Krumhorn v. Comm'r of Internal Revenue

• Decision Date: 19 July 1994
• Docket Number: No. 4397–90.,4397–90.
• Citation: 103 T.C. No. 3,103 T.C. 29
• Parties: Morris KRUMHORN and Adrian Krumhorn, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

103 T.C. 29

103 T.C. No. 3

Morris KRUMHORN and Adrian Krumhorn, Petitioners,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 4397–90.

United States Tax Court.

July 19, 1994.

Robert J. Paley and Peter C. Woodford, for petitioners and George B. Collins, for petitioner Adrian Krumhorn.

Alan M. Jacobson and Jan E. Lamartine, for respondent.

P, a commodities dealer, deducted losses in 1978 from straddle transactions purportedly executed on London commodities exchanges. Held, P's purported losses from straddle transactions are not deductible pursuant to Deficit Reduction Act of 1984, Pub.L. 98–369, sec. 108(b), 98 Stat. 494, as amended by sec. 1808(d), Tax Reform Act of 1986, Pub.L. 99–514, 100 Stat. 2085, 2817, or sec. 165(c), I.R.C., because Ps failed to establish that the transactions actually occurred or had economic substance. Held, further, Ps are liable for an addition to tax under sec. 6653(a), I.R.C.

RUWE, Judge:

Respondent determined deficiencies in petitioners' 1978 and 1979 Federal income taxes in the respective amounts of $2,801,888 and $186,585, plus an addition to tax for the taxable year 1978 in the amount of $140,094, pursuant to section 6653(a).¹

After concessions, the issues for decision are: (1) Whether petitioners properly deducted capital losses from purported commodities transactions on their 1978 joint Federal income tax return, and (2) whether petitioners are liable for the addition to tax as determined by respondent.²

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and attached exhibits are incorporated herein by this reference. ³ At the time of filing their petition, petitioner Morris Krumhorn resided in Lake Forest, Illinois, and petitioner Adrian Krumhorn resided in Highland Park, Illinois.⁴

1. Professional Commodities Trader

During the years at issue, petitioner was a professional commodities trader on the Chicago Mercantile Exchange (CME). Petitioner began his commodities career as a runner on the CME. Petitioner purchased a seat on the CME and began trading for his own account in 1970. Petitioner formed K & S Commodities, Inc., which was a commodities brokerage and trading corporation. “K” stood for “Krumhorn” and “S” stood for “Schiller”. During the years 1978 and 1979, petitioner was a 50–percent shareholder and served as president of K & S Commodities, Inc.

A commodities futures contract requires the buyer to receive and the seller to deliver a specified quantity of a given commodity at some future date. The buyer's position is referred to as a “long” position whereas the seller's position is referred to as a “short” position. Every futures position is matched by an exact opposite position. Thus, a price movement creating a gain or loss in one position produces a contrary result in the opposite position. A long position increases in value during a time of rising prices. When prices are rising, the trader's right to purchase the commodity for a lower price becomes more valuable. The reverse is true for short positions. When prices are declining, a contract right to sell the commodity at a higher price becomes more valuable.

A single position (holding either a long or short position) is described as an “open contract” or (in petitioner's vernacular) as “being naked”. A straddle consists of the simultaneous holding of a long position (a purchased contract) of a commodity for delivery in a future month and a short position (a sold contract) for the identical amount of the same commodity for delivery in a different future month. These positions are referred to as the legs of the straddle.

The legs of a straddle may be entered into simultaneously or established by separately executing the legs at different times. When the holder of a straddle liquidates (i.e., closes out) one leg of the straddle, the other leg becomes an open contract. A “switch transaction” occurs when the holder of a straddle liquidates one leg of the straddle and replaces the liquidated leg with an identical quantity of the same commodity for delivery in a different month, thereby maintaining the straddle position.

The potential for profit from a straddle arises from changes in the price differential between the legs of the straddle. A trader is exposed to greater risk, and concomitantly greater profit potential, when the trader holds an open position, as opposed to a straddle, because, due to market forces, the price of the commodity inevitably rises or declines. A trader is exposed to less risk, and thereby less profit potential, if the trader enters into straddle transactions. The reason for this is that as the value of one leg of the straddle decreases, the value of the other increases.

Actual delivery of the underlying commodity rarely occurs. The holder of a futures contract usually avoids delivery by purchasing or selling an offsetting futures contract.

In addition to his domestic commodities trading, petitioner purportedly entered into commodities futures transactions in London with the following brokers: Competex, S.A. (Competex) beginning 1976 through 1977; Comfin ⁵ beginning 1978 through 1980; and Southern Commodities, Ltd. (Southern), beginning 1980 through 1982. Petitioner could have entered into similar commodities transactions in New York.

During the 1978 taxable year, petitioner's purported trades with Comfin were solely straddle transactions. Petitioners reported on their 1978 joint Federal income tax return losses of $4,168,844 from commodities transactions with Comfin,⁶ long-term capital gains of $2,485,476 from closing commodities transactions originally initiated with Competex during 1976 and 1977,⁷ and short-term capital gains of $1,901,344 from domestic trading. As a result, petitioners reported in 1978 net capital gains from all trading of $217,976.

2. Competex

Competex has been the subject of previous commodities straddle cases. ⁸ In each of these cases, the transactions entered into by the taxpayers and brokered by Competex were found to be either factual or economic shams. In 1976 and 1977, petitioner entered into purported commodities transactions with Competex. At issue before us, however, are claimed losses from petitioner's purported commodities trades with Comfin.⁹

3. Comfin

During all relevant years, Comfin ¹⁰ was a futures broker specializing in sugar, cocoa, and coffee. Comfin would also trade other commodities or financial contracts if required by a client. Comfin was a member of several London exchanges.

Comfin had its own traders on the floors of the London cocoa, sugar, and coffee exchanges. The trading practices of these exchanges were subject to certain rules and regulations.¹¹ These exchanges were members of International Commodity Clearing House (ICCH). The ICCH is a clearinghouse for London exchanges and brokerage firms.

Comfin was a member of the ICCH. The ICCH offered computer services to its members. During all relevant years, Comfin utilized the ICCH's computer services for processing records relating to its “futures administration”. ¹²

Documents prepared by the ICCH for Comfin consisted of (1) computerized lists of trades executed in Comfin's name; (2) a monthly document listing any futures positions each Comfin client held as of the last day of the month; and (3) a “final settlement” document prepared when a client closed a position. Upon receiving documents from the ICCH, it was Comfin's practice to verify the information and allocate the documents to the appropriate client based on a client account number.¹³

On the day after a trade, Comfin would mail a confirmation contract to its client. A confirmation contract is a statement confirming what Comfin bought or sold on the client's behalf. Comfin considered this statement to be a contract. Printed on the confirmation contract was a request that the client sign a provided duplicate. It was Comfin's practice to require that the customer sign these contracts. In many cases, if a client did not sign and return these contracts, Comfin would send out chasers to request that the duplicates be signed and returned.

4. Petitioner's Trades With Comfin

Petitioner states that he did not rely on any other person's advice when selecting trades. Petitioner did not utilize any market analysis or projections; and he had no special expertise relating to the sugar, cocoa, or coffee industries. Petitioner did not trade in sugar, cocoa, or coffee on any domestic exchange.

The potential for profit from a straddle arises from changes in the price differential between the legs of the straddle. The larger the price differential, the greater the profit or loss potential. Petitioner did not enter into straddle transactions with the expectation that he would make “material profits”.

Petitioner acknowledged that a major consideration in entering into a straddle transaction was the potential tax advantage. Petitioner stated in answer to respondent's interrogatories the following:

I was aware of and took advantage of opportunities to defer income or convert short-term gains into long-term gains in connection with my commodity trading business and I did offset commodity trading gains with losses realized by closing commodity straddle positions.

* * *

My commodity futures trading business which I did in London was based on tax benefits that I could realize from claiming losses which could be used to offset profits from my trading business, converting short-term capital gains into long-term capital gains where possible, and the possibility that I might be able to make profits from price changes in various commodities traded in London.

[S]ince commodity straddle trading was part of my overall commodity trading business, and taxes did reduce my economic gain, the possibility of using the specific commodity straddle transaction in order to reduce my tax liability in a taxable year was always a factor in my decision to engage in the straddle transaction.

The reason that I used...