Killingsworth v. C.I.R.

• Decision Date: 08 February 1989
• Docket Number: Nos. 87-4623,88-4227 and 88-4551,s. 87-4623
• Citation: 864 F.2d 1214
• Parties: -735, 89-1 USTC P 9167 Raymond KILLINGSWORTH and Patsy Killingsworth, Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. T.B. HUDSON and Dorothy Hudson, Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Donald R. METZ and Cathy S. Metz, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Herbert H. BLANKINSHIP and V. Elizabeth Blankinship, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Hugh L. CLEARMAN and Dorothy Clearman, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Robert C. NOREN and Willie M. Noren, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Alfred L. FRIEDLANDER and Paula Friedlander, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1214

864 F.2d 1214

63 A.F.T.R.2d 89-735, 89-1 USTC P 9167

Raymond KILLINGSWORTH and Patsy Killingsworth, Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

T.B. HUDSON and Dorothy Hudson, Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Donald R. METZ and Cathy S. Metz, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Herbert H. BLANKINSHIP and V. Elizabeth Blankinship, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Hugh L. CLEARMAN and Dorothy Clearman, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Robert C. NOREN and Willie M. Noren, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Alfred L. FRIEDLANDER and Paula Friedlander, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 87-4623, 88-4227 and 88-4551.

United States Court of Appeals Fifth Circuit.

Feb. 8, 1989.

Martin M. Ruken, Chicago, Ill., for petitioners-appellants in No. 87-4623.

William F. Nelson, Chief Counsel, I.R.S., Kenneth L. Greene, Glenn L. Archer, Jr., Michael L. Paup, Chief, Michael C. Durney, Richard Farber, Asst. Attys. Gen., Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee in No. 87-4623.

Martin M. Ruken, Vedder, Price, Kaufman & Kammholz, Chicago, Ill., for petitioners-appellants in No. 88-4227.

William F. Nelson, Chief Counsel, I.R.S., Kenneth L. Greene, Gary R. Allen, Chief, William S. Rose, Jr., Richard Farber, Asst. Attys. Gen., Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee in No. 88-4227.

Martin M. Ruken, Stuart D. Kenney, Chicago, Ill., for petitioners-appellants in No. 88-4551.

Gary R. Allen, William S. Rose, Jr., William F. Nelson, Chief Counsel, I.R.S., Kenneth L. Greene, Asst. Attys. Gen., Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee in No. 88-4551.

Appeal from the Decision of the United States Tax Court.

Before JOHNSON, DAVIS, and JONES, Circuit Judges.

JOHNSON, Circuit Judge:

Petitioners/appellants appeal from a decision of the Tax Court which disallowed their claimed tax deductions for losses incurred as a result of straddle transaction trading on the London Metal Exchange. For the reasons cited herein, we affirm.

I. FACTS AND PROCEDURAL HISTORY

At issue in this case is the deductibility of losses allegedly incurred by taxpayers as a result of trading on the London Metal Exchange, or, as the Seventh Circuit appropriately characterized the controversy, the "eternal tension between form and substance." ¹ The transactions involved here are the so called "straddle transactions" which have been traditionally used by investors to minimize or reduce market risks associated with commodities trading. ² In the instant case, appellants are among over 1,100 investors who claimed as tax deductions some 100 million dollars in aggregate losses from option straddle or option hedge transaction trading on the London Metal Exchange. More specifically, the investors (hereafter referred to as the "taxpayers") reported losses from the straddles as ordinary losses (which offset ordinary income), and reported the gains from the straddles as capital gains. After the Commissioner of Internal Revenue (the "Commissioner") disallowed the deductions, the taxpayers, including the appellants in the instant case, filed suit in the Tax Court seeking review of the Commissioner's ruling. The Tax Court thereafter consolidated the cases in the largest consolidated proceeding in Tax Court history. Glass v. Commissioner, 87 T.C. 1087 (1986).

In the Tax Court, the Commissioner argued that 1) the London options transactions were factual shams; 2) that if the transactions were real, they nevertheless lacked economic substance; and 3) that regardless of the economic substance inquiry, the transactions were not deductible under Section 165(c)(2) of the Internal Revenue Code of 1954 or Section 108 of the Tax Reform Act of 1984 because the taxpayers did not enter into the transactions primarily for profit. The Tax Court assumed, without really reaching the issue, that the transactions were not factual shams because they actually occurred. The Tax Court then ruled that the transactions lacked economic substance and were therefore shams in substance. ³ The Tax Court further concluded that because the taxpayers, including the appellants in the instant case, did not enter into the transactions primarily for profit, neither section 108 nor section 165 was available to permit the claimed deductions. Accordingly, the Tax Court upheld the Commissioner's disallowance of appellants' tax deductions for losses incurred in the straddles. Thereafter, the appellants timely appealed.

II. DISCUSSION

It is a well settled rule of law that transactions that lack economic substance will not be recognized for tax purposes. Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). Since Gregory was decided, courts have consistently held that although a transaction may, on its face, satisfy applicable Internal Revenue Code criteria, it will nevertheless remain unrecognized for tax purposes if it is lacking in economic substance. See e.g., Knetsch v. United States, 364 U.S. 361, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960); United States v. General Geophysical Co., 296 F.2d 86 (5th Cir.1961). The presence or absence of economic substance is determined by viewing the objective realities of the transaction, namely, whether what was actually done is what the parties to the transaction purported to do. Gregory at 469, 55 S.Ct. at 267. In the instant case, the Tax Court, applying the Gregory standard, concluded that the straddle transactions at issue lacked economic substance because they were entered into by the taxpayers solely to reduce the taxpayers' respective tax liabilities.

With respect to the Tax Court's findings of fact, the appropriate appellate standard of review is whether those findings of fact were clearly erroneous. Commissioner v. Duberstein, 363 U.S. 278, 291, 80 S.Ct. 1190, 1200, 4 L.Ed.2d 1218 (1960); Laney v. Commissioner, 674 F.2d 342, 345 (5th Cir.1982). For the Tax Court's conclusions of law, however, we are free to review on a de novo basis. Fender v. United States, 577 F.2d 934, 936 (5th Cir.1978). The Tax Court assumed that the straddle transactions involved in the instant case were not factual shams, and logically, the taxpayers have no quarrel with that assumption. The taxpayers do, however, dispute the Tax Court's legal conclusion that the straddle transactions were shams in substance and urge this Court to find, upon de novo review, that the Tax Court was in error in that conclusion. The taxpayers on brief contend that the Tax Court's erroneous legal conclusion in that regard "flow[s] inevitably from the [Tax Court's] false premise that the sham, profit and economic substance determination can all be made by focusing on the first year closing transaction to the exclusion of the strategy as a whole." The taxpayers remarkably, however, overlook the following language in the Tax Court's thorough opinion which is clearly representative of the Tax Court's perspective--

[w]e reemphasize ... that the focus of our attention is petitioners' entire tax straddle scheme and not each separate straddle. It is the overall scheme which taints the deductibility of the year one losses.

Glass v. Commissioner, 87 T.C. 1087, 1174 (citations omitted). Viewing the transactions as a whole, as did the Tax Court, we are unable to find error in the Tax Court's conclusion that the straddle transactions were shams in substance. We agree with the Tax Court's conclusion that

[i]t requires no lengthy or elaborate analysis of the facts to demonstrate that [the taxpayers] did not enter into these transactions primarily for economic profit, and that the transactions under scrutiny were not "the type of tax-motivated transaction which Congress intended to encourage."

Id. at 1162 (quoting Fox v. Commissioner, 82 T.C. 1001, 1019 (1984)).

The taxpayers next pay much attention to Section 108 of the Tax Reform Act of 1984, Pub.L. No. 98-369 Sec. 108, 98 Stat. 494, 630 (1984) ("section 108") and urge that its provisions countenance the type of straddle transactions which are at issue in this case. Specifically, the taxpayers argue that because there was an objectively reasonable potential for profit in the transactions, then section 108 applies with full force so as to allow the claimed deductions. The original version of section 108 reads in part as follows:

(a) GENERAL RULE.--For purposes of the Internal Revenue Code of 1954, in the case of any disposition of 1 or more positions--

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

... any loss from such disposition shall be allowed for the taxable year of the disposition if such position is part of a transaction entered into for profit. ...

Pub.L. No. 98-369, Sec. 108, 98 Stat. 494, 630 (1984) (emphasis added).

Before the enactment of section 108, the circumstances under which a taxpayer could deduct the losses from a commodities future straddle were unclear. In a 1977 private letter ruling, the Internal Revenue Service (IRS) held that losses on one leg of a straddle were not deductible as long as the other leg of the straddle remained open. See Rev.Rul. 77-185, 1977-1 C.B. 48. The Tax Court, however, disagreed with the IRS' standard and concluded that the appropriate litmus for deductibility of losses in year one of a straddle transaction was whether a taxpayer seeking to claim such a deduction entered into the transaction for profit as required by section 165(c)(2). The Tax Court's adoption of this subjective test ⁴ proved troublesome since the IRS stuck to its position that losses incurred on one leg of an open straddle were not deductible. ...