Friedman v. C.I.R.

• Decision Date: 03 March 1989
• Docket Number: No. 87-1154,87-1154
• Citation: 869 F.2d 785
• Parties: -830, 89-1 USTC P 9198 Sheldon E. FRIEDMAN; Debby B. Friedman; Zell C. Hurwitz; Myrna Hurwitz; Alvin Akman; Marion Akman; Leonard Gilmor; Sandra Gilmor; Morton M. Perry; Dorothy G. Perry, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 785

869 F.2d 785

63 A.F.T.R.2d 89-830, 89-1 USTC P 9198

Sheldon E. FRIEDMAN; Debby B. Friedman; Zell C. Hurwitz;

Myrna Hurwitz; Alvin Akman; Marion Akman;

Leonard Gilmor; Sandra Gilmor; Morton

M. Perry; Dorothy G. Perry, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 87-1154.

United States Court of Appeals, Fourth Circuit.

Argued Oct. 6, 1988.

Decided March 3, 1989.

Martin M. Ruken (Stuart D. Kenney, Vedder, Price, Kaufman & Kammholz, Kenneth C. Shepro, Altheimer & Gray, Chicago, Ill., on brief), for petitioners-appellants.

Kenneth L. Greene, Washington, D.C. (William S. Rose, Jr., Asst. Atty. Gen., Gary R. Allen, Richard Farber, Tax Div., Dept. of Justice, Washington, D.C., on brief), for respondent-appellee.

Before WIDENER, PHILLIPS, and ERVIN, Circuit Judges.

ERVIN, Circuit Judge:

The appellants herein all claimed ordinary loss deductions on their 1976 income tax returns as a result of losses incurred in London options transactions. The Commissioner challenged these deductions, and assessed deficiencies against each of the appellants for the 1976 tax year. The Tax Court found in favor of the Commissioner. We affirm the decisions of the Tax Court.

I.

The instant case is one of several appeals taken from decisions entered pursuant to the United States Tax Court's opinion in Glass v. Commissioner, 87 T.C. 1087 (1987). Appeals were filed in ten of the country's thirteen federal judicial circuits. Glass involved the largest single consolidation of cases in the history of the Tax Court, with petitioners at one time numbering over 1,400. The Glass petitioners all claimed ordinary loss deductions on their income tax returns as a result of "London options transactions."

The options trading strategies at issue in this appeal resulted from a series of IRS letter rulings which reaffirmed two basic federal tax principles. "First, a person who bought an option held that underlying commodity as a capital asset. Accordingly, any loss or gain on a bought option would be treated as capital. Second, one who sold or granted an option did not own the underlying commodity. Any gain or loss as a sold option would therefore be treated as ordinary." Glass, 87 T.C. at 1153. These rulings, known as the Zinn rulings, spawned a substantial offshore cottage industry in commodity tax straddles.

The rulings resulted at least in part from Sec. 1234 of the Internal Revenue Code as it read prior to September 2, 1976:

SEC. 1234. OPTIONS TO BUY OR SELL.

(a) TREATMENT OF GAIN OR LOSS--Gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, a privilege or option to buy or sell property shall be considered gain or loss from the sale or exchange of property which has the same character as the property to which the option or privilege relates has in the hands of the taxpayer or would have in the hands of the taxpayer if acquired by him.

* * *

(c) SPECIAL RULE FOR GRANTORS OF STRADDLES.--

(1) GAIN ON LAPSE.--In the case of gain on lapse of an option granted by the taxpayer as part of a straddle, the gain shall be deemed to be gain from the sale or exchange of a capital asset held for not more than 6 months on the day that the option expired.

26 U.S.C. Sec. 1234 (1976). Thus Sec. 1234(c)(1) as in effect prior to September, 1976, only addressed the character of the gain realized on the lapse of an option which had been granted as part of a straddle. The statute did not address the character of the gain or loss realized on a closing transaction entered into with respect to a granted option prior to the lapse of that option.

In response to the Zinn rulings, Congress amended Sec. 1234. The statute now provides that gain or loss from a closing transaction is to be treated as short term capital gain or loss. This amendment was only prospective in application, and the taxpayers here are all disputing the amount of tax owed for the 1976 year.

All the London options trades were executed on the London Metal Exchange (LME), a commodity exchange on which cash, future, and option contracts in silver, copper, zinc, tin and lead are all traded. There is no governmental regulation of the LME and, unlike its American counterparts, the LME does not operate as a clearinghouse for trades. Rather, all transactions are executed on a principal to principal basis. Thus, a taxpayer who purchased an option or futures contract through a broker/dealer was, in effect, actually purchasing that contract directly from the broker/dealer. Conversely the broker/dealers were the purchasers of all contracts sold by taxpayers executing transactions on the LME.

Because the LME operates as a principal's market, broker/dealers are legally obligated to fulfill their part of any contract entered into with either another broker or a client. For this reason a broker/dealer will normally "lay off" her trades--i.e., will enter into an offsetting contract with a third party. Although the LME does not require broker/dealers to lay off trades, one who fails to do so is said to be "running a position" (taking a risk) in the market.

No limits exist on price changes for metals traded on the LME. Prices are free to fluctuate on the exchange as market conditions dictate.

The traditional LME option is known as a "market option." The strike price ¹ of a market option is usually equal to the current forward trading price of the underlying metal. These options are normally traded for a specific delivery date falling 1, 3, 6, 9 or 12 months from the day the option contract is made. Market options are very difficult to "close out" by entering into an offsetting contract for two reasons: (1) the usual practice of setting the strike price at the current market price at the time the option is granted; and (2) the relatively rigid setting of declaration dates ² usually involved in market options.

Because of this lack of flexibility all of the options traded by the taxpayers in this case were "traded" or "dealer" options. With dealer options the price is not tied to the current trading price of the underlying metal. The contracting parties are free to use their discretion to set both delivery and declaration dates and the strike price. Any difference between the strike price and the market price of the underlying commodity, however, is usually reflected in the premium paid or received by the holder or grantor of the option.

All of the taxpayers involved in this appeal traded through Rothmetal Trading, Ltd. (Rothmetal), one of the six major offshore broker/dealers who executed these types of transactions. Rothmetal's promotional materials explained to prospective clients exactly what an option is, and why the transactions in question had to take place on the LME in order to achieve the desired tax consequences. Those materials provided:

A "call" is an option to buy property such as real estate, securities or commodity future contracts. A "put" is the opposite, an option to sell. The most common example of a call option is the real estate option to buy property. All options contracts include a span of time for which the offer is held open, an offering price for the property itself (called the striking price) and a cost for buying the option (called the option premium). For example, if you owned a piece of real estate, you could write an option against the underlying property for say, $100,000 that is good for the next six months. Anyone desiring to tie up this property at $100,000 offering price for six months would buy this option from you for say $1,000 (the option premium).

One of three things can then happen to the option (a) The option is exercised if the option holder buys the property within six months for $100,000 (b) The option is not exercised within the six months and expires (c) Prior to the six month expiration, the option is sold to another party. In our transactions for taxes (a) and (b) never occur since the "sold" options are always bought back in a closing transaction prior to expiration or exercise.

The preceding example can similarly be applied in the securities and commodities markets. We have chosen the commodities markets on the London Bullion Markets for tax transactions because of the following reasons (a) Real estate does not work because of little liquidity, little market movement and no real "put" options available (b) The stock market options in the U.S. are not feasible because of no "put" options available, large fluctuations in spreads resulting in high risk, too little leverage available (i.e. it's ridiculous to buy $2,000,000 of IBM stock to create a $100,000 loss) and commission costs are exorbitantly high (c) The U.S. commodities markets do not have puts and calls available which are what the IRS rulings are based on.

The only alternative is to use the largest foreign market exchange in the world, the London Bullion Market, because all of the tools that are needed are available at minimum risk. Here the tax client is insured [sic] that all transactions made are registered (cleared) trades through the Bullion Market with detailed records checked monthly by the Bank of England. He is also quoted a firm but low price for effecting these trades (no more than 15%) [sic] of the amount to be converted).

A typical London options transaction involved a two year (or more) series of commodity straddles and employed either an "option straddle" or an "option hedge" trading strategy. With the option hedge trading strategy used by Rothmetal the sale of a call and/or a put option was hedged by the purchase and/or sale of a forward contract. ³ Such a contract may be closed out prior to the delivery date by entering into an offsetting contract with identical terms. The option position would then be closed out at a net loss through the purchase of an identical offsetting call and/or put option. This loss would be reported as ordinary loss during the first year.

Simultaneously with...