1 Cases of the following petitioners are consolidated

herewith: Maria Rivera, docket Nos. 41343-85 and 22921-86; Leon

E. Richartz, docket Nos. 41987-85 and 25313-86; Leema

Enterprises, Inc., docket No. 4797-86; and K. Richard Keeler,

docket No. 8648-93. Monex Corp. & Subsidiaries, docket Nos.

24251-92 and 16162-94, originally consolidated herewith, has been

resolved by agreement of the parties after trial, and stipulated

decisions have been entered therein.

T.C. Memo. 1999-18

UNITED STATES TAX COURT

LEEMA ENTERPRISES, INC., ET AL.,1 Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 39476-85, 41343-85, Filed January 28, 1999.

 41987-85, 4797-86,

 22921-86, 25313-86,

 8648-93. 

Matthew D. Lerner, for petitioners in docket Nos. 39476-85, 

41987-85, 4797-86, and 25313-86.

Maria Rivera, pro se in docket Nos. 41343-85 and 22921-86.

Matthew D. Lerner, Sidney J. Machtinger, and Lisa M.

Zarlenga, for petitioner in docket No. 8648-93.
- 2 -

2 All section references are to the Internal Revenue

Code, unless otherwise indicated. All Rule references are to the

Tax Court Rules of Practice and Procedure.

Gary D. Kallevang, Wilton A. Baker, Kim A. Palmerino, and

William H. Quealy, Jr., for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge: These cases were assigned to Chief Special

Trial Judge Peter J. Panuthos pursuant to the provisions of section

7443A(b)(4) and Rules 180, 181, and 183.2 The Court agrees with

and adopts the opinion of the Special Trial Judge, which is set

forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

PANUTHOS, Chief Special Trial Judge: By timely notices of

deficiency, respondent determined that petitioners in these

consolidated cases are liable for deficiencies, additions to tax,

and penalties as follows:

Leema Enterprises, Inc., docket No. 39476-85

 Additions to Tax

 Year Deficiency Sec. 6653(a)(1)

6/30/80 $432,667 $21,633

6/30/81 1,100,399 55,020

Leema Enterprises, Inc., docket No. 4797-86

 Addition to Tax

 Year Deficiency Sec. 6653(a)(1)

6/30/82 $785,688 $39,284
- 3 -

 

Leon E. Richartz, docket No. 41987-85

 Additions to Tax 

Year Deficiency Sec. 6653(a)(1) Sec. 6661

1979 $45,528 $2,276 ---

1980 296,373 14,819 ---

1981 879,244 43,962 ---

1982 871,014 43,551 $87,101

Leon E. Richartz, docket No. 25313-86

 Additions to Tax 

Year Deficiency Sec. 6653(a)(1) Sec. 6661

1983 $67,501 $3,375 $6,750 

Maria Rivera, docket No. 41343-85

 Additions to Tax

 Year Deficiency Sec. 6653(a)(1)

1980 $57,648 $2,882

1981 279,751 13,988

Maria Rivera, docket No. 22921-86

 Additions to Tax 

Year Deficiency Sec. 6653(a)(1) Sec. 6661

1982 $45,823 $2,291 $4,582 

1983 26,894 --- ---

K. Richard Keeler, docket No. 8648-93

 Additions to Tax

Year Deficiency Sec. 6653(a)(1)

1981 $4,407,190 $220,360

1982 1,533,276 76,664

1983 158,894 7,945

1984 3,065,654 153,283 

Respondent has also determined that all petitioners are liable for

increased interest on an underpayment attributable to a taxmotivated transaction as defined in section 6621(c).
- 4 -

The issues presented for decision are: (1) Whether the

Treasury note/bond (T-bond) option activities, Treasury bill (Tbill) option activities, and stock forwards activities (a market

for the future sale of corporate stock) of Merit Securities, Inc.

(Merit), a subsidiary of petitioner Leema Enterprises, Inc.

(Leema), lacked economic substance; (2) whether participants in

Merit's T-bond option, T-bill option, and stock forwards programs

had a profit motive; (3) whether participants in Merit's T-bond

option, T-bill option, and stock forwards programs are liable for

additions to tax pursuant to section 6653; (4) whether participants

in Merit's T-bond option, T-bill option, and stock forwards

programs are liable for the 120-percent interest rate for taxmotivated transactions pursuant to section 6621(c); and (5) whether

petitioners Maria Rivera and Leon E. Richartz are liable for

additions to tax pursuant to section 6661.

In docket Nos. 41343-85, 41987-85, 22921-86, and 25313-86,

additional issues remain to be resolved. An appropriate order in

these dockets, permitting the parties an opportunity to resolve the

remaining issues, will be issued.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulations

of facts are incorporated in our findings by this reference. 

At the time the respective petitions in these cases were

filed, the principal place of business of petitioner Leema

Enterprises, Inc., was located in Tiburon, California; petitioners

Leon E. Richartz and Maria Rivera were residents of Tiburon,
- 5 -

California; and petitioner K. Richard Keeler was a resident of

Evanston, Wyoming.

Our use in this opinion of the terms "loss", "gain", "profit

position", "spread", "straddle", "option", "market", "trade", and

"transaction" is not to be construed as a finding that the

transactions at issue are, or are not, valid for Federal income tax

purposes. Rather, our use of those terms is only for convenience.

I. Corporate Structure

Petitioner Leema was the parent of a consolidated group of

companies that included Merit and Futures Trading, Inc. (FTI).

Merit shared an office with Leema and its subsidiaries. In

addition, Leema, Merit, and FTI shared the same computer system and

employees. Merit was a registered broker/dealer throughout the

period at issue. Leema had two additional wholly owned

subsidiaries, Horizon Trading, Inc. (formerly Merit Trading, Inc.),

and Omni Securities, Inc. During the years at issue, petitioner

Leon E. Richartz (Dr. Richartz) owned the majority of Leema's

stock; for some portion of those years petitioner Maria Rivera

owned 15 percent of Leema's stock. Dr. Richartz was Merit's

chairman of the board of directors.

Merit operated three over-the-counter markets, one for options

to buy or sell T-bills, a similar market for options in T-bonds,

and, subsequently, stock forwards.

A. T-bill and T-bond Options

Late in 1979, Merit began its T-bill and T-bond option

activity. T-bills and T-bonds represent debt obligations of the
- 6 -

United States. T-bills are non-interest-bearing short-term

obligations with a maturity of 1 year or less. They are sold at

less than face value; the discount reflects the fact that a period

of time must elapse before the bill reaches maturity and the

obligation is payable at face value. T-bonds are interest-bearing

long-term obligations generally having maturities in excess of 10

years. T-bills and T-bonds are actively traded; their market

values depend upon changes in interest rates. As a rule, the

market value of a given T-bill or T-bond will decline if interest

rates rise, and its value will increase if interest rates fall.

Merit's markets did not deal directly with T-bills and Tbonds. Rather, Merit dealt only with options. The two types of

options that Merit sold were "puts" and "calls". A put option

consists of a contract giving the holder the right to sell T-bills

or T-bonds on a specific future date at a specific price. A call

option is a contract which gives the holder the right to purchase

T-bonds or T-bills on a specific future date at a specific price.

The price of an option is referred to as a premium. The price at

which the parties to an option agree that the underlying commodity

would be sold is called the "strike" price. An investor who

purchases or sells such a contract is said to have established a

"position".

When an investor holds a contract or a series of identical

contracts, he is said to have an "open position". Merit's

investors did not establish open positions. Rather, Merit's

options were sold only in the form of "spreads". A spread is a
- 7 -

hedged position composed of two substantially offsetting positions

--for example, the sale of a contract for a put option together

with the purchase of a contract for a put option--called a "put

spread". Each of the offsetting positions is called a "leg" of the

spread.

 In an open position, price changes in the underlying asset

directly affect the value of a futures contract. In the case of a

spread, the holder is both a purchaser and a seller of the same

asset. Accordingly, when there is a change in the market price of

the underlying asset, the price of each leg changes; one leg

appreciates while the other depreciates.

The movements in each leg do not necessarily equal those in

the other, and the price differential between them could change.

A gain or loss will be incurred if the price differential widens or

narrows; there will be no gain or loss if the spread remains

constant. The profit or loss potential of a spread is measured by

the increase or decrease in the price differential between the

legs. Owning a spread involves less risk than owning an open

position because the spread is less volatile than the price of

either leg. Therefore, the profit potential of a spread is less

than that of an open position. 

Initial positions in the Merit T-bill option market took the

form of "combination spreads". A combination spread involves

acquiring a put spread and a call spread at the same time. Each

put spread and call spread consists of two options--one bought and

one sold--on the same underlying T-bill. A combination spread
- 8 -

further limits the risk to an investor, because the price

differential between the legs of one spread would have to change

with respect to the price differential of the legs of the other

spread before there would be a net economic effect.

(1) Merit's Nominal Pricing Formula

Because there was no publicly traded T-bill options market,

Dr. Richartz engaged Dr. Leonard Auerbach to develop a pricing

system for the options. Dr. Auerbach has taught at the University

of California at Berkeley, the University of Southern California,

and St. Mary's College. Dr. Auerbach adapted the Black-Scholes

model formula for pricing stock options as the basis for devising

a pricing formula for Merit's T-bill and T-bond options. The

Black-Scholes formula determines stock option values on the basis

of the price of the underlying security, the length of the option,

the strike price, the risk-free interest rate, and volatility. See

Black & Scholes, "The Pricing of Options and Corporate

Liabilities", 81 J. Pol. Econ. 637 (1973). Dr. Auerbach developed

and repeatedly revised a formula for Merit which could be used to

calculate a price estimated to be equal to the price that would

have applied in an open market.

(2) Merit's Income Structure

Merit earned income from operating its option markets in two

ways. First, it collected a bid/ask differential on opening

positions. The bid/ask is the difference between the price a

dealer will pay for an item and the price at which he will sell

that item. The difference between the price paid to purchase an
- 9 -

item and the price received for selling it constitutes profit to

the dealer.

Secondly, Merit retained the interest earned on the margin

deposits that it required from its customers. "Margin" was the

amount of money deposited by both buyers and sellers of Merit's

contracts to ensure their performance pursuant to the terms of

those contracts. "Initial" margin is the minimum deposit required

when a position is established, and "maintenance" margin is the

money that an investor must maintain on deposit to allow the

investor to continue to hold that position. 

Merit insiders--so-called market makers--were not required to

pay the bid/ask price, and they were allowed to retain the interest

earned on cash they had deposited as margin with Merit.

(3) Trading in Merit Options

The options that Merit dealt with in its T-bill and T-bond

activities were available only through Merit. No participant in

the Merit T-bill or T-bond activity ever took delivery of any Tbills or T-bonds with respect to this activity.

The options traded over the Merit option markets were not

listed on any formally organized exchange. Nor were these

instruments registered with the Securities and Exchange Commission;

rather, Merit marketed its instruments as private placements.

Under Federal securities laws, a private placement can be offered

only to high-income, sophisticated investors and to investors

represented by qualified advisers. In order to trade in the

marketplace, a potential participant had to fill out a
- 10 -

questionnaire indicating the participant's qualifications to

participate in the Merit markets.

The officers of Merit believed that the margin requirements

for their option trades were governed by Regulation T, Credit by

Brokers and Dealers, 12 C.F.R. pt. 220 (1998), promulgated by the

Federal Reserve Board pursuant to the Securities Exchange Act of

1934 as amended, 15 U.S.C. sec. 78g (1994). Under Regulation T,

the margin requirements for "open" T-bill options are higher than

the deposits required as margins for offsetting spread positions.

It was not feasible for Merit to offer open positions, and it

offered only spreads.

Merit provided a private placement memorandum (PPM) to each of

its T-bill option investors. This document informed potential

investors that "among other considerations, there are material

income tax considerations involved". The section "Federal Income

Tax Aspects" contained the advice that T-bills--

are expressly excluded from the definition of a capital

asset under section 1221(5) of the Code. Accordingly,

based on the provisions of Sections 1234(a) and 1221 of

the Code, gain or loss recognized by a holder of an

Option resulting from the sale or exchange (including the

expiration) of such option would be recognized as

ordinary income or loss.

The PPM further advised that "gain or loss recognized by a writer

resulting from the sale of T-Bills pursuant to the exercise of a

call by the holder would be taxable as ordinary gain or loss".

Further, it advised that--

In the event a T-Bill is determined not to constitute a

'security,' * * * gain or loss realized by a writer of a

T-Bill option, which is attributable to the lapse of the
- 11 -

option or any other closing transactions with respect

thereto, should be treated for tax purposes as ordinary

gain or loss.

In practice, Merit's trades were placed by "investment

advisers", a few individuals who traded for their own accounts or

as advisers for certain of their customers. These included, inter

alia, Dr. Richartz, Chris Carabini (for Monex Corp.; see supra

note 1), Edward Seykota, Donald Haberlein, and Albert Alessandra.

In 1979, Merit's personnel designed a computer system with

connections to the trading advisers' offices. Merit developed and

made available to its customers or their advisers computer programs

to assist them in analyzing possible positions. Merit's computer

system enabled it to keep accurate track of the daily trades and

margin requirements, as well as a record of its customers' realized

and unrealized gains and losses. The computer system enabled

advisers and customers to analyze their trading positions and to

show the income tax consequences of the possible trading positions.

Merit's computers could also be used to develop new programs.

Merit required an initial margin deposit of $25,000 upon

opening an account. It also required customers to deposit

sufficient funds as a "maintenance margin".

(4) Actual Initiation of Trades

(a) T-bill Transactions

A trade on the Merit markets began when an investment advisor

would contact Merit employees to seek a certain trading position

for himself or his customers. The parties would discuss the

interest rate to be used in pricing their options and, if before 11
- 12 -

3 The mechanics of such trading are complex. A

simplified example comes from examining one leg of the T-bond

trading of one of Merit's clients. On Dec. 12, 1980, the client

purchased 285 put contracts each for T-bonds at a strike price of

$815,000, paying a premium of $23,323 per contract. Twelve days

later, on Dec. 24, 1980, the client sold 250 of the put

contracts, receiving a premium of $2,635 per contract. He

declared a loss of $5,172,000, representing the net of the

premiums--a minus $20,688 per contract--times 250 contracts.

 

Twelve days later, in his next taxable year, the client

permitted the remaining put contracts to lapse at a loss totaling 

$816,305 (35 x $23,323 premium). Thus, his total loss on the

purchased put contracts was $5,988,305.

Like all Merit customers, he had balanced each of the above

transactions by maintaining an offsetting position in sold put

contracts. Thus, on Dec. 12, 1980, the client, who had purchased

285 put options, also sold 285 put options on identical bonds. 

There were no transactions with these sold contracts until the

exercise date of Jan. 5 in the next calendar year. On that date,

the purchaser of the client's put options elected not to exercise

those options. The client thus retained the premium he had

received ($22,755 x 285), for a gain of $6,485,175. This more

than offset his loss of $5,988,305 on his purchased put option

position.

Like other Merit customers, the client had also hedged the

effects of the put option spread by establishing an offsetting

call option spread. This formed a combination spread. When the

call option facet of the client's combination spread trades is

(continued...)

a.m. Pacific time, would agree to an adjustment to conform to the

interest rate in effect at 11 a.m.--the close of the trading in New

York that day. If the discussion took place after 11 a.m., then

the price would be based upon the next day's close. Merit would

adjust the 11 a.m. interest rate by the basis point adjustment the

parties agreed to, and it would price the options accordingly. In

actual practice, premium values stayed the same, while strike

prices were adjusted. Merit calculated its clients' gains or

losses on the basis of changes in premium values over time.3
- 13 -

(...continued)

figured in, he ended up with an overall economic loss of $205,930

in the trade sequence.

Merit initially organized its option customers into two

groups--the A side and the B side. Members of the A side traded

only with members of the B side, and vice versa.

Almost all of the trades for the 1979-80 tax year demonstrate

what has been called an open-switch-close pattern. Six sets of

orchestrated trades or trading sequences took place in the 1979

Merit T-bill option market. In each of these sequences, only 3

trading days were involved. The first occurred in the second week

of December 1979, when all the investors "opened" a position by

buying or selling an option spread from members of the other side.

On December 28, 1979, all participants "switched" by buying or

selling options that would offset the loss legs of their opening

positions. In so doing, every investor in the T-bill program

incurred a loss that was an ordinary loss for tax purposes.

Then, on January 4, 1980, in the subsequent taxable year, the

investors acquired offsetting positions to close out their gain

legs--or they allowed their options to expire unexercised. They

incurred gains that approximated their taxable losses incurred a

few days earlier, in the prior taxable year. 

In 1980-81, trading in the Merit T-bill accounts was slightly

more complex, but 23 of 27 trading sequences followed the openswitch-close pattern which took place shortly before and shortly

after the end of the investors' taxable years. 
- 14 -

4 One notable exception was Case Enterprises, an offshore

entity set up by the Carabini family, who also controlled Monex.

In its first participating transaction, Case Enterprises

deposited $1 million with Merit in September 1981, the last month

of its fiscal year, incurring losses of $7,200, and in October

1981 (the beginning of its next taxable year), it withdrew

$992,800. In September 1982, it again deposited $1 million,

incurred substantial gains, and, 10 days later, in October 1982

(the beginning of its third taxable year), it withdrew

$1,255,000.

Of 76 participants in the initial Merit T-bill market, only

one had a gain, of $961, at the end of the first taxable year of

investing. Upon completion of their T-bill trading, only 12 of the

participants had earned overall profits; however, these were

generally very small.4

(b) T-bond Transactions

Merit also offered a market in T-bond options for which it

issued a separate PPM. This PPM advised that "there are material

income tax considerations involved". The material under the

heading "Federal Income Tax Aspects" provided an explanation of tax

aspects of trading in options. It traced the provisions of Rev.

Rul. 78-182, 1978-1 C.B. 265, which discussed trading commodity

options on the Chicago Board of Exchange. It discussed the

"special rules relating to the tax treatment accorded to the writer

of an option on inter alia, securities such as T-Bonds". It

explained that--

gain or loss recognized by a writer resulting from the

sale of T-Bonds pursuant to the exercise of a call would

be taxable as capital gain or loss. Such gain or loss

will be characterized as long-term * * * where the TBonds sold have been held for a period of at least one

year * * *.
- 15 -

5 One notable exception was the case of Surya Trust. For

1979 through 1981, it posted T-bond option losses of $341,843 and

$9,474,174.71 and a gain of $10,042,498.97, respectively. Its

(continued...)

The PPM further noted that upon a "closing transaction" any gain or

loss was to be treated as short-term capital gain or short-term

capital loss.

The Merit T-bond option market functioned similarly to the Tbill option market. The T-bond trades also featured an openswitch-close pattern. In the 1979 T-bond option market, there were

two trading sequences. In each, only three trading dates were

involved. The first occurred in the second week of December 1979,

when each investor opened a position by buying (or selling) an

option spread from a member of the other side. On December 28,

1979, every participant "switched" by buying or selling an option

that would offset the loss leg of the opening position. This

generated short-term capital losses for 1979. A few days later,

but in 1980, each investor would buy or sell an offsetting position

or allow the option to expire unexercised. For 1979, each T-bond

investor realized a short-term loss. 

In 1980, the pattern shifted. Some trade sequences followed

the open-switch-close pattern, and others appeared to be selected

to generate long-term capital gains.

For each participant, the first taxable year of T-bond trading

produced substantial losses. Of the 25 accounts (other than Merit)

in the T-bond option market between 1979-81, 9 made profits,

generally in relatively small amounts.5
- 16 -

5(...continued)

overall gain was $226,481.17. 

B. Stock Forwards

(1) Formation

In 1981, Congress eliminated the tax advantages of straddling.

It passed the Economic Recovery Tax Act of 1981 (ERTA), Pub. L. 97-

34, sec. 508(a), (c), 95 Stat. 172, 333, parts of which operated to

deny deductions for losses produced by tax straddles except to the

extent that such losses exceed the unrealized gains retained for

realization in the next taxable year.

In 1981, after enactment of ERTA, Merit decided to offer a

market in forward contracts on selected listed corporate stocks.

Stock forwards are contracts for the sale of shares of corporate

stock at a specified future date for a specified price. Merit's

forward contracts were similar to its option contracts in that both

involved agreements for the future purchase of a commodity. In a

forward transaction, however, one party agrees that it will be

obligated to buy or sell marketable corporate stock at a future

date (the settlement date) at a fixed price. Merit's option

contracts, in contrast, involved the sale of a right, but not the

obligation, to buy or sell that commodity. 

Merit's forward contracts were written on common stocks traded

on the New York Stock Exchange or on the American Stock Exchange.

In the stock forwards market, Merit functioned as a clearinghouse,

whereby it was the opposite party to every transaction between

customers in its market. It did not take positions that exposed it
- 17 -

to market risk. Thus, Merit would find a willing party to take the

opposite position for every position it sold or purchased. Merit

employees, as well as others recruited by Merit, functioned as

market makers who would accept positions offered by non-marketmaker customers of Merit. These market makers took "assignments"

of stock from other non-market-maker customers. Often these

parties were subsidiaries, such as Omni and Horizon, controlled by

Dr. Richartz.

Although it ostensibly offered open positions in stock

forwards, Merit traded only in spreads or combinations of spreads.

In a stock forwards spread position, an investor would purchase

both a long contract to purchase stock from Merit at a future date

and specified price together with an equivalent short contract to

sell the same stock to Merit at another future date and specified

price.

A combination spread involved two spreads in different stock.

Typically in one of the spreads, the long position matures before

the short, while in the other spread, the short position matures

first. A combination spread in stock forwards in two different

stocks operates as a hedge against adverse market moves.

Differences between the relative performances of each of the

spreads have an economic effect.

Merit issued a PPM for its stock forwards program, advising

that the holder of a stock forwards position had three options for

acting with respect to that position: (1) The investor could hold
- 18 -

6 The only documentary evidence of delivery of assets in

any of the Merit markets pursuant to an option or forward

contract was the delivery of Tandy stock to an investor in

October 1983, which was redelivered the following month, and the

delivery of Zapata stock to an investor partnership in November

1983.

the contract to maturity and take (or make) delivery;6 (2) he could

obtain Merit's "cancellation" of his position, thus freeing the

investor from his or her obligations under the contract; or (3) the

investor could engage Merit "as a broker" to sell the investor's

contractual obligation to some other participant.

The PPM noted the passage of the loss disallowance rules in

ERTA, but stated--

Because the Forward Contracts presumably represent

an interest in stock, and stock is excluded from the

definition of "personal property", the Contracts should

not constitute "positions" which are subject to the loss

disallowance rules of Section 1092 of the Code.

The PPM also discussed "cancellations" and the possibility of

deducting losses from trading in stock forwards as ordinary income:

Alternatively, an investor may, from time to time,

negotiate with Merit to cancel his obligations under a

particular Forward Contract, rather than sell or perform

under such Forward Contract. Under these circumstances,

such investor may take the position that losses, if any,

realized upon the cancellation of a Forward Contract are

ordinary losses, on the basis that a cancellation is not

a "sale or exchange" for tax purposes * * *.

As with its earlier options markets, Merit generated profits

from its stock forwards program in two ways. First, it collected

a bid/ask differential on most opening positions. Second, it

retained the interest earned on customers' deposits in their
- 19 -

trading accounts. Merit typically charged a bid/ask spread only on

opening trades.

Customers of the stock forwards were required to make an

initial margin deposit of $25,000. Customers were also required to

post a "maintenance" margin during the time they had established a

position. Like the option trades, Merit's stock forwards did not

trade as outright positions in the stock forwards. All its trades

took the form of spreads or combination spreads. 

 Most margin accounts had excess funds on deposit. In

general, margin deposits were greater than the amount required.

Moreover, these accounts were left with Merit longer than the

clients' spread positions were open.

(2) Trading in the Merit Stock Forwards Market

In order to trade, investors first had to fill out an offeree

questionnaire in the PPM, and, if they lacked the requisite

sophistication, their offeree representative was required to submit

a questionnaire as well. Inexperienced traders were required to be

represented in their trading by investment advisers. Of these

advisers, at least eight traded their customers' accounts in the

Merit stock forwards market--including petitioners Keeler and

Richartz, and Messrs. Alessandra, Seykota, Haberlein, and Monex--as

well as other customers who traded for themselves. There were 60

participants in the stock forwards market.

As was the case for its option markets, Merit used a

demonstration model of its computer system to show potential

customers how the stock forwards market worked. Merit disseminated
- 20 -

information about potential trades by giving customers and their

advisers computer terminals with modems through which they could

dial into Merit. Printouts from these terminals also informed

customers of the status of their realized and unrealized gains

and/or losses in the Merit stock forwards trading.

(3) Nominal Pricing Formula

Merit instructed Mr. Auerbach to develop a formula to

determine the initial price to be charged for stock forwards

contracts. The formula was designed to replicate the price that

would be offered in a freely competitive market. Mr. Auerbach

created such a formula, taking into account the costs of holding

the stock as well as the payment of dividends.

(4) Actual Initiation of Trades

Merit's stock forwards market conducted trading activity from

early in the morning until 11 a.m. Pacific time. Merit's personnel

quoted the stock forwards prices to potential buyers as the

differential between the prices of two legs of a spread. Thus, if

the quoted forward price for a share of stock to be sold in May

were $1 more than the quoted forward price for a share of the same

stock to be sold in March, the quoted price of the spread was $1.

Customers could seek to negotiate cents off the spread price.

Trades would take place with Merit, which attempted to maintain a

market equilibrium by taking offsetting positions with different

customers, or with Merit insiders and market makers.

The final price was the price of the forward spread, based

upon the 11 a.m. price of the stock. The price took into account
- 21 -

7 Mr. Keeler's taxable year 1980 is not at issue in this

case, but the trading is set forth as background for the trades

executed in 1981 and thereafter which are at issue.

any agreed modifications of the spread price made earlier in the

day of the trade or after 11 a.m. on the day before. Merit printed

and provided to customers a record of transactions.

Forward spread positions had the potential for returning

economic profits if the underlying stock market prices moved in

advantageous directions.

Merit engaged an accounting firm that reviewed its system of

control and records, finding them adequate. The accountants did

not, however, audit each trade shown on Merit's books.

II. Trading Activity of Individual Petitioners

A. K. Richard Keeler

Petitioner Keeler is a professional trader who has traded

commodities for his own account and for the accounts of clients.

In all of such trading, Mr. Keeler has never taken delivery of the

underlying commodity.

Mr. Keeler opened a T-bill option account on November 20,

1980. He deposited a $150,000 check with Merit and established a

combination spread of options in Merit's account No. 139. On

December 29, 1980, the T-bills were switched. As a result, Mr.

Keeler's account reflected deductible option losses of $689,600,

and unrealized gains of $667,685, carried over into the next year.7
- 22 -

8 This was the amount remaining from the trading in the

T-bill account, which had shown a net cash loss of $38,280.

(1) 1981 Merit Transactions

Mr. Keeler closed out his option account in the opening days

of 1981. The account showed income of $1,657,260, taxable as

short-term capital gains, and losses of $1,005,940, reported as

ordinary loss deductions. On February 3, 1981, Mr. Keeler withdrew

his cash balance of $111,720.8 This ended his option trading with

Merit.

After passage of ERTA, Mr. Keeler began his participation in

the Merit stock forwards program. On November 18, 1981, he

deposited $700,000 with Merit and established six forward spreads

in six different stocks. In December 1981, he engaged in 17

taxable transactions. One of those transactions produced a gain of

$96,600, but all the other 16 produced losses, totaling $8,250,260

--including $1,100,620 in ordinary losses for "cancellations" and

$7,149,640 in short-term capital losses. Mr. Keeler's income tax

return for 1981 indicated that these short-term capital losses

operated to offset some $6,697,000 in gains from other commodity

futures accounts.

Mr. Keeler's net realized losses from T-bill options and stock

forwards in 1981, compared to his adjusted gross income in the same

year, were as follows:

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 ($3,660) ($7,598,940) $7,595,280 100%
- 23 -

9 When Mr. Keeler's losses of $8,250,260 from T-bill

option trading in 1980 are netted against his gains of $7,984,320

from T-bill option trading in 1981, the result is an overall 

loss of $265,940. This amount, subtracted from his original

deposit of $700,000, produces the balance of $434,060.

(2) 1982 Merit Transactions

Mr. Keeler retained unrealized gains of $7,970,300 from his

1981 stock forwards trades and carried them over into January 1982.

At that time, Mr. Keeler engaged in trades which produced shortterm capital gains of $7,984,320, and he withdrew his remaining

cash balance of $434,060.9 

For the next 5 months, Mr. Keeler made no trades in his Merit

account. When he resumed trading in July 1982, he deposited

$500,000; in November he deposited an additional $800,000; and in

December he deposited an additional $300,000 (for a total of

$1,600,000 cash deposited). In the latter half of 1982, Mr. Keeler

established 36 spread transactions. Thirty-two of these made up

"combination spreads" consisting of four straddles in two different

stocks. The only taxable incidents in the account after January

that year occurred in December 1982, when Mr. Keeler engaged in 43

taxable closing transactions. None produced any gain; all 43

produced losses, totaling $9,955,447. These losses consisted of

cancellation losses of $2,725,268 and short-term capital losses of

$7,230,179. Mr. Keeler used them to offset the long-term capital

gain of $7,984,320 from trades executed the previous January.

Mr. Keeler's reported ordinary loss from T-bill options and

stock forwards in 1982, compared to his adjusted gross income in
- 24 -

the same year, was as follows:

A.G.I. Merit Loss % of A.G.I.

 Per Return Losses w/o Merit Loss 

 $2,799,1701 ($2,725,268) 97%

1 Mr. Keeler's adjusted gross income was the figure

represented above. He deducted Merit stock forwards losses of

$2,725,268 for that year, however, in effect reducing his income to

$73,902.

(3) 1983 Merit Transactions

Mr. Keeler retained unrealized income on the "gain" legs of

his trading in the amount of $9,851,790 and carried it into 1983.

The taxable incidents of Mr. Keeler's 1983 trading in Merit stock

forwards, however, were very modest in comparison to those of the

prior 2 years. His taxable transactions for that year took place

only in November and December 1983; his taxable year ended with a

net Merit trading loss of $35,230 of cancellation fees and an

additional unrealized loss of $2,520. He did, however, report net

profits of $630,446 from his profession of "investments". During

1983, Mr. Keeler established an additional 24 stock option

straddles; in 20 of these he retained both the gains and losses and

carried them into 1984. In 1983, Mr. Keeler neither added to, nor

subtracted from, his cash margin account. 

Mr. Keeler's net realized losses from T-bill options and stock

forwards in 1983, compared to his adjusted gross income in the same

year, were as follows:

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $621,480 ($35,230) $656,710 5%
- 25 -

10 Sec. 101(a) of the Deficit Reduction Act of 1984

(DEFRA), Pub. L. 98-369, 98 Stat. 494, repealed the exception of

stock from the loss disallowance rules of sec. 1092, effective

for positions established after Dec. 31, 1983, in taxable years

beginning after Dec. 31, 1983.

11 Sometime later Mr. Keeler filed an amended return

seeking to apply carrybacks from 1985.

(4) 1984 Merit Transactions

In January 1984, Mr. Keeler ended his participation in the

Merit programs.10 In that month, he incurred short-term capital

losses of $9,591,801 and had long-term capital gains of

$19,180,297--including the $9,851,790 he had retained as unrealized

capital gains from his trading in 1982. He withdrew his cash

balance of $1,197,891. On his 1984 Federal income tax return, Mr.

Keeler netted his capital gains against his capital losses and

applied the 60-percent reduction for taxable long-term capital

gains permitted by section 1202(a). He reported taxable income of

$5,079,712 and taxes of $2,505,189. To this amount, he credited

prepayments and credits of $1,740,800 and paid the resulting tax

liability of $764,399.11

B. Leon E. Richartz

Dr. Richartz taught economics and finance courses at the

University of Illinois and the University of California at Berkeley

and coauthored a book entitled "Vertical Market Structures".

During his academic career, Dr. Richartz began using computers to

develop trading models in making markets more efficient. Beginning

in 1971, Dr. Richartz worked as a professional trader for his own

account and for others. He also tried to earn additional
- 26 -

compensation through selling or licensing electronic marketing

software that he had developed.

After he established Merit and its related companies, Dr.

Richartz functioned principally as a market maker; he would take

positions that a customer might wish to make, but for which there

were no ready takers. Dr. Richartz would charge some "points" in

the process. As a market maker Dr. Richartz received interest on

his own excess margin deposits and paid no bid/ask premiums for his

trades on the Merit markets.

Dr. Richartz maintains a personal account, designated account

No. 51, in Merit's T-bill options activity. In 1979, he deposited

$25,000 with Merit. His trading followed the same open-switchclose pattern as that of every other trader in Merit T-bills. It

was opened on December 13, 1979, and switched 15 days later on

December 28, 1979. The switch produced an ordinary loss deduction

of $77,440 for Dr. Richartz's 1979 tax return. Dr. Richartz

retained those positions in which he had a net unrealized gain of

$78,080 and carried them for 4 days into the next taxable year when

he closed the account. His realized losses from T-bill options in

1979, compared to his adjusted gross income in the same year, were

as follows:

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $46,804 ($77,440) $124,244 62%

In 1980, Dr. Richartz's trading was somewhat more involved.

On January 4, 1980, he closed the 1979 trades he had initiated 3
- 27 -

weeks earlier, realizing a net gain of $1,048. On February 19,

1980, he withdrew the resulting $26,048 from his account and ceased

trading in that account for several months.

In August 1980, Dr. Richartz opened a four-participant trade

sequence, joining with Leema and an investment adviser, Mr.

Alessandra, to take positions opposite Monex, which had a taxable

year ended September 30, 1980. The trade closed on November 4,

1980. It produced $57,942 in ordinary losses for Dr. Richartz, as

well as ordinary losses of $14,955 for Mr. Alessandra. The trades

produced a taxable gain of $67,068 for Monex, but that amount was

not recognized until its taxable year ended September 30, 1981.

Dr. Richartz performed no other T-bill trading until the end

of 1980. He then participated in four other T-bill sequences, all

opened and switched in December 1980. They followed the familiar

open-switch-close pattern. Opened on December 5 and 17, 1980, none

produced taxable gains that year. Instead, when the switches

occurred on December 29 and 30, 1980, Dr. Richartz realized

additional losses of $1,142,630. He carried unrealized gains of

$1,155,550 for 5 days into his next taxable year, when these

trading sequences closed. On the next day, he withdrew his cash

balance of $105,276, representing a cash loss of $44,724.

Dr. Richartz included an ordinary loss from his T-bill options

of $450,901 on his 1980 Federal income tax return. This loss,

compared to his adjusted gross income in the same year, revealed

the following:
- 28 -

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 ($6,649) ($450,901) $444,252 199%

1 The parties agree that Dr. Richartz also reported shortterm capital losses of $670,883 on his 1980 return. The statutory

notice for 1980 did not disallow these losses.

Dr. Richartz was also a partner in an entity known as Peng

Partners. Peng Partners maintained an account, designated account

No. 41, in Merit's T-bill options activity. In 1979, Dr. Richartz

reported from Peng Partners a guaranteed payment of a net $11,946,

plus his proportionate share of partnership gains and losses. In

1980, he reported income of $37,105 and his proportionate share of

Merit-related losses of $21,204.

(1) 1981 Transactions

(a) T-bill Options

Early in 1981, Dr. Richartz realized capital gains retained

from the prior year of $1,219,370. With the passage of ERTA, Dr.

Richartz terminated his investments in the T-bill program. In July

1981, he deposited cash of $37,000 and engaged in his last option

trades by opening and closing two sequences that produced a gain of

$24,340. He accordingly withdrew $61,340.

(b) Stock Forwards

Dr. Richartz began trading in Merit's stock forwards in

November 1981. He deposited cash of $1,068,880 and established

spread positions in 12 separate trades. The next month, his

"switch" transactions produced 17 taxable transactions in his stock

forwards account for 1981--all were losses. For his stock forwards
- 29 -

account in 1981, Dr. Richartz incurred a net of $913,230 in

ordinary losses and $1,713,090 in short-term capital losses, a

total net loss of $2,626,320. During 1981, Dr. Richartz did not

trade positions in which he had an unrealized gain of $2,656,440.

Those he retained and carried into January 1982. On his 1981

Federal income tax return, his net realized ordinary losses from Tbill options and stock forwards in 1981, compared to his adjusted

gross income in the same year, were as follows:

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $94 ($952,710) $952,615 1100%

1 Dr. Richartz's Federal income tax return for 1981 also

showed a short-term capital loss carryover from 1980 of $1,732.27

plus additional short-term capital losses of $3,426,248 and shortterm capital gains of $4,436,741.

(2) 1982 Merit Transactions

In January 1982, Dr. Richartz engaged in stock forwards trades

that produced short-term capital gains of $2,668,910. He withdrew

his remaining cash balance of $1,111,470 in January and February.

He made no trades in his Merit account until April. Dr. Richartz

then deposited $25,000 into his account and in September deposited

an additional $25,000. In 1982, he established 35 spread

transactions. In these spreads, Dr. Richartz engaged in 23 taxable

closing transactions. One of his trades resulted in a gain of

$56,800, and his records reflect the receipt of "other" income of

$3,807. The other 22 of these transactions, however, produced

losses which totaled $4,499,307. These losses consisted of

cancellation-fee ordinary losses of $191,792 and short-term capital
- 30 -

losses of $4,307,515. They offset his long-term capital gain of

$2,668,910 incurred in the previous January, leaving him with a net

capital loss of $1,826,589. This amount was used to offset other

capital gains and to add to his capital loss carryover.

Dr. Richartz also retained and carried unrealized income of

$1,857,057 in the "gain" legs of his 1982 stock forwards into his

next taxable year or the year following.

Dr. Richartz's reported ordinary losses from Merit stock

forwards in 1982, compared to his taxable income in the same year,

were as follows:

 T.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $2,8871 ($191,792) $194,679 99%

1 Dr. Richartz's adjusted gross income was $208,894. He

deducted Merit stock forwards cancellation fees of $191,792 for

that year, however, reducing his income by that amount.

(3) 1983 Merit Transactions

In 1983, Dr. Richartz neither added to nor subtracted from his

cash account for the stock forwards account. He engaged in no

taxable transactions until July. At that time he began trading,

and by November he had realized net short-term capital gains of

$736,285 and long-term capital gains of $1,437,766. In December

1983, however, he incurred cancellation losses of $65,448 and

short-term capital losses of $2,234,054. In that month, he

realized an additional $55,342 in long-term capital gains, but the

overall effect of these trades (including "other" income of $8,301)

was to leave him with a net loss of $61,807 at the end of 1983.
- 31 -

Dr. Richartz's reported ordinary losses from stock forwards in

1983, compared to his taxable income in the same year, were as

follows:

 T.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $52,2601 ($65,448) $117,708 56%

1 Dr. Richartz's adjusted gross income was $152,044. He

deducted Merit stock forwards cancellation fees of $65,448,

however, reducing his income by that amount.

Dr. Richartz continued trading in the stock forwards account for

the next 2 years, which are not at issue here. At the end of his

trading, he reported an economic profit from stock forwards trades

of $103,089.

C. Maria Rivera

Petitioner Rivera is a native of Spain. She began trading

with Dr. Richartz in 1971, making trades based upon Dr. Richartz's

recommendations. When the Merit programs began, Ms. Rivera allowed

Dr. Richartz to trade her account, understanding that he would use

her account, like his own, as a market maker. Her Merit

investments included trading in the T-bill options, T-bond options,

and stock forwards contracts. As a market maker, Ms. Rivera

received interest on her excess margin deposits and paid no bid/ask

differential in acquiring her positions on the Merit markets.

During the period that Dr. Richartz actively traded her

account, Ms. Rivera suffered from Addison's disease, a debilitating

illness that makes it difficult to work for long hours or under
- 32 -

stress. Ms. Rivera left the country during part of that period to

recover from her illness.

(1) 1980 Merit Transactions

(a) T-Bill Options

For her 1980 taxable year, Ms. Rivera claimed ordinary losses

of $81,001 from T-bill option trades and capital losses of $408,527

from T-bond option trades. The 1980 T-bill trade followed the

yearend open-switch-close trading pattern. Her account, No. 203,

was opened with the purchase of 24 put and 24 call options on

December 17, 1980. On December 29, 1980, 12 days later, the switch

occurred by closing 22 of the contracts--each generating a loss--

and replacing them with new ones. The switch terminations

generated ordinary losses of $81,001. The account maintained an

unrealized gain of $80,985 a few days into 1981, her next taxable

year.

(b) T-Bond Options

Ms. Rivera's 1980 capital losses arose from trading in her Tbond account, No. 189. These also followed the open-switch-close

pattern. The account shows the purchase of 20 T-bond contracts in

a combination spread on December 5, 1980. The switch came on

December 30, 1980, when the account closed out 17 contracts,

generating a capital loss of $408,527. She maintained an

unrealized capital gain on her bond transactions of $423,538 into

1981.

Ms. Rivera's reported ordinary losses from T-bill options and

stock forwards in 1980, compared to her taxable income in the same
- 33 -

12 The data in evidence does not make clear whether any of

the trades that combined to produce the $699,300 loss was for an

economic gain. There is no indication that any such gains were

realized.

year, were as follows:

 T.I. Merit T.I. Loss % of T.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 ($6,211) ($81,001) $74,790 1108%

1 Ms. Rivera's adjusted gross income was $107,342. In

addition to other deductions, she claimed an ordinary loss

deduction of $81,001 on T-bill trades, reducing her income pro

tanto. She utilized her capital losses as long-term and short-term

carryovers.

(2) 1981 Merit Transactions

(a) T-Bill Options

On January 5, 1981, Ms. Rivera closed her T-bill account,

realizing a net gain of $80,955. On the entire transaction, she

incurred a net loss of $45. Her T-bond account closed the same

day, indicating proceeds of $426,959. Compared to her 1980 losses

in this account, the overall trading produced a net gain of

$18,432.

(b) Stock Forwards

In November 1981, a stock forwards account was opened in Ms.

Rivera's name. This account, No. 667, reflected an initial cash

deposit of $150,000; $51,400 was added in December. Trading in

that account generated yearend short-term capital losses of

$653,550 and yearend cancellation fees of $45,750, or a total loss

of $699,300. The account maintained unrealized capital gains of

$700,180 into January 1982.12
- 34 -

Ms. Rivera's reported ordinary losses from Merit trading

activities in 1981, compared to her adjusted gross income in the

same year, were as follows:

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $13,9271 ($63,176) $77,103 82%

1 Ms. Rivera's adjusted gross income reflects ordinary losses

from Merit trading totaling $63,176. This amount includes

cancellation fees and $17,426 identified as "options" on her

return. The capital losses appear to have been incorporated in her

loss carryover.

(3) 1982 Transactions

In January 1982, Ms. Rivera recognized the unrealized gains

from her stock forwards account, now totaling $701,750. She

withdrew her cash balance of $203,850, then deposited $10,000 in

April and $14,035 in May. There was no trading in her account

until July 1982. At that time, her trades generated capital losses

of $245,484. In October, the account incurred capital losses of

$313,483, and in December it incurred additional capital losses of

$209,385, for a total of $768,352. These losses exceeded the

$701,750 capital gains realized in the previous January by $66,602.

She also incurred cancellation fees of an additional $35,877. The

amount of the cancellation fees, $35,877, was added to her cash

account. For 1982, all of her combined cancellation fees and

losses from the account exceeded her gains--including an amount of

$2,427 as "other" income--by $100,052. The account also retained

an unrealized gain of $105,498 into 1983, plus a capital loss

carryover of $123,570. These transactions, when compared to her
- 35 -

adjusted gross income for 1983, produced the following results:

A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Losses w/o Loss w/o Merit Loss 

 $50,599 ($33,666) $84,265 140%

1 Ms. Rivera's adjusted gross income was the figure set forth

above. She deducted her cancellation fees, however, and when

adjustments were made for the zero bracket amount, the deduction

had the effect of lowering her otherwise taxable income by $33,666.

(4) 1983 Transactions

In 1983, there was no activity in Ms. Rivera's stock forwards

account until July. Thereafter, in trading during the last half of

1983, she realized losses of $317,463 and long-term capital gains

of $532,276. The trading records indicate income of $218,468,

including an item of $3,655 as "other" income. She retained

unrealized gains of $211,116 and carried them into 1984. On her

tax return for 1983, she applied the capital loss carryover of

$123,570 from the previous year. Respondent disallowed the capital

loss carryover. Taking into account the long-term capital loss

deduction, the disallowance increased her adjusted gross income by

$49,428. This amount, when compared to her adjusted gross income

for 1983, produces the following results:

 A.G.I. Merit A.G.I. Loss % of A.G.I.

 Per Return Loss w/o Loss w/o Merit Loss 

 $47,329 ($49,428.40) $96,775 51%

D. Leema Enterprises, Inc.

Leema, through its subsidiary Merit Securities, engaged in

trading on its own accounts in the T-bill, T-bond, and stock

forwards markets. The tax results of its trades appeared on the
- 36 -

13 One trade in the switch transactions which gave rise to

these losses generated income of $266.09. 

consolidated Federal income tax returns filed by Leema, Merit's

parent corporation. Leema and its subsidiaries, including Merit,

report their income on the basis of a fiscal year ending on June

30. For taxable years 1980 through 1982, respondent disallowed

losses reported by the Leema consolidated group with respect to

Merit's transactions that gave rise to realized losses.

(1) 1980 Transactions: T-Bond Options

Beginning in June 1980, Merit's T-bond option account, No.

111, engaged in two separate trading series, each of which featured

the open-switch-close pattern of generating tax losses.

 On June 11, 1980, Merit set up four straddles involving puts

and calls in T-bonds in trade No. 210. On June 19, 1980, 8 days

later, Merit set up four additional straddles involving T-bond puts

and calls in trade No. 211. Six days later, Merit closed out the

purchased call contracts in a "switch" in trade No. 211. The

switch transactions generated short-term capital losses of

$411,500.1713 for Merit's 1980 taxable year. On June 27, 1980, 2

days later, Merit closed out the purchased call contracts in trade

No. 210 by selling offsetting call contracts. This second switch

in the T-bond options generated additional short-term losses of

$435,235. For its 1980 taxable year, Merit's total T-bond option

losses were $846,735.67. There were no realized gains.
- 37 -

(2) 1981 Transactions

(a) T-Bond Options

In its next taxable year, Merit closed out its remaining Tbond option contracts and ended its participation in the T-bond

program. These transactions generated short-term capital gains of

$1,091,479.16, or an apparent overall gain on T-bond trading of

$244,742.

(b) T-Bill Options

Merit's trading in T-bill options began later in Merit's 1981

taxable year. Merit used four accounts. 

By far the largest of Merit's T-bill trading volume--hundreds

of trades with many of its customers--occurred in account No. 219.

Merit opened account No. 219 on December 26, 1980, with 62 trades

which constituted 31 spread transactions. Merit's only taxable

transactions during the calendar year occurred 4 days later, on

December 30, 1980. In one of two switch transactions, Merit

realized a gain of $50,050 in a switch of 11 T-bill option

contracts with a customer identified as RPV. The other transaction

yielded a loss of $18,236 in a trade with G & G Associates. 

Many of the trades involving account No. 219 terminated early

in January 1981, when Merit's customers realized the corresponding

gains that related to their December losses and claimed deductions

in their 1980 taxable years. By January 7, 1981, Merit's

cumulative realized gain in account No. 219 stood at $6,598.

Account No. 219 remained inactive until May, and its realized gain

figure remained at $6,598 until June 30, 1981. On that date, the
- 38 -

last day of its taxable year, Merit engaged in transactions that

produced realized yearend T-bill losses of $3,238,420. Twelve of

these transactions were for losses; there was one gain transaction

of $12,000. Merit retained and carried unrealized gains of

$3,330,690 in account No. 219 into its next taxable year.

During its taxable year 1981, Merit traded in three other Tbill accounts, apparently as an accommodation to other customers'

trades. Activity in Merit's account No. 133 began and ended

between September and the end of November 1980. The trading left

Merit with a realized gain of $144,860. The principal purpose of

account No. 133 (and most of its profits) arose from its taking the

other side of a trade in which Merit's customer, Monex, switched

and closed a trade involving 1,650 call contracts. The switch,

executed on September 26, 1980, generated a loss of $9,060,958.50

for Monex, whose taxable year ended 4 days later.

Merit's account No. 221 traded only over a 10-day period from

December 29, 1980, through January 7, 1981. Merit realized a loss

of $2,940. Its most notable activity was taking the other side of

a trade in which Merit's customer Seykota switched and closed

trades involving 1,500 put and another 1,500 call contracts. The

switches, executed on December 31, 1980, generated losses totaling

$9,345,000 for Mr. Seykota, whose taxable year ended that day.

Similarly, Merit's account No. 223 traded only over an 8-day

period during the last week of December 1980 and the first week of

January 1981. It traded with a number of customers. Its largest

transaction arose from a trade on January 5, 1981, closing out a
- 39 -

14 Case Holdings ended its T-bill trading in 1982. Merit

continued to trade T-bill options with its single remaining

customer, Monex, until 1988.

customer named Milburn Partners at a loss of $119,000. At the end

of trading, account No. 233 showed a profit of $7,466 for Merit.

(3) 1982 Transactions

(a) T-Bill Options

During its taxable year 1982 (beginning July 1, 1981), after

passage of ERTA, Merit's T-bill operations slowed dramatically. It

had only two clients, Case Holdings and Monex.14 Merit closed out

a number of its spreads, realizing carried-over gains of

$2,774,360. Its accounts, reflected on Leema's 1982 Federal income

tax return, show T-bill option trading income of $2,766,085,

apparently reflecting the unrealized appreciations retained from

trading in earlier years.

(b) Stock Forwards

During its taxable year 1982, Merit's principal trading

activity took place in its new stock forwards program. Merit's

stock forwards account was account No. 601. Merit acted as the

"other side" for its stock forwards clientele. The nonmarket

makers had approximately 17,000 trades. At the end of its taxable

year, Merit reported T-bill option income of $2,766,085 and

"cancellation fee" deductions of $2,845,358.

Leema (Merit's parent corporation) had two additional wholly

owned subsidiaries which engaged in stock forwards trading:

Horizon Trading, Inc. (formerly Merit Trading, Inc.) (Horizon),
- 40 -

15 Leema's other subsidiary, Omni Securities, Inc., also

functioned as a market maker, but it performed no trading in the

stock forwards market until Leema's next taxable year.

which maintained account No. 603, and Omni Securities, Inc., which

maintained account No. 701. Horizon functioned as a market maker

with respect to other traders. It traded for only 2 months at the

end of 1981 and the beginning of 1982. During December 1981, it

had cancellation-fee income of $26,347,590; the following month, in

January 1982, it incurred cancellation-fee losses of $26,256,320.

At the end of the taxable year, Horizon reported the $91,270

difference as income on Leema's consolidated return.15

OPINION

These cases are part of a series of cases that examines the

investment programs of Merit. We have addressed various aspects of

these programs in other, previously issued opinions. See Lee v.

Commissioner, T.C. Memo. 1997-172, affd. in part and remanded in

part 155 F.3d 584 (2d Cir. 1998); London v. Commissioner, T.C.

Memo. 1996-192; Alessandra v. Commissioner, T.C. Memo. 1995-238,

affd. without published opinion 111 F.3d 137 (9th Cir. 1997);

Lamborn v. Commissioner, T.C. Memo. 1994-515; Seykota v.

Commissioner, T.C. Memo. 1991-234, modified T.C. Memo. 1991-541.

None of these previous cases is dispositive of the current cases,

which involve different petitioners and the holding of a new trial

at which the parties presented different testimony and documentary

evidence. We have accordingly addressed the issues in the present
- 41 -

16 To be consistent with the parties' usage, we have

described the offsetting positions as "spreads". These

positions, however, also come within the definition of the term

"straddle" as that term is used in the Internal Revenue Code. 

See Katz v. Commissioner, 90 T.C. 1130, 1136 n.12 (1988); Perlin

v. Commissioner, 86 T.C. 388, 391 n.8 (1986).

cases de novo, and we have based our findings and holdings upon

consideration of the evidence produced in these cases.

Issue 1. Tax Straddles and Economic Substance

These cases involve various "spreads".16 With respect to the

T-bill and T-bond options, a spread is a hedged position comprising

two substantially offsetting option positions. When the interest

rate changes, the price of one leg of a T-bill or T-bond option

will appreciate in value while the other will depreciate. 

In the case of stock forwards, the spread consisted of a long

leg--one for the sale of a corporation's stock at a specific future

date--and a short leg--a contract for the purchase of an equivalent

amount of that corporation's stock on a different future date.

Again, a change in the underlying stock price would cause one leg

to appreciate, while the other would depreciate.

These spreads operated efficiently as tax straddles. A

typical tax straddle works as follows: first the investor

simultaneously acquires offsetting positions. These positions have

different exercise dates, so that they do not cancel each other

out. As the market price of the underlying commodity changes, one

leg will appreciate in value and the other will depreciate. At the

end of the investor’s taxable year, he or she will sell the

depreciated loss leg and replace it with a new contract. The sale
- 42 -

17 In Smith v. Commissioner, 78 T.C. 350, 365 (1982), we

stated:

In fact, if petitioners' analysis of the tax law is

correct, nothing but commission costs and death would

prevent a taxpayer from perpetually straddling,

achieving perhaps the ultimate tax goal of permanent

deferral of taxation of an initial short-term capital

gain. * * *

produces a tax-deductible loss in that year, but no corresponding

gain. In the next taxable year, the investor will sell or close

out the gain leg. Thus, the investor has not only obtained a

current deduction but also deferred taxable gain on his or her

investment into the next year. Presumably, if the investor is

interested in further deferral, he or she could go back to the

first step in the second taxable year and, in effect, move the

taxable gain into a third taxable year.17

These tax tactics were subject to some added refinements. For

example, the sale or exchange of a purchased ("long") option was

deemed to have the same character as the underlying property.

During 1979 through June 23, 1981, T-bills--the underlying property

of the T-bill options--were excluded from the definition of a

capital asset by then section 1221(5). Accordingly, investors

reported losses upon the sale of purchased options as ordinary

losses.

In 1981, Congress enacted ERTA. The explanation accompanying

the legislation noted that "Congress was concerned about the

adverse impact of Treasury bill straddles on Government tax

revenues." Staff of Joint Comm. on Taxation, General Explanation
- 43 -

18 Congress repealed the statutory provision that stock

was not subject to the loss limitation provisions of ERTA in

1984. See supra note 10.

of ERTA, at 309 (J. Comm. Print 1981). ERTA removed the chief

advantage of commodity straddling--that is, taking a loss on one

leg the first year and deferring the cognate gain from the other

leg into later tax years. Sec. 1092, added by ERTA sec. 508(a),

(c). 

The conference report explained that the new law "allows

straddle losses only to the extent such losses exceed the

unrealized gains on offsetting positions. Disallowed losses are

deferred. * * * The loss deferral rule applies to actively-traded

personal property (other than stock)". H. Conf. Rept. 97-215, at

258 (1981), 1981-2 C.B. 481, 513. 

The same legislation repealed section 1221(5) with respect to

obligations acquired after June 23, 1981, and subjected short-term

governmental obligations to new section 1232(a)(3) (now section

1232(a)(4)). The new law thus eliminated the possibility of

reporting ordinary losses on the disposition of options relating to

Treasury bills.

After the enactment of ERTA, Merit began to deal in stock

forwards. The PPM for its stock forwards advised that a forward

position in stock is not subject to the loss limitations of ERTA.

See Rivera v. Commissioner, 89 T.C. 343 (1987).18

This Court has often examined the tax aspects of straddles of

futures or forward contracts for financial instruments. Where the
- 44 -

market is limited to transactions among the straddles' customers

and the creator of the market, we have focused upon whether the

purported transactions existed in substance. Freytag v.

Commissioner, 89 T.C. 849, 876 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991).

The underlying issue in these cases is whether petitioners are

entitled to deduct losses for various years between 1979 and 1984

resulting from their trading on the Merit T-bill, T-bond, and stock

forwards markets. Respondent contends that even if petitioners'

straddle transactions actually occurred, they lacked economic

substance. 

The economic substance doctrine was articulated in Gregory v.

Helvering, 293 U.S. 465, 469 (1935), where the Supreme Court

explained: "the question for determination is whether what was

done, apart from the tax motive, was the thing which the statute

intended". The Court of Appeals for the Third Circuit has

explained the Supreme Court's holding in Gregory as "settled

federal tax law that for transactions to be recognized for tax

purposes they must have economic substance. Therefore, economic

substance is a prerequisite to the application of any Code

provisions allowing deductions". Lerman v. Commissioner, 939 F.2d

44, 52 (3d Cir. 1991) (emphasis added), affg. Fox v. Commissioner,

T.C. Memo. 1988-570.

The economic substance test involves an objective examination

of the transactions at issue. The test is whether the substance of

a transaction reflects its form and whether from an objective
- 45 -

standpoint the transaction was likely to produce economic benefits

aside from a tax deduction. Casebeer v. Commissioner, 909 F.2d

1360 (9th Cir. 1990), affg. in part and revg. in part on another

ground Larsen v. Commissioner, 89 T.C. 1229 (1987).

A review of the actual transactions and their characteristics

demonstrates that the substance of the Merit transactions did not

reflect their form. The form was the investment in financial

products; the substance was the production of tax deductions.

A. Structure of the Merit Markets

Economically insubstantial tax-straddle programs are often

characterized by trading exclusively in tax-advantaged assets and

by stressing the tax-avoidance aspect of those assets. Realistic

projections of actual economic returns, however, are notably absent.

Fox v. Commissioner, 82 T.C. 1001 (1984); Leslie v. Commissioner,

T.C. Memo. 1996-86, affd. 146 F.3d 643 (9th Cir. 1998). 

Here, the principal attraction of the Merit markets plainly was

the ability to generate tax deductions far in excess of the amounts

invested. Merit’s T-bills and T-bonds were both traded as options.

Thus, yearend losses on T-bill options could be ordinary losses,

which, unlike capital losses, could be fully used as deductions to

reduce ordinary income from other sources. 

Similarly, the T-bond options were created and traded in a way

that they could produce capital losses and, in some defined

circumstances, long-term capital gains. The T-bond PPM sets forth

explicitly the provisions of Rev. Rul. 78-182, 1978-1 C.B. 265,

which discuss the circumstances for generating tax advantages. To
- 46 -

a knowledgeable investor, T-bond capital losses would be useful in

eliminating short-term capital gains that had been retained from

spread transactions in prior years. Moreover, the long-term capital

gains offered taxation at 40 percent of the rate applied to ordinary

income. 

The subsequently developed stock forwards had their own tax

advantages, which Merit again set forth in PPM's. Merit advised

that the forwards could be exempt from the loss disallowance

provisions of ERTA, and thus, provide the traditional straddle

opportunity for current deductions and postponed income. Moreover,

although contracts for the sale of stock were capital assets in the

hands of the investors, the promoters of Merit claimed that the

disposition of those contracts would produce ordinary losses if the

investors could arrange with Merit for “cancellation” of the

contracts. 

In contrast to the explication of tax benefits, none of the

Merit programs depicted a realistic projection of the way in which

investments would produce meaningful economic profit. The PPM's

offered only abstract and technical discussions of spread

strategies, but no detailed projections of realistic economic

returns. No attempt was made to demonstrate the size and likelihood

of profits, set forth in terms that take into account the pervasive

combination spread structure, the amount of transaction fees, and

the amount of forgone interest. The Merit programs instead show

that their actual objectives were tax avoidance and not the

realistic production of profits.
- 47 -

19 Even in the exceptional case, when investors reported

appreciable economic earnings, they immediately terminated

trading in those markets. See supra notes 3 and 4.

The tax-avoidance orientation of these tax straddles is

reflected in the historic background of the offerings. Fox v.

Commissioner, supra at 1016, 1017. In Merit's case, the T-bond and

T-bill programs flourished until the effective date of ERTA in 1981,

when Congress eliminated the tax benefits of trading option

straddles. Merit’s trading in options stopped suddenly, even though

Congress had done nothing to impair the economic profitability of

trading in options.19 In the same year, however, Merit developed

another tax-favored plan, claiming that its new stock forwards would

provide the benefits of tax straddling that had been the focus of

congressional disfavor in ERTA. Moreover, Merit advised that the

resulting losses could be ordinary losses, because it could provide

its customers with a “cancellation” of their contracts. It is clear

that Merit was interested only in offering tax-advantaged

instruments. When Congress removed the touted tax benefits desired

by the Merit programs, Merit's interest in them dwindled, even

though Congress did nothing to impair the economic viability of

those programs. 

Merit’s restriction of its trades to spreads and combination

spreads also indicates that its trading was designed for tax

benefits and not economic gains. Two laws permit the deduction of

straddle losses, Code section 165 and section 108 of the Deficit

Reduction Act of 1984 (DEFRA), as amended by the Tax Reform Act of
- 48 -

1986 (TRA), Pub. L. 99-514, sec. 1808(d), 100 Stat. 2085, 2817.

Both require a “loss”. If a transaction lacks economic substance,

it cannot provide a basis for a deductible “loss”. Lerman v.

Commissioner, supra at 45. 

Like other tax straddles, Merit trades appear to indicate that

its investors had actually incurred substantial yearend losses. In

reality, there were no such losses; the investors, who purchased

only straddles, were substantially protected against the economic

effect of actual losses by holding onto unrealized gains--gains that

would be taxed only in the next year, or even later. Merit employed

combination spreads--that is, two spreads, each of whose movements

in response to a market shift would counteract the other.

Combination spreads thus afforded even more protection against

actual economic effects--whether losses or gains. Such tactics take

unintended "advantage of the practical necessity of preserving the

integrity of separate taxable years. Congress never intended such

stratagems to prosper.” Fox v. Commissioner, supra at 1027.

As petitioners point out, we have permitted the deduction of

straddle losses incurred by profit-motivated individuals who trade

consistently on established markets and hedge their positions. See,

e.g., Laureys v. Commissioner, 92 T.C. 101 (1989). In those cases,

however, we have been convinced that the taxpayers had primarily

for-profit objectives and that the markets on which they invested

possessed a potential for delivering meaningful profits.

Petitioners have failed to make that showing.
- 49 -

20 Glass v. Commissioner, 87 T.C. 1087 (1986), affd. sub

nom. Bohrer v. Commissioner, 945 F.2d 344 (10th Cir. 1991), affd.

sub nom. Lee v. Commissioner, 897 F.2d 915 (8th Cir. 1989), affd.

sub nom. Kielmar v. Commissioner, 884 F.2d 959 (7th Cir. 1989),

affd. sub nom. Dewees v. Commissioner, 870 F.2d 21 (1st Cir.

1989), affd. sub nom. Freidman v. Commissioner, 869 F.2d 785 (4th

Cir. 1989), affd. sub nom. Keane v. Commissioner, 865 F.2d 1088

(9th Cir. 1989), affd. sub nom. Ratliff v. Commissioner, 865 F.2d

97 (6th Cir. 1989), affd. sub nom. Killingsworth v. Commissioner,

864 F.2d 1214 (5th Cir. 1989), affd. sub nom. Kirchman v.

Commissioner, 862 F.2d 1486 (11th Cir. 1989), affd. sub nom.

Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988), affd. sub

nom. Herrington v. Commissioner, 854 F.2d 755 (5th Cir. 1988).

B. Trading on the Merit Markets

The lack of economic substance of the Merit trades is evident

from an examination of the trades themselves. Petitioners executed

their trades for tax deductions, not for economic benefits. Their

tactics reveal many characteristics of tax-motivated, but

economically insubstantial, tax-straddle trades. Chief among these

is the deliberate incurring of first-year losses. In Glass v.

Commissioner, 87 T.C. 1087, 1172, 1176 (1986),20 we stated:

The one consistent thread which runs through all of the

cases consolidated in this proceeding is that losses,

either ordinary or capital, were intentionally incurred

in year one, followed by countervailing gains in year two

or in many instances later as a result of rollovers.

* * * * * * *

The intentionally realized losses in year one were not

necessary or helpful in profiting from difference gains

in * * * [the taxpayers'] commodity straddle

transactions. Put in this light, the * * * options

strategy was "a mere device which put on the form of [*

* * option and futures transactions] as a disguise for

concealing its real character," the obtaining of

unallowable loss deductions. As such, the * * * options

transaction lacked economic substance and was a sham.

[Fn. refs. and citations omitted.]
- 50 -

In this case, the pattern of first year losses is unmistakable.

Mr. Keeler began with his T-bill investment in November 1980.

His only taxable transactions that year were the sales of 80 T-bill

contracts in December. Each produced losses. He left the T-bill

market in February 1981. In November 1981, Mr. Keeler began his

involvement with the Merit stock forwards. His only taxable

transactions came in December of that year, when 16 of his 17 stock

forwards trades produced losses. The pattern held true in the next

year; in December 1982, he engaged in 43 taxable transactions, all

resulting in losses. His trading was relatively quiet in 1983 and

ended in 1984.

Dr. Richartz's trades reveal a similar pattern. His T-bill

involvement began in November 1979, and his closings all took place

in December of that year, generating losses of $77,440. In 1980,

he engaged in some midyear trades with other Merit participants;

those trades generated a small gain. In December, however, he

disposed of 115 T-bill contracts, all for losses. He then invested

in the stock forwards program beginning in November 1981. He made

17 trades in December, all for losses. At the end of 1982, he

engaged in 23 stock forwards trades; 22 were for losses. His single

gain transaction of $56,600 was vastly overshadowed by the losses

of $4,499,307. His 1983 trading took place in the last half of that

year, and by November he had more than $2 million in capital gains.

In December, however, he eliminated this gain by taking losses,

leaving his account at a minus $61,807.
- 51 -

Although the record does not provide as much detail concerning

the trades of Ms. Rivera, they nonetheless indicate yearend lossonly transactions for 1980, when switches in her account generated

a loss of $81,001 in T-bills and a loss of $408,527 in T-bonds. In

1981, she had stock forwards losses of $699,300; the summaries of

her account offer no indication that any of her stock forwards

trades generated gains. In 1982, she took losses in July, October,

and December, eliminating her option gains incurred the previous

January. Her trades in 1983 were confined to the last half of the

year. Her records show a substantial profit going into the end of

the year, but she reduced her gain to $218,468 in December by taking

a loss of $536,985. She further reduced her gain by applying a

capital loss carryover of $123,570.

Leema engaged in switch transactions shortly before the end of

its taxable year; on June 19 and 27, 1980, its switch transaction

in the T-bond option account yielded no gains but only losses of

$846,735.67. Its first involvement with T-bills reflected modest

changes in response to customer trading, but, on the last day of its

taxable year, it engaged in 13 transactions, producing 12 losses and

1 gain. The net of this yearend trading was a loss of $3,321,822.

Although the record lacks detail about Leema's last year in issue,

its tax return indicates option income of $2,766,085 and

cancellation fee deductions of $2,845,358.

A further indication of a transaction lacking economic

substance is petitioners' consistent rolling of taxable income from

one year into the next. This practice completed the "tax
- 52 -

centerpiece" of tax straddles--the closing of positions which

produce losses for the first year and the movement of the offsetting

gain to subsequent years by rollovers. Krumhorn v. Commissioner,

103 T.C. 29, 51 (1994); Glass v. Commissioner, supra. The Merit

trades again show consistent patterns of such rollovers, with

realized losses being taken in the first year and unrealized gains

being rolled over so that they will not be taxed until the next

year, or even later years.

Mr. Keeler's trading in the Merit T-bill program produced the

following deferrals and rollovers:

December 1980 Realized loss ($689,600)

December 1980 Unrealized gain 667,685

January 1981 Realized gain 651,320

Trading in his stock forwards account showed a similar pattern,

rolling gains from 1981 and 1982 into taxable status in 1984:

December 1981 Realized loss ($8,250,260)

December 1981 Unrealized gain 8,207,410

January 1982 Realized gain 7,984,320

December 1982 Realized loss (9,955,447)

December 1982 Unrealized gain 9,851,790

January 1983 Realized gain -0-

December 1983 Realized loss (35,230)

December 1983 Unrealized gain (2,520) 

January 1984 Realized gain 9,588,496

Dr. Richartz's T-bill activity showed the following 

patterns:
- 53 -

December 1979 Realized ordinary loss ($77,440)

December 1979 Unrealized gain 78,205

January 1980 Realized capital gain 78,488

November/December 

 1980 Realized loss (1,200,273)

December 1980 Unrealized gain -0-

January 1981 Realized gain 

11,115,550

1 Peng Partners indicated the same open-switch-close patterns

which are indicative of a lack of economic substance. Dr.

Richartz's distributive share of Peng Partners' T-bill option losses

are thus indistinguishable from his personal losses from T-bill

option trading.

The pattern persisted in Dr. Richartz' stock forwards trading:

December 1981 Realized loss ($2,626,320)

December 1981 Unrealized gain 2,656,440

January 1982 Realized gain 2,668,910

As a market maker, Dr. Richartz entered into taxable

transactions at various times in the last half of 1982 and 1983.

The yearend results were as follows:

December 1982 Realized loss ($1,826,589)

December 1982 Unrealized gain 1,857,057

January 1983 Realized gain 668

December 1983 Realized loss (61,807)

December 1983 Unrealized gain 82,054

January 1984 Realized gain 1,642,552

Ms. Rivera's T-bond and T-bill accounts also reflect the

pattern of first-year losses and deferral of gains:

T-bills:

December 1980 Realized loss ($81,001)

December 1980 Unrealized gain 80,985

January 1981 Realized gain 80,956

T-bonds:

December 1980 Realized loss (408,527)

December 1980 Unrealized gain 423,538

January 1981 Realized gain 426,959
- 54 -

Her stock forwards account shows a similar pattern, with trades that

rolled gains from 1981 and 1982 into taxable status in 1984:

December 1981 Realized loss ($699,300)

December 1981 Unrealized gain 700,180

January 1982 Realized gain 701,750

December 1982 Realized loss (100,051)

December 1982 Unrealized gain 105,498

January 1983 Realized gain 328

December 1983 Realized gain 218,468

December 1983 Unrealized loss (211,116)

January 1984 Realized gain 103,376

The evidence in these cases provides less detail concerning

Leema's trading than is available for the individual petitioners.

Leema and Merit had taxable years ending on June 30. The available

evidence shows losses and gains incurred through Leema's subsidiary,

Merit, as follows:

T-bonds:

June 1980 Realized loss ($846,736)

June 1980 Unrealized gain -0-

July 1981 Realized gain 1,091,479

T-bills:

June 1981 Realized loss 3,227,296

June 1981 Unrealized gain 3,330,690

July 1981 Realized gain 2,774,360

Information regarding Merit's stock forwards trading is

sketchy. Its tax returns reveal T-bill option trading income of

$2,766,085 but stock forwards "cancellation fee" deductions of

$2,845,358.

Petitioners urge that their intentionally realized first-year

losses on their spreads were merely part of investment programs that

extended over several years. Their evidence, however, falls far
- 55 -

short of demonstrating that these losses were "necessary or helpful

in profiting from difference gains". Glass v. Commissioner, 87 T.C.

at 1176. The actual trading records set forth above show that

petitioners held their initial positions for a relatively short time

before taking substantial losses. Moreover, the amount of losses

taken was generally close to the amount of the next year's gains.

These factors indicate that actual economic gains from changes in

the spread positions were not significant and, in any event, were

overshadowed by the tax losses that could be generated. 

Two other factors which reflect lack of economic substance are

a correlation of losses to tax needs, coupled with a generalized

indifference to, or absence of, economic profits. Freytag v.

Commissioner, 89 T.C. 849 (1987).

Mr. Keeler's tax returns indicate that his Merit losses,

expressed as a percentage of his income before deduction of the

losses, equaled 100 percent of his adjusted gross income in the

first year at issue and 97 percent of his adjusted gross income for

the second year. In the third year, his Merit losses were minimal,

but the Merit program enabled him to defer taxation on income of

approximately $9 million. It was not until the fourth year that he

reported the substantial deferred income from the Merit

transactions. In the meantime, his indifference to, and lack of,

economic profits was marked. He persisted in the Merit programs,

despite consistent economic trading losses which totaled $706,401.

Dr. Richartz's tax returns indicate that his Merit losses,

again expressed as a percentage of income, equaled 62 percent of his
- 56 -

21 At times, petitioners gave effect to their Merit losses

by deducting them instead of by making adjustments to gross

income. In such cases, comparison to taxable income reveals the

tax effect of those losses.

adjusted gross income in 1979, 99 percent of his adjusted gross

income in 1980, 100 percent of his adjusted gross income in 1981,

and 92 percent of his taxable income in 1982.21 The percentage of

Merit losses dropped to 56 percent of taxable income during 1983.

His overall profit on T-bill options and stock forwards, after 6

years, was $59,413. 

During the years in issue, Ms. Rivera's Merit losses, as a

percentage of income, equaled 108 percent of her taxable income in

1980, 82 percent of her adjusted gross income in 1981, and 40

percent of her taxable income in 1982. Merit losses equaled 51

percent of taxable income during 1983. Her overall profit on T-bill

and T-bond options and stock forwards during the years at issue was

$1,102.

Leema's patterns do not lend themselves to this analysis

because of its use of a subsidiary to engage in trading.

Nevertheless, Merit's trades demonstrate multimillion-dollar losses

which assisted handsomely in eliminating much of the other corporate

income in Leema's consolidated returns.

The trading at issue is plainly tax motivated. Each of

petitioners' trades reveals consistent first-year losses. All

petitioners deliberately incurred these losses either to generate

tax deductions or to create losses that would offset other gains.

The taxable transactions that occur in the first year or first 2
- 57 -

years are overwhelmingly trades that yield losses, not income.

Moreover, the trading pattern shows consistent retention of

unrealized gains to be carried into the next taxable year or years.

Petitioners claim that their trades were motivated by profit

potential; any tax losses were incurred to take advantage of yearend

opportunities. We do not accept this characterization. Petitioners

have presented voluminous expert testimony, computerized charts, and

printouts of past trading in support of their claims that the Merit

trading was profit motivated. The pervasive flaw in these

presentations is that they are taken out of the context of the total

Merit trading. For example, petitioners state that Mr. "Keeler's

account increased in value during January 1982, September, 1982,

February 1983, April, 1983, June, 1983, August, 1983, September,

1983, and October, 1983." The context of Mr. Keeler's trades in

those years shows, however, that the account decreased in value

during the other unlisted 16 months of that 2-year period. The gain

in January 1982 represented the reaping of rollover gains from the

prior year's trades, but these gains were approximately $80,000 less

than the prior month's (and previous taxable year's) losses. The

gains from the other 7 listed months do not reflect any trading

activity; they show only modest market fluctuations that resulted

from application of Mr. Auerbach's algorithms used to create prices

for the Merit markets.

Petitioners next contend that "Of his [i.e., Mr. Keeler's]

combination spreads, from opening to closing, more than 25 percent

were profitable." We are more impressed with the converse; that is,
- 58 -

that some 75 percent of his spreads lost money. Petitioners next

add: "At the end of 1981, some of his closing transactions caused

him to realize gains totaling $96,600." The record reveals that,

at the end of 1981, Mr. Keeler's other closing transactions caused

him to realize overall net losses of $8,250,260.

We have examined petitioners' many diagrams depicting each

investor's range of profit possibilities in the Merit markets. They

may well be individually accurate. Indeed, the realization of token

profits in straddle transactions--where a loss in one leg is offset

by a gain in the other--is not unexpected. It is a given that the

straddle programs had the potential of generating a profit.

Petitioners' demonstration, however, overlooks the fact that the

straddle programs were more efficient at generating skewed tax

deductions. Here the patrons of the Merit markets utilized them to

generate tax deductions, not to earn economic profits. In rejecting

similar contentions, the Court of Appeals for the Third Circuit

explained the governing principle as follows:

The potential for a profit existed but the taxpayers

avoided making a profit by intentionally realizing losses

in the first year which "were not necessary or helpful in

profiting from difference gains in petitioners' commodity

straddle transactions." * * * [Glass v. Commissioner, 87

T.C.] at 1175-76. * * * [Lerman v. Commissioner, 939 F.2d

at 49.]

Nor are we convinced by petitioners' arguments that the Merit

trades were not characterized by uniform results. Petitioners urge

that, instead of uniform results, "some investors made money, some

broke even, and some lost hundreds of thousands of dollars".

However, when uniformity of results was needed--as in first-year
- 59 -

22 Investor Hindshaw showed an overall trading gain of

$5,161 (account No. 631) but deferred the tax on $275,000 in

unrealized gains through 1982 into 1983. Similarly, investor RPV

showed an overall profit of $6,365 (account No. 673). It

deferred approximately $500,000 from 1981 into 1983.

losses for tax purposes--the trades produced uniformity. Of the 79

T-bill accounts, 4 were owned by Merit. Of the other 76, only 1

made a first-year profit--in the amount of $961. Moreover, three

of the four Merit accounts lost money as well. In the T-bond

markets, all 26 investors incurred first-year losses. In the stock

forwards market, all 52 investors incurred first-year losses. In

all the programs, economic losses far outweighed the modest economic

gains. In fact, only two of the non-Merit investors showed any

profits as a result of their overall stock forwards trading.22

C. Other Factors in the Merit Markets 

A number of other factors contribute to our conclusion that the

Merit programs lacked economic substance. Merit set the prices and

controlled these markets, trading only with a small circle of savvy

trading advisers or sophisticated customers. See Freytag v.

Commissioner, 89 T.C. 849 (1987). These individuals were able to

keep up with the Merit program by using computer linkups. Merit

employees provided computerized information sufficient to guide taxmotivated trades. The computer programs informed the advisers and

their clients of current losses and unrealized gains that could be

generated by any trade.

We have evaluated petitioners' demonstration that a number of

trades were executed for short-term capital gains instead of for
- 60 -

23 We have noted the single minor exception supra p. 14 and

note 4.

generally more favorable long-term capital gains. Such trading,

they claim, demonstrates that economic profits, and not tax savings,

were the object of the trades. Again, petitioners have presented

evidence of such trades without explaining their context--including

the extent to which the short-term capital gains they incurred were

offset by similarly artificial short-term capital losses.

Petitioners also contend that it is "simply not the case" that

Merit's trading was characterized by uniform patterns. Glossing

over undeniable lockstep patterns of the early Merit markets,

petitioners urged that Merit trading became "more and more

idiosyncratic". They indicate that the percentage of open-switchclose trades varied among the various accounts. Petitioners'

argument obscures the fact that, when Merit trades needed to be

uniform for tax purposes, they were uniform. The investors in each

of the Merit programs uniformly incurred losses in their first years

of trading.23 They then deferred taxable gains into subsequent

years. After posting first-year losses, they could afford to be

more idiosyncratic in their trading. Some investors--such as

petitioners Keeler and Richartz in 1983--having begun a series of

tax deferrals, chose to engage in very little activity. Such

inactivity does not require a finding that the trades were

economically substantial. In fact, during 1983, petitioners Keeler

and Richartz, while generating little in terms of economic results,

were deferring the reporting of millions of dollars of taxable
- 61 -

24 Moreover, the historic stock prices, rates, and

(continued...)

income into 1984. Petitioners' actual trading patterns may indeed

have become more idiosyncratic, but the trades still represented

substantial tax avoidance.

Another indication of a lack of economic substance is the fact

that the prices of the items traded on the Merit markets were not

set by market forces. Instead, the prices were set by Merit itself,

according to formulas derived by its employees. As was the case in

Freytag v. Commissioner, supra, the parties have expended a great

deal of time, energy, and resources in arguing the theoretical

viability of Merit's pricing structure for options and forwards.

Those considerations are largely irrelevant. The loss legs of

tax straddles presented the opportunity for large tax losses at the

end of a taxable year. Economically, these are not losses at all,

because they are balanced by the offsetting (but unrealized for tax

purposes) gain legs. Thus, alleged negotiations between Merit and

its customers as to the prices of the legs are not particularly

significant, because the prices offset each other. We explained

that point in Smith v. Commissioner, 78 T.C. 350, 379 (1982):

Neither were petitioners' prices the product of an

economically adversarial or tax-consequence adversarial

process. While the relative prices of straddle legs are

of great economic consequence to a straddle trader, the

absolute prices have little or no economic significance.

The buyer or seller of a straddle suffers no economic

benefit or detriment by agreeing to leg prices above the

market or below the market. To the extent that one leg

is economically deprived of its true value by such

pricing, the other leg's value is equally enhanced. * *

* [Fn. ref. omitted.24]
- 62 -

24(...continued)

dividend data that Merit used to compute its formula prices are

unavailable. Thus, the validity of the prices actually charged--

to the extent it is relevant--cannot be verified.

We thus decline petitioners' invitation to give effect to

alleged negotiations that, compared to the manifest tax advantages,

mattered very little to the parties. Petitioners' reply brief sets

forth a detailed example of the effect of negotiations on the

pricing of T-bills in trade No. 74. It focuses upon a combination

spread between petitioner Keeler and another investor. In that

spread, the formula strike prices per T-bill were $89.14 and $89.02

for the respective legs. Petitioners urge that negotiated changes

produced actual prices of $89.01 and $88.89, respectively. They

demonstrate that, if the market moved to a price of $89.05, the

negotiations would produce an 18-cent change in the price of a Tbill option spread. 

We accept that negotiations for strike prices could, in theory,

produce an economic effect. Petitioner's example, however, fails

to demonstrate that, from an objective standpoint, the transaction

was likely to produce economic benefits aside from a tax deduction.

See Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990).

The trading in account No. 74 began on November 21, 1980; it

ended on January 5, 1981. During the 45 days of its existence,

recorded trades took place on 3 days--the open-switch-close days.

For petitioner Keeler, the results were as follows:
- 63 -

First-Year Gain Deferred Overall Economic Economic Cost as

 Tax Loss to Second Year Cost Percent of Tax Loss

 $689,600 $667,685.40 ($38,280) 5.55%

The above transactions reflect the actual economic substance

of petitioner Keeler's investments in Merit's T-bill options. They

demonstrate that tax deferrals were the object of the trades, and

that there were no economic profits. The actual economic costs were

minimal when compared with the tax deferrals; in reality, the

economic losses represent a cost of obtaining tax benefits. 

A more extensive examination of trade No. 74 underscores this

point. Five investors, other than Merit itself, engaged in trade

No. 74. Three of them, including petitioner Keeler, incurred

economic losses, but the other two can show that their trades in

trade No. 74 produced modest profits of approximately $3,000 each--

at least before commissions and forgone interest on margin accounts

are taken into account. In the context of this single trade, these

modest profits might be some evidence of economic substance.

Petitioners have made such arguments, pointing out occasional

positive changes in investors' Merit accounts. These arguments,

however, do not hold up when they are considered in the context of

the investors' total T-bill trading. With the exception of

petitioner Keeler, four other non-Merit investors engaged in T-bill

trading sequences in addition to trade No. 74. When all five

investors' overall trading in the T-bill market is considered, the

pattern of consistent yearend tax deferrals and overall economic

profits becomes obvious:
- 64 -

 First-Year Overall Economic Loss as Percent

Trader Deferral Effect of Deferral 

Timmons $3,309,819 ($165,087) 4.99%

Walker 9,917,243 (367,560) 3.71

Rapien 3,232,101 (133,020) 4.12

Origlia 1,520,610 (77,390) 5.09

Keeler 689,600 (38,280) 5.55

Ultimately, the record does not reveal any basis to conclude

that the assertedly "negotiated" trades in issue were likely to

produce economic benefits aside from a tax deduction.

Petitioners' citation of isolated instances of profitable

transactions does not affect this conclusion. To the contrary, we

have consistently held that "the fact that the entire transaction

produces a nominal net gain will not impute substance into an

otherwise sham transaction." Krumhorn v. Commissioner, 103 T.C. at

55. The Merit program, like other tax straddles, turned its back

on the possibility of any meaningful profits, because its function

was the generation of early losses and the postponement of any gain.

We also take note of Merit's practice of charging bid/ask only

on the opening transaction. It may be questioned why the operators

of a market would levy a charge only on the first use of its

resources and, thereafter, permit its traders to operate free of

charge. Here, the first trade was in fact only the first link in

a prearranged chain of transactions. That is why a fee was charged

only at the outset. 

Similarly, Merit's consistent practice of retaining its

clients' margin deposits in amounts larger than required--and for

periods longer than trading took place--suggests that the deposits
- 65 -

served a purpose other than guaranteeing the investors' good faith.

Merit kept the interest generated by these deposits, during a time

when interest rates were relatively high. Merit insiders, however,

such as Dr. Richartz and Ms. Rivera, were allowed to keep the

interest on their own deposits. This practice suggests that the

margins were used as a source of interest income for Merit and its

insiders, and not as a basis for maintaining a valid market. 

Additionally, there were no deliveries of the underlying

commodity in Merit's history of trading options in T-bills and Tbond options and only two deliveries pursuant to forward contracts

in corporate stock. This suggests that Merit was not dealing in

valid trades, but rather only in made-up positions that could be

balanced as Merit (or the investment advisers) desired in order to

generate tax deductions or offsets. Petitioners argue that

deliveries of the underlying commodities are the exception to the

rule in commodity transactions, and they point out that contemporary

derivative markets have no delivery of the underlying asset at all.

We understand that, even on valid markets, most options contracts

are offset and do not result in delivery of the underlying

commodities. The fact remains, however, that evidence of a

meaningful number of deliveries of the items sold on the Merit

markets would have supported a finding that the markets possessed

economic validity. Merit has made no such showing. Its evidence

of two deliveries of stock (one of which was later undone) does not

dissuade us from the belief that the thousands of other Merit

transactions took place with no concern for delivery, or even the
- 66 -

25 Petitioners contend that, to the extent their

deductions are disallowed under the Merit programs because of a

lack of economic substance, the corresponding income should be

removed from taxable income as well. We agree. In a sham

situation, we must give effect neither to the deductions nor to

the income generated by the program at issue. Sheldon v.

Commissioner, 94 T.C. 738, 762 (1990); see Julien v.

Commissioner, 82 T.C. 492, 498, 508-509 (1984); see also

Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), affg. 44

T.C. 284 (1965); cf. DEFRA sec. 108(c), 98 Stat. 630, as amended

by the Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec.

1808(d), 100 Stat. 2817. 

existence, of the underlying commodities. Merit was "playing a

football game without the football". See Price v. Commissioner, 88

T.C. 860, 884 (1987).

Petitioners' counsel have ably compartmentalized the elements

of respondent's criticisms of the Merit program and then gone to

work on each singly. But in the end, we must bring all these

elements together. Treating the facts as a bundle, we cannot escape

the conclusion that the Merit markets lacked economic substance.

Although the form appeared as markets for particular financial

instruments, the substance was the creation of straddles to generate

loss deductions without corresponding economic losses. From an

objective standpoint, the straddles were unlikely to produce

economic benefits aside from tax deductions. In short, the Merit

trades lacked economic substance and cannot support the losses

claimed. See Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir.

1990).25

Issue 2. Primary Profit Objective

Our holding as to economic substance may obviate the need to

discuss at length the question of petitioners' profit motives; in
- 67 -

any event, we find that their motives were not primarily for profit.

The laws that permit the deduction of valid straddle losses do so

only "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". DEFRA sec. 108; see Code sec.

165. For a taxpayer to be in a "trade or business", the taxpayer's

activity must have a "primarily for profit" motive. Polakof v.

Commissioner, 820 F.2d 321 (9th Cir. 1987), affg. per curiam T.C.

Memo. 1985-197; Zell v. Commissioner, 763 F.2d 1139 (10th Cir.

1985), affg. T.C. Memo. 1984-152. Thus, whether a taxpayer is in

a trade or business or not, he or she must have incurred tax

straddle losses in an activity engaged in primarily for profit.

Our time focus on a taxpayer's profit motive is at the time the

taxpayer initiated his transactions. Nevertheless, all the

circumstances surrounding the taxpayer's transactions, including the

disposition of the options, are material to the question of the

taxpayer's intent. See Fox v. Commissioner, 82 T.C. at 1022. We

accord greater weight to objective facts than to a taxpayer's selfserving statements characterizing his or her intent. See id. In

this regard, "It is a fundamental legal maxim that the consequences

of one's acts are presumed to be intended." Id.

 Here, the Merit investors who defend their investments were

knowledgeable; many were insiders in the Merit markets. All were

aware that spread transactions offered impressive tax savings while

minimizing the risk associated with those savings. All were aware

of the tax-advantaged nature of the assets being sold, such as T-
- 68 -

26 We note that none of the individual petitioners have

claimed coverage of the per se rule applicable to commodities

dealers; that is, that any loss incurred "shall be treated as a

loss incurred in a trade or business". TRA sec. 1808(d).

Citing cases such as International Trading Co. v.

Commissioner, 484 F.2d 707 (7th Cir. 1973), revg. and remanding

57 T.C. 455 (1971), petitioner Leema argues that, as a

corporation, it need not demonstrate that it was in a trade or

business or otherwise engaged in an activity primarily for

profit. Our conclusion that the Merit trades lacked economic

substance vitiates any claim that petitioners might make under

either the per se rule or International Trading Co. "[E]conomic

substance is a prerequisite to the application of any Code

provisions allowing deductions". Lerman v. Commissioner, 939

F.2d 44, 52 (3d Cir. 1991), affg. Fox v. Commissioner, T.C. Memo.

1988-570.

bills that would yield ordinary losses and stock forwards which

promised ordinary losses with "cancellations". We believe that such

investors would not invest in new and untried ventures in marketing

options in Treasury obligations or stock forwards unless they would

benefit from prompt and sizable tax deductions. Their arguments

about economic possibilities are self-serving and unconvincing. The

tax returns reflect that they accomplished what they set out to do--

obtain first-year deductions from their spread positions and

postpone gains. Other objective facts, including the tax-flavored

aspect of the instruments involved, their almost immediate

disposition for tax losses, and the investors' substantial

indifference to profits all combine to show that petitioners'

primary objective was obtaining tax benefits. We, therefore,

conclude that because petitioners lacked a "primarily for profit"

motive, they failed to meet the statutory requirements for deducting

the losses at issue.26
- 69 -

Issue 3. Section 6653(a) Additions to Tax

We must additionally decide whether each petitioner is liable

for an addition to tax under section 6653(a) for each of the years

at issue. Section 6653(a) provides that if any part of any

underpayment is due to negligence or intentional disregard of rules

or regulations, there shall be added to the tax an amount equal to

5 percent of the underpayment. Negligence is a lack of due care or

the failure to do what a reasonable and ordinarily prudent person

would do under the circumstances. Krumhorn v. Commissioner, 103

T.C. at 56; Freytag v. Commissioner, 89 T.C. at 887.

In this case, Mr. Keeler, presumably an experienced trader,

repeatedly invested in untried types of transactions with a small,

new, and inexperienced company. He invested in a program whose

promoters invented and operated the markets involved and who created

the prices for the market's commodities by computer, rather than by

market principles. He has demonstrated no objective basis for

believing that the Merit programs possessed economic substance or

that he proceeded with a primarily for-profit motive. Mr. Keeler

nevertheless did not hesitate to claim enormous tax deductions and

deferrals. 

Mr. Keeler urges that he studied the PPM's and gave them to his

accountants and talked to Merit's principals. We are not persuaded

that these actions suffice to avoid the negligence penalty. 
- 70 -

Reliance upon disinterested expert advice may satisfy the prudent

person standard, but only when the taxpayer has shown that he

provided correct and complete information to an adviser who knows

something about the business in which the taxpayer has invested.

Freytag v. Commissioner, 904 F.2d at 1017; Collins v. Commissioner,

857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner,

T.C. Memo. 1987-217. Here Mr. Keeler has failed to make that

showing. 

Similarly, Dr. Richartz and his corporation, Leema, are both

chargeable with knowledge of how Merit operated--not as a valid

economic enterprise, but rather as one formed and used to obtain

immediately large tax deductions and deferrals of highly

questionable validity. Neither Dr. Richartz nor any of Merit's

principals exhibited any concern about the obvious lack of economic

substance or about the absence of any meaningful profit motive in

selling and operating the Merit markets. The additions to tax under

section 6653(a) are properly imposed upon Dr. Richartz and Leema.

Ms. Rivera is also subject to the section 6653(a) additions to

tax. We have taken into account her circumstances, which included

a limited familiarity with English and her illness during at least

some of the period in issue. She apparently placed her trust in Dr.

Richartz. Ms. Rivera, however, was also a part-owner of Merit and

a participant in its activities. Having appraised the evidence and

her testimony, we believe that she was aware of its activities and

of its tax-benefit orientation. She filed tax returns which claimed

large, but economically unsubstantial, tax savings. It was not
- 71 -

reasonable for her to do so. We hold that the imposition of section

6653(a) additions is warranted in the case of Ms. Rivera as well.

Issue 4. Section 6621(c) Additional Interest

Section 6621(c) (formerly section 6621(d)) provides for an

increase in the interest rate where there is a substantial

underpayment (i.e., one that exceeds $1,000) in any taxable year in

which the understatement is "attributable to 1 or more tax motivated

transactions". Tax-motivated transactions include "any straddle (as

defined in section 1092(c) without regard to subsections (d) and (e)

of section 1092)". Sec. 6621(c)(3)(A)(iii).

All of the positions in the Merit T-bill and T-bond options,

as well as the stock forwards, constitute "straddles" within the

meaning of section 6621(c)(3)(A)(iii). We recognize that section

1092(d) ordinarily operates to exempt section 1092(c) from

application to positions in corporate stock or to property that is

not "actively traded". Section 6621(c)(3)(A)(iii), however,

provides that section 1092(d) does not apply to limit the definition

of "straddle" for purposes of the additional interest penalty.

Accordingly, the additional interest imposed by section 6621(c) is

applicable to all petitioners herein.

Issue 5. Section 6661 Substantial Understatement of Tax

Respondent has also determined that petitioners Richartz and

Rivera are subject to the provisions of section 6661, because of

their trading in the Merit stock forwards. Section 6661(a) imposes

an addition to tax when there is a "substantial understatement of

income tax for any taxable year". Section 6661(b)(2)(A) defines
- 72 -

"understatement" as the excess of the amount of tax required to be

shown on the return over the amount of tax actually reported on the

return. The understatement is "substantial" when the amount of the

understatement exceeds the greater of 10 percent of the amount of

tax required to be shown on the return for the taxable year or

$5,000. Sec. 6661(b)(1)(A). There is an exception to this addition

to tax, however, if there is substantial authority for the position

taken on the taxpayer's return, or when there is adequate disclosure

on the return of the relevant facts affecting the treatment of the

item. Sec. 6661(b)(2)(B)(i) and (ii).

In this case, there was neither substantial authority for

petitioners' positions nor adequate disclosure. As set forth above,

we have determined that the trading in the Merit stock forwards

markets lacked economic substance and was not undertaken "primarily

for profit". Any substantial authority that exists with respect to

such trading establishes that petitioners' positions were erroneous;

the deduction of losses in transactions that lack the requisite

profit motive and economic substance is not permitted. United

States v. Generes, 405 U.S. 93, 103 (1972); Gregory v. Helvering,

293 U.S. at 469. Nor do petitioners' returns adequately disclose

the facts surrounding their claims of Merit stock forwards losses.

Identification of the controversy here resolved against petitioners

can only be made by examining the records of Merit's operation and

petitioners' trading pattern. That information did not appear on,

or with, petitioners' Federal income tax returns. Accordingly, the

additions to tax under section 6661(c) are properly imposed.
- 73 -

To reflect the fact that additional issues remain to be

resolved in docket Nos. 41343-85, 41987-85, 22921-86, and 25313-86,

and to reflect our agreement with petitioners' contention that if

the Merit program trades are deemed to lack economic substance so

as to deny claimed loss deductions, then the corresponding income

should be removed from taxable income, see supra note 25,

In docket Nos. 41343-85,

41987-85, 22921-86, and 25313-86,

an appropriate order will be 

issued.

In docket Nos. 39476-85,

4797-86, and 8648-93, decisions

will be entered under Rule 155.