Horn v. C.I.R.

• Decision Date: 26 June 1992
• Docket Number: 91-1359,Nos. 91-1201,s. 91-1201
• Citation: 968 F.2d 1229
• Parties: , 70 A.F.T.R.2d 92-5196, 61 USLW 2044, 92-2 USTC P 50,328 Terence J. HORN and Jean Horn, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. COMMISSIONER OF INTERNAL REVENUE, Appellant, v. Terence J. HORN and Jean Horn, Appellees.
• Court: U.S. Court of Appeals — District of Columbia Circuit

Page 1229

968 F.2d 1229

296 U.S.App.D.C. 358, 70 A.F.T.R.2d

92-5196, 61 USLW 2044,

92-2 USTC P 50,328

Terence J. HORN and Jean Horn, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

COMMISSIONER OF INTERNAL REVENUE, Appellant, v. Terence J. HORN and Jean Horn, Appellees.

Nos. 91-1201, 91-1359.

United States Court of Appeals District of Columbia Circuit.

Argued May 11, 1992.

Decided June 26, 1992.

Elias Rosenzweig, with whom Stanley Klein and Michael Weitzner, New York City, were on the brief, for appellants in No. 91-1201 and appellees in No. 91-1359.

Kimberly S. Stanley, Attorney, Dept. of Justice, with whom Shirley D. Peterson, Asst. Atty. Gen., and Gary R. Allen and Kenneth L. Greene, Attorneys, Dept. of Justice, Washington, D.C., were on the brief, for appellee in No. 91-1201 and appellant in No. 91-1359.

Before: EDWARDS, BUCKLEY and SENTELLE, Circuit Judges.

Opinion for the Court filed by Circuit Judge HARRY T. EDWARDS.

HARRY T. EDWARDS, Circuit Judge:

In this case, we are called upon to decide whether Congress intended to authorize a deduction for losses incurred by certain taxpayers who engaged in transactions of a type designed to secure tax benefits while avoiding any economic risk. More specifically, we must decide whether section 108 of the Tax Reform Act of 1984, as amended, permits commodities dealers to deduct losses incurred in the disposition of the legs of straddle transactions, even if the taxpayer's pattern of trading reveals that the transactions were designed only to produce tax benefits.

The Commissioner of the Internal Revenue Service ("Commissioner") principally claims that the transactions at issue were "economic shams"--i.e., devoid of any "economic substance" or any prospect of true gain or loss--and, therefore, must fall outside section 108. In taking this position, the Commissioner gives no credence to section 108(b)'s irrebuttable presumption that commodities dealers were acting in the course of their trade or business in making these trades. The Tax Court agreed with the Commissioner and found against the taxpayers. On the record before us, the Commissioner's position is plainly and simply wrong. Thus, we are constrained to reverse and remand.

The principal problem that we find with the Commissioner's argument is that it takes the sham transaction doctrine too far. Although useful in determining congressional intent and in avoiding results unintended by tax code provisions, the doctrine cannot trump the plainly expressed intent of the legislature. In this case, the plain meaning of the statute authorizes the claimed deductions, and the Commissioner has utterly failed to provide any other colorable interpretation. Therefore, we reverse the judgment of the Tax Court and remand the case for further proceedings.

I. BACKGROUND

The parties submitted this case to the Tax Court on cross-motions for summary judgment and on stipulated facts sub nom. Fox v. Commissioner, 56 T.C.M. (CCH) 836 (1990). Fox was a consolidated case involving twelve taxpayers associated with the Czarnikow-Rionda Company, a subchapter S corporation which regularly traded physical sugar, sugar futures and options on sugar futures for its own account and as a broker, and which was a member of the New York Coffee and Sugar Exchange (now the New York Coffee, Sugar and Cocoa Exchange). See Stipulation of Facts pp 10-12, reprinted in Joint Appendix ("J.A.") 11. Each of the taxpayers was assessed a deficiency by the Commissioner based upon similar commodities trades made on the London Metal Exchange ("LME"). Id. pp 4-7, J.A. 8-9.

The stipulated facts stated that the "London options transactions at issue in this case are of the same type as those described by the [Tax] Court in" Glass v. Commissioner, 87 T.C. 1087, 1104-06 (1986) (section III.A of the court's opinion). The details of the type of transaction involved have been well described by numerous other courts and commentators ¹ and, ultimately, are not central to our decision. Briefly stated, the taxpayers primarily utilized an "option-straddle transaction," a two-year commodities market trading strategy which involves an options straddle and two futures straddles. A "straddle" is the simultaneous taking of offsetting positions with different delivery dates in a given commodity. ² In the first year, the taxpayers engaged an options straddle and a futures straddle, closed out the options straddle and the loss leg of the futures straddle and reestablished the futures straddle by purchasing a futures contract to offset the leg remaining from the original futures straddle. The simultaneous closing of the loss leg and reestablishing the straddle is known as a "switch." In the second year, but not sooner than six months after the switch, the taxpayer closed out the remaining futures straddle. ³

The strategy yielded an ordinary income loss in the first year and a long-term capital gain in the second year, thereby converting ordinary income to long-term capital gain income and deferring taxation to subsequent years. These results were possible because, at the time, disposing of the offsetting legs of a given straddle transaction was not identified as a single taxable event and because the Commissioner treated the disposition of a granted option as creating ordinary income or loss while treating the disposition of a purchased option as creating capital gain or loss. ⁴ These results were desirable not only because the real cost of money always makes tax deferral preferable but also because, at the time, the tax on long-term capital gain was much lower than the top marginal rate on ordinary income. See, e.g., 26 C.F.R. §§ 1.1, 1.1201, 1.1234 (1978) (tax rates). Finally, because the legs of a straddle represent opposite sides of an interest in a given commodity, straddle transactions substantially reduce market risk, although they do not eliminate it completely; thus, the strategy could be counted upon to produce the desired tax results.

These "tax straddle" transactions were extremely widespread in the middle and late 1970s. The Commissioner responded in 1977 by issuing a revenue ruling which held that straddle transactions would be treated as single events--that the legs of a straddle would be identified and gains and losses from the legs would be netted whether or not disposition occurred in a single year, see Rev.Rul. 77-185, 1977-1 C.B. 48--and by issuing a huge number of notices of deficiencies. The Commissioner's actions regarding straddles engaged in on the LME eventually resulted in Glass v. Commissioner, the largest consolidated action in Tax Court history, which involved approximately 1400 taxpayers. In 1981, in the Economic Recovery Tax Act of 1981 ("ERTA"), Pub.L. No. 97-34, 95 Stat. 172 (1981), the Congress also responded to the tax straddle phenomenon, eliminating the strategy by requiring identification of straddles and unitary treatment of the disposition of coordinate legs. However, the legislation was wholly prospective, and the Commissioner and the taxpayers who had been assessed deficiencies continued to battle over pre-ERTA tax straddle transactions; the Commissioner claimed that the transactions were wholly tax-motivated sham transactions while the taxpayers claimed that the transactions were genuine, were not undertaken solely for tax purposes and were legal.

In 1984, in an attempt to clarify the law governing pre-ERTA straddles and to eliminate the backlog of pre-ERTA cases in the Tax Court, Congress passed section 108 of the Deficit Reduction Act of 1984, Pub.L. No. 98-369, 98 Stat. 494, 630-31 (1984) ("section 108"). Section 108 provided that, for all pre-ERTA straddles, losses incurred from closing out legs of straddles would be allowed in the year of disposition only if the straddle was entered into for profit. Straddles executed by commodities dealers were rebuttably presumed to be for profit. See 98 Stat. at 630. In 1986, Congress amended section 108 to allow the loss in the year of disposition when the straddle was entered into for profit or in a trade or business; Congress also strengthened the presumption for commodities dealers by making it irrebuttable that they acted in a trade or business. Tax Reform Act of 1986, Pub.L. No. 99-514, § 1808(d), 100 Stat. 2817 (1986). As amended, section 108 now reads, in primary part, as follows:

(a) GENERAL RULE--For purposes of the Internal Revenue Code ..., in the case of any disposition of 1 or more positions--

(1) which were entered into before 1982 and form part of a straddle, and

(2) to which the amendments made by [ERTA] do not apply,

any loss from such disposition shall be allowed for the taxable year of the disposition if such loss is incurred in a trade or business, or if such loss is incurred in a transaction entered into for profit though not connected with a trade or business.

(b) LOSS INCURRED IN A TRADE OR BUSINESS--For purposes of subsection (a), any loss incurred by a commodities dealer in the trading of commodities shall be treated as a loss incurred in a trade or business.

I.R.C. § 1092 note (1988) (Treatment of Certain Losses on Straddles Entered Into Before Effective Date of Economic Recovery Tax Act of 1981). ⁵

The Glass case dealt with taxpayers who were not commodities dealers and who had engaged in pre-ERTA tax straddle transactions on the LME. The Tax Court found that the transactions were without economic substance--that is, they were engaged in solely for the expected tax benefits and without any expectation of or reasonable prospect for true economic gain. See 87 T.C. at 1153-77. The Glass decision has been affirmed by each circuit which has considered the issue. ⁶ Subsequent to Glass, the Tax Court considered two cases involving taxpayers who claimed to be commodities dealers, Cook v. Commissioner, 90 T.C. 975 (1988), aff'd, 941 F.2d 734 (9th Cir.), cert. denied, --- U.S. ----, 112 S.Ct. 172, 116 L.Ed.2d 135 (1991), and the case on...