a certain price, which price is called the "strike price.")

Even though the strike price is 280 and July silver now sells for 280, Jane will have to pay something for her option. That is because she wants a one-way bet. If the July price goes up, she will exercise her right to buy, and make money; if the July price goes down, she will throw the option away. Someone may be willing to make this "bet" with her, but only at a price. The person who sells her this bet is called the "grantor" of an option, and the price she pays him is called the "premium." The grantor is betting that the price of July silver will decrease, or not increase by much. If he is right, it will not be to Jane's advantage to exercise the option, and he will have gained the premium. However, if July silver goes up, he will have to buy silver at a higher price, to offset his obligation to deliver silver to Jane at 280. If the difference between that higher price, and the strike price of 280, comes to more than the premium Jane paid him, then he loses money overall. The premium paid for an option depends both on whether the strike price favors the buyer or the grantor of the option, and on the "time value" of the option, i.e., how long the option remains open and the grantor remains at risk.

So far we have described Jane's purchase of a "call" option, an option to buy. Jane might also purchase a "put" option, an option to sell silver, for example, next July at 280. In buying a "put" option, Jane is hoping the price of July silver will fall, while the grantor of the option is hoping the price will stay fairly constant or rise, so that Jane does not exercise her option and the grantor can simply keep its purchase price.

Third, the London Metal Exchange is a principal-to-principal market, in which broker/dealers buy and sell directly from and to clients. This differs from a clearinghouse market like the American stock exchanges, in which brokers arrange trades between their clients and third parties. The London broker/dealers have greater freedom than American stockbrokers in setting the terms of trades. They can make trades both inside and outside of formal market sessions, and they are free to set strike prices and premiums through private negotiation. The result is that one cannot easily determine (by, say, looking to public exchange prices) the precise terms that a "free market" would set for a particular option or futures contract. However, brokers on the Exchange have a practice of

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"laying off" their trades with each client, each day, by entering into offsetting transactions with other buyers or sellers. This way, the brokers are exposed to no net market risk, and do not hold interests adverse to their clients'. Laying off trades is possible only if brokers' discretionary trades with their clients are at prices that conform to the market, so this practice tends to standardize prices on any given trading day.

Fourth, the Internal Revenue Service, in 1974, issued a ruling that the closing out of either a put or call option that one has bought produces a capital gain or loss, but the closing out of an option that one has granted produces an ordinary gain or loss. Private Letter Ruling 7404080200A (April 8, 1974) (the "Zinn Ruling," issued to the Chicago Board Options Exchange). This treatment made legal sense in light of the wording of the relevant statutory provisions, see 26 U.S.C. Sec. 1234, but it produced an economic asymmetry that made it possible to create ordinary losses for tax purposes and offset them with capital gains. See Glass, 87 T.C. at 1153-55.

Fifth, the Internal Revenue Code treats offsetting sales and purchases that take place within a single month as "wash sales," and disregards them. 26 U.S.C. Sec. 1091(a). However, the transactions in this case involve lots of silver for sale in different months, so they are not "wash sales," even if they seem to cancel each other out.

II.

The Transactions

On the basis of the Tax Court's descriptions, the parties' briefs, and oral argument, we believe we can view the essence of the trading strategy used by the Deweeses as a series of transactions having three parts, an options straddle, a futures straddle, and a futures switch. A taxpayer buys and sells both "put" and "call" options on future silver (the "options straddle"). He waits a few weeks for prices to change, and then liquidates his positions, creating ordinary losses and short-term capital gains. The taxpayer uses the ordinary losses to offset ordinary income from other sources. He then buys and sells silver for delivery several months later (the "futures straddle"). He waits a month or so for prices to change. He then liquidates whichever is the loss leg of the futures straddle, to create a short-term capital loss to offset his short-term capital gain. Finally, the taxpayer "locks in" his gain leg, by making an offsetting futures purchase or sale (the "futures switch"). The next year he liquidates all his futures positions, realizing a capital gain. This gain may be a long-term capital gain, see 26 U.S.C. Sec. 1222(3), which was taxed at a low rate, or a short-term capital gain. If it was the latter, the taxpayer can use another futures straddle to "roll over" the gain into the next year, again deferring tax liability, and hoping to convert it into a long-term capital gain.

We shall now describe what we have come to regard as the "paradigm" transaction in greater detail, through an example. Although the example is simplified, we believe it embodies the essence of the actual transactions into which the Deweeses (and many other taxpayers) entered. The example uses imaginary dates and numbers, and makes the important simplifying assumption that the...