Sochin v. C.I.R.

• Decision Date: 29 March 1988
• Docket Number: 87-7032,Nos. 87-7024,s. 87-7024
• Citation: 843 F.2d 351
• Parties: -926, 88-1 USTC P 9248, 25 Fed. R. Evid. Serv. 316 James E. SOCHIN, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Dennis S. BROWN, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 351

843 F.2d 351

61 A.F.T.R.2d 88-926, 88-1 USTC P 9248,

25 Fed. R. Evid. Serv. 316

James E. SOCHIN, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Dennis S. BROWN, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 87-7024, 87-7032.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Dec. 16, 1987.

Decided March 29, 1988.

Joseph Wetzel, Wetzel & DeFrang, Portland, Or., for petitioners-appellants.

Michael C. Durney, Acting Asst. Atty. Gen., Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee.

Appeal from a Decision of the Tax Court of the United States.

Before CHOY, GOODWIN and BEEZER, Circuit Judges.

CHOY, Circuit Judge:

James Sochin and Dennis Brown ("Taxpayers") appeal from the tax court's deficiency determinations. The court disallowed the losses and expenses deducted by Taxpayers with respect to investments in straddle transactions involving forward contracts. The court held that the transactions were "factual shams." Brown v. Commissioner, 85 T.C. 968, 998-1000 (1985). On appeal, Taxpayers allege that the tax court: 1) failed to apply the proper legal standard for determining what a sham is; 2) failed to make adequate factual findings as required by 26 U.S.C. Sec. 7459(b); 3) improperly considered evidence of other investors involved in the same investment program; and 4) based its sham determination on clearly erroneous factual findings. We affirm.

FACTUAL BACKGROUND

Taxpayers claimed losses from investments in straddles ¹ in forward contracts ² to buy and sell certificates issued by the Government National Mortgage Association ("Ginnie Maes") and the Federal Home Loan Mortgage Corporation ("Freddie Macs"). The investments were part of an investment program promoted by Gregory Government Securities, Inc. ("GGS") and Gregory Investment & Management, Inc. ("GIM"). William Gregory incorporated both organizations in Oregon in 1979. Under the program, GIM served as a financial adviser to prospective investors, while GGS, as a registered broker-dealer, was the requisite seller or buyer in each investor transaction.

A disclosure memorandum provided by GIM to each prospective investor purported to offer an interest rate speculation program. The investor informed GIM of his or her forecast of interest rates; GIM, in turn, would recommend a portfolio of forward contracts for Government securities that it believed would create a profit if the forecast was accurate. The memorandum also stated that the investor could request cancellation of a particular contract before its settlement date, at which point he or she would be credited or charged with any profit or loss, in addition to being charged a fee for the "risk and administrative costs created by the cancellation of the contract." The memorandum indicated the fees to be charged for each transaction. Furthermore, GGS had full authority to determine the contract prices.

The tax court found that the program worked essentially as follows: The investor would make a deposit (of the greater of $10,000 or .125 percent of the face value of the portfolio) and furnish GIM with an interest rate forecast. At this point, each No investor ever purchased or sold Ginnie Maes or Freddie Macs. Instead, all loss positions were canceled and all gain positions were assigned (and reassigned to GGS) before the settlement date. The tax court found that adjustments to the contract price or fees charged generated the minor net profits or net losses reflected in investor accounts.

investor executed a customer agreement giving GGS full power to liquidate any open position whenever "necessary for [its] protection," with or without notice to the investor. Each investor also executed a power of attorney authorizing GIM to act for the investor. Based on the interest rate forecast, GIM would prepare a portfolio of forward contracts on Ginnie Maes and Freddie Macs. This original portfolio constituted a straddle, since fifty percent of the contracts were to purchase securities (long positions), and fifty percent were to deliver securities (short positions). Any significant change in the prevailing interest rate would result in a loss in one "leg" of the straddle; that leg would be canceled to create an ordinary loss for the investor in the year of cancellation. The court found that such losses generally approximated ten times the original investment. GGS would then replace the canceled contracts with similar contracts, thus reestablishing the straddle. GGS then entered into new contracts with the investor which offset or opposed the existing contracts to "lock in" the gain from the non-canceled leg of the original straddle. Finally, after the gain was deferred for a sufficient period of time, the contracts were assigned to a third party, ³ which allowed the investor to realize his gain. The amount payable to GGS from the initial cancellation of the loss leg was offset against the receivable due the investor in approximately the same amount as a result of the assignment of the gain leg.

Brown's experience with the program resulted in the following: ⁴ after proceeding through the process outlined above, his $10,000 investment generated a $100,160 ordinary loss in 1979, and a $106,382 net long-term capital gain in 1981. The net gain of $6,222 before taxes was reduced to a net overall profit of $122 after the deduction of $6100 in fees. Brown deducted the alleged losses and reported the subsequent gains on his federal income tax returns for 1979 and 1981, respectively. Sochin, who was employed by Harsh Investment Corporation, participated in the program with a group of the corporation's employees. His $2000 portion of the group investment generated a $20,080 ordinary loss in 1979, and a $21,961 net long-term capital gain in 1981. The net gain of $1,881 before taxes was reduced to a net overall profit of $461 after the deduction of $1,420 in fees. ⁵

DISCUSSION

I. The Proper Legal Standard for the "Sham" Determination

Taxpayers argue that the tax court failed to apply the correct legal standard to determine whether the investments were shams. The tax court's conclusion that the transactions were shams is a finding of fact that is reviewed under the clearly erroneous standard. Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1548 (9th Cir.1987). However, the legal standard applied by the tax court in making the sham determination is reviewed de novo. ⁶ Id.

A. The Proper Test

We noted in Bail Bonds that courts "typically focus" on the related factors of whether the taxpayer has shown 1) a non-tax business purpose (a subjective analysis), and 2) that the transaction had "economic substance" beyond the generation of tax benefits (an objective analysis). 820 F.2d at 1549. However, we did not intend our decision in Bail Bonds to outline a rigid two-step analysis. Instead, the consideration of business purpose and economic substance are simply more precise factors to consider in the application of this court's traditional sham analysis; that is, whether the transaction had any practical economic effects other than the creation of income tax losses. See, e.g., Neely v. United States, 775 F.2d 1092, 1094 (9th Cir.1985); Thompson v. Commissioner, 631 F.2d 642, 646 (9th Cir.1980), cert. denied, 452 U.S. 961, 101 S.Ct. 3110, 69 L.Ed.2d 972 (1981). Thus, the tax court's failure to specifically delineate a two-prong test and the factual findings that support each prong is not itself fatal.

B. The Tax Court's Legal Standard

The tax court's analysis indicates that it considered the proper factors and applied the correct legal standard to reach its conclusion. After noting that the loss must result from a "bona fide transaction," the court held that Taxpayers "failed to establish that the entire program ... did not exist solely to provide tax benefits for its investors." Brown, 85 T.C. at 988. Further, the court likened the transactions to those in Julien v. Commissioner, 82 T.C. 492 (1984), in which the disallowance was based on a finding that the transaction served no economic function other than the generation of tax deductions. 85 T.C. at 999. Finally, in discussing the imposition of damages, the court held that "[Taxpayers] were sufficiently knowledgeable and sophisticated with respect to business and tax matters to have known, and actually did know, ... that the transactions were "too good" to be real and therefore were shams." Id. at 1001.

In short, the tax court reviewed the transactions for economic effects other than the creation of income tax losses, and in doing so considered both economic substance and business purpose. The court thus applied the proper legal standard.

II. Factual Findings Under 26 U.S.C. Sec. 7459(b)

Title 26 U.S.C. Sec. 7459(b) (1982) requires the tax court to "report in writing all its findings of fact." Taxpayers allege that the tax court's factual findings failed to account for substantial evidence presented at trial.

Findings of fact are sufficient if they provide the appellate court with a clear understanding of the basis of the lower court's decision and the grounds upon which it reached that decision. ⁷ Unt v. Aerospace Corp., 765 F.2d 1440, 1444 (9th Cir.1985); Nicholson v. Board of Education Torrance Unified School District, 682 F.2d 858, 866 (9th Cir.1982). This court will not reverse because of inadequate factual findings "unless a full understanding of the question is not possible without the aid of separate findings." Vance v. American Hawaii Cruises, 789 F.2d 790, 792 (9th Cir.1986).

While the tax court did not specifically account for the basis upon which a great deal of testimony was discounted or disregarded, its twenty-eight pages of factual findings clearly outline its conclusions regarding the operation of the investment program. The court's findings are "sufficient to indicate the factual basis for its ultimate...