Keeler v. Comm'r of Internal Revenue
| Decision Date | 13 March 2001 |
| Docket Number | No. 99-9032,99-9032 |
| Citation | 243 F.3d 1212 |
| Parties | (10th Cir. 2001) K. RICHARD KEELER, PETITIONER - APPELLANT, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT - APPELLEE |
| Court | U.S. Court of Appeals — Tenth Circuit |
Appeal from the United States Tax Court T.C. No. 8648-93
[Copyrighted Material Omitted] Matthew D. Lerner, Steptoe & Johnson Llp, Washington, D.C., for the Petitioner-Appellant.
Donald B. Tobin (Kenneth L. Greene with him on the brief), Department of Justice, Tax Division, Washington, D.C., for the Respondent-Appellee.
Before Ebel, McKAY and Lucero, Circuit Judges.
We consider whether the Commissioner of Internal Revenue properly disallowed losses incurred by petitioner-appellant K. Richard Keeler ("taxpayer") through his participation in a derivatives market created by Merit Securities, Inc. The Commissioner determined taxpayer's transactions lacked economic substance and were not entered into primarily for profit. The Tax Court agreed with the Commissioner, holding that taxpayer's gains and losses from trading in the Merit market could not be recognized for tax purposes. The court also ordered Keeler to pay additional taxes for his negligence in reporting losses under I.R.C. § 6653(a) and increased interest for substantial underpayments attributable to tax-motivated transactions under I.R.C. § 6621(c). See Leema Enters., Inc. v. Comm'r, 77 T.C.M. (CCH) 1261 (1999). Exercising jurisdiction pursuant to I.R.C. § 7482, we affirm.
The trading program we examine provided hefty opportunities for tax savings but only illusory opportunities for economic profit. Under scrutiny, what profit potential the Merit markets offered appears anemic beside their considerable capacity for tax gaming. Merit traders incurred inflated losses in one year and recognized corresponding gains in the next, accelerating deductions and deferring gains to reduce overall tax liability in a given year to as little as zero. These "straddle" trades allowed taxpayer to exploit the necessary construct of separate taxable years and to violate a cardinal rule of the tax code: transactions lacking economic substance are not recognized for tax purposes. See Gregory v. Helvering, 293 U.S. 465, 469-70 (1935).
Because the relevant facts in this case are recounted in the Tax Court's exhaustive opinion, we need only summarize them here. In 1981, Congress passed the Economic Recovery Tax Act of 1981 ("ERTA"), Pub. L. No. 97-34, § 501(a), 95 Stat. 172, 323. To limit the use of straddle tax shelters, ERTA added § 1092 to the Internal Revenue Code ("the Code"), providing that losses from straddle trades can be recognized only to the extent they exceed unrealized gain on the offsetting portion of the straddle.1 See I.R.C. § 1092; S. Rep. No. 97-144, at 9 (1981). However, losses from ownership of stock were excepted from § 1092's loss disallowance rule, and in 1981 Merit created its stock forwards program, the derivatives trading market at issue in the instant case.
Participation in the stock forwards program allowed taxpayer to incur significant tax losses in one year while deferring corresponding gain into future taxable years by holding instruments in the form of a straddle, a hedged position composed of two substantially offsetting positions. Typically, taxpayer would purchase both a long contract to buy stock from Merit at a future date and specified price and an equivalent short contract to sell the same stock to Merit at another future date and specified price. A rise in the value of one contract, or "leg," ordinarily approximates a decline in the value of the other leg, functioning as a hedge against adverse market moves. While the price differential between two legs may change, a straddle carries substantially less risk than a single short or long contract-and correspondingly less profit potential. Ownership of "combination spreads" further limited the risk to investors through the acquisition of two straddles on the same underlying security. In order for a combination spread to undergo a net change in value, the price differential between the legs of one straddle would have to change with respect to the price differential of the legs of the other straddle.
Nearly all of the trades in Merit's stock forwards program exhibited an "open-switch-close" pattern. An investor "opened" a position by buying or selling a straddle. Late in the year of purchase, the investor would sell or cancel the losing leg-recognizing a tax loss-and purchase a replacement leg (the "switch"), waiting until the new tax year to close out his or her position and recognize gains approximating taxable losses from the previous December. Although cancellations are typically used in derivatives trading only to correct errors, see Freytag v. Comm'r, 904 F.2d 1011, 1014 n.4 (5th Cir. 1990), aff'd on other issues, 501 U.S. 868 (1991), Merit's promotional materials advertised that positions could be canceled and losses from cancellations could be deducted as ordinary losses.
Because the forward contracts were not subject to the loss disallowance rules of ERTA, investors could continue to enjoy the tax advantages of the "open-switch-close" sequence no longer available through Merit's option programs. Merit's offering memorandum for the stock forwards program included an extended discussion of its tax advantages.2 In contrast detailed projections of actual economic returns were notably absent from the document.
The high volatility of the stocks chosen as the underlying securities in the program ensured that substantial tax losses would be available at year's end. The stock forwards program was open only to sophisticated, experienced investors, and Merit's small group of clients transacted almost exclusively among themselves, never with unrelated participants, making arms-length competitive pricing improbable at best.
Merit profited from operation of its markets in two ways. First, it charged a fee known as a "bid/ask differential," which, with few exceptions, was used only on opening transactions. Second, it retained the interest on participants' margin deposits. Merit's investors maintained margin accounts in amounts much larger than its explicit margin policy would suggest was necessary. For example, taxpayer had approximately $1.2 million on deposit for over a year, while his margin requirement averaged less than $200,000.
Instruments traded on the stock forwards market were not listed on any formal exchange, registered with the Securities and Exchange Commission or sold anywhere outside the Merit market, and the prices of the contracts were determined according to a Merit-devised formula. Although option and forward contracts contemplate actual delivery of the underlying commodity or security, delivery was the rare exception in the Merit programs: Out of 54,065 transactions, investors took delivery on only two, and taxpayer never took delivery.3 See Freytag, 904 F.2d at 1013 ().
In 1981, the first year of the stock forwards program, every participant took a first-year loss, for aggregate losses of $75.3 million. Those losses were accompanied by simultaneous replacement contracts and by aggregate unrealized gains of $73.5 million. In 1982, the aggregate loss incurred late in the year was $15.8 million, and the amount of offsetting unrealized gains was $13.9 million.
Taxpayer's results in the stock forwards program mimicked that pattern. In 1981, his net losses of $7,598,940 in the Merit programs were within $3660 of his adjusted gross income ("AGI")-a difference of only 0.05%-offsetting his entire AGI for that year. Of his seventeen transactions in that year, only one produced a gain. All of taxpayer's closing transactions in December of 1981 produced realized losses. In 1982, his December losses offset ninety-seven percent of his adjusted gross income for that year, including gains incurred in January by closing out his 1981 straddles. Of taxpayer's forty-three closing transactions in December 1982, each produced a loss, for a total of $9,955,447.
Amid concern that taxpayers were exploiting a loophole to achieve tax deferral, Congress repealed its exception of stock from the loss disallowance rules of I.R.C. § 1092, effective for positions established after December 31, 1983. See Deficit Reduction Act of 1984 ("DEFRA"), Pub. L. No. 98-369, § 101, 98 Stat. 494.4 Taxpayer ended his participation in the stock forwards program in January 1984.
The Commissioner disallowed taxpayer's claimed Merit losses from 1981, 1982, and 1983 and issued a notice of deficiencies and additions to tax. Following trial, the Tax Court determined Keeler's liability in the following amounts:
The Tax Court also ordered additions to tax pursuant to I.R.C. § 6653(a)(2) in amounts equal to fifty percent of the statutory interest on his deficiencies, as well as increased interest on underpayments attributable to tax-motivated transactions pursuant to I.R.C. § 6621(c).
In inquiring whether taxpayer's deductions were properly disallowed, we look past the form of the transactions at issue and examine their substance. We conclude the Tax Court properly determined that the Merit trades were intended as generators of tax benefits, not of economic profits. See Leema Enters., slip op. at 45 ( ).
When examining a finding that a transaction lacks economic substance, this Court reviews findings of fact...
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