Source: https://law.justia.com/cases/federal/appellate-courts/F2/870/21/312089/
Timestamp: 2019-08-23 00:58:28
Document Index: 305526872

Matched Legal Cases: ['§ 165', '§ 1234', '§ 1091', '§ 1222', '§ 1233', '§ 1407']

David Dewees and Anne Dewees, Petitioners, Appellants, v. Commissioner of Internal Revenue, Respondent, Appellee, 870 F.2d 21 (1st Cir. 1989) :: Justia
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David Dewees and Anne Dewees, Petitioners, Appellants, v. Commissioner of Internal Revenue, Respondent, Appellee, 870 F.2d 21 (1st Cir. 1989)
US Court of Appeals for the First Circuit - 870 F.2d 21 (1st Cir. 1989)
Heard Oct. 4, 1988. Decided March 15, 1989
Taxpayers David and Anne Dewees appeal from a Tax Court decision that a 1978 loss they incurred while engaged in "straddle" trading on the London Metals Exchange was not an "ordinary loss" deductible from their income. See Internal Revenue Code, 26 U.S.C. § 165(c) (2) (1982); Deficit Reduction Act of 1984, Pub. L. No. 98-369, Sec. 108, 98 Stat. 494, 630-631 (1984) (a provision enacted specifically to govern deductions of losses from straddle transactions). The Tax Court held that their loss was not deductible because the transactions were shams, without economic substance, see Gregory v. Helvering, 293 U.S. 465, 469-70, 55 S. Ct. 266, 267-68, 79 L. Ed. 596 (1935), or, alternatively, because the transactions were not "entered into for profit" within the meaning of Sec. 108. Consequently, the Deweeses cannot deduct the loss from their ordinary income, though they can use it in calculating the net losses or gains they incurred from the whole series of transactions, under Sec. 108(c). Glass v. Commissioner, 87 T.C. 1087 (1986).
Fourth, the Internal Revenue Service, in 1974, issued a ruling that the closing out of either a put or call option that one has bought produces a capital gain or loss, but the closing out of an option that one has granted produces an ordinary gain or loss. Private Letter Ruling 7404080200A (April 8, 1974) (the "Zinn Ruling," issued to the Chicago Board Options Exchange). This treatment made legal sense in light of the wording of the relevant statutory provisions, see 26 U.S.C. § 1234, but it produced an economic asymmetry that made it possible to create ordinary losses for tax purposes and offset them with capital gains. See Glass, 87 T.C. at 1153-55.
Fifth, the Internal Revenue Code treats offsetting sales and purchases that take place within a single month as "wash sales," and disregards them. 26 U.S.C. § 1091(a). However, the transactions in this case involve lots of silver for sale in different months, so they are not "wash sales," even if they seem to cancel each other out.
On the basis of the Tax Court's descriptions, the parties' briefs, and oral argument, we believe we can view the essence of the trading strategy used by the Deweeses as a series of transactions having three parts, an options straddle, a futures straddle, and a futures switch. A taxpayer buys and sells both "put" and "call" options on future silver (the "options straddle"). He waits a few weeks for prices to change, and then liquidates his positions, creating ordinary losses and short-term capital gains. The taxpayer uses the ordinary losses to offset ordinary income from other sources. He then buys and sells silver for delivery several months later (the "futures straddle"). He waits a month or so for prices to change. He then liquidates whichever is the loss leg of the futures straddle, to create a short-term capital loss to offset his short-term capital gain. Finally, the taxpayer "locks in" his gain leg, by making an offsetting futures purchase or sale (the "futures switch"). The next year he liquidates all his futures positions, realizing a capital gain. This gain may be a long-term capital gain, see 26 U.S.C. § 1222(3), which was taxed at a low rate, or a short-term capital gain. If it was the latter, the taxpayer can use another futures straddle to "roll over" the gain into the next year, again deferring tax liability, and hoping to convert it into a long-term capital gain.
Assume that it is January 1 (Year One). Silver prices are as follows: Jan. Feb. Mar. Apr. May June July Aug. 250 255 260 265 270 275 280 285
Jan. Feb. Mar. Apr. May June July Aug. old 250 255 260 265 270 275 280 285 new 310 315 320 325 330 335
Jan. Feb. Mar. Apr. May June July Aug. old 250 255 260 265 270 275 280 285 new 210 215 220 225 230 235
Oct. Nov. Dec. Jan. Feb. Mar. Apr. May 250 255 260 265 270 275 280 285
Oct. Nov. Dec. Jan. Feb. Mar. Apr. May June old 250 255 260 265 270 275 280 285 290 new 285 290 295 300 305 310 315 320
Oct. Nov. Dec. Jan. Feb. Mar. Apr. May June old 250 255 260 265 270 275 280 285 290 new 225 230 235 240 245 250 255 260
Jane sells all her futures contracts, after holding the contracts to buy for 6 months. That is, in case "1" she waits until April, when she will have held her contracts to buy 5 lots of April silver from October to April; in case "2" she waits until May, when she will have held her contract to buy June silver from November to May. The reason for waiting 6 months is that a capital gain qualifies as "long-term," and is taxed at a lower rate, if it results from the sale of an asset held for 6 months or longer (that was true in all the tax years in question). However, Jane still cannot be certain that her gain will count as long-term, because silver prices may have changed such that her profit, when she closes out all her contracts, comes instead from the sale of her contracts to sell, which under IRS rules is classified as a short-term capital gain no matter how long the contracts are held. 26 U.S.C. § 1233; see Miller v. Commissioner of Internal Revenue, 836 F.2d 1274, 1277 n. 2 (10th Cir. 1988) (long-term capital gain, under the Code, can result only from the sale of contracts to buy, not contracts to sell).
A second relevant tax doctrine, the "sham in substance" doctrine, originated in Gregory v. Helvering, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935). In that case, the Supreme Court held that the taxpayer's corporate reorganization could be disregarded for tax purposes, even though it technically complied with tax code provisions, for it was not "the thing which the statute intended." Id., 293 U.S. at 469, 55 S. Ct. at 267. The Court examined only the transaction on its face, not the motives of the taxpayer. It concluded that the reorganization was
Id. The Court held that the statute governing taxation of stock distributed on reorganization need not be applied; the sham transaction should be entirely disregarded for tax purpose because it "lies outside the plain intent of the statute." Id., 293 U.S. at 470, 55 S. Ct. at 268.
Later decisions applied this doctrine to cases in which the transactions, though they actually occurred and technically complied with the tax code, were mere devices to avoid tax liability. See, e.g., Knetsch v. United States, 364 U.S. 361, 366, 81 S. Ct. 132, 135, 5 L. Ed. 2d 128 (1960) (interest payments not deductible because "there was nothing of substance to be realized ... from this transaction beyond a tax deduction"); DeMartino v. Commissioner of Internal Revenue, 862 F.2d 400, 406 (2d Cir. 1988) (losses in oil futures straddle trading disallowed because they were "prearranged, contrived transactions conducted in a market rigged to produce tax losses"); Neely v. United States, 775 F.2d 1092, 1094 (9th Cir. 1985) (a trust was not recognized for tax purposes because it had "no economic effect other than to create income tax losses").
In our view, however, the Tax Court could lawfully find the contrary. It could find that any prospect of profit was so remote as both to make the transactions shams, and to warrant the conclusion that they were "not entered into for profit." For one thing, the Tax Court was obligated to give some deference to the Commissioner's view of the application of the sham in substance doctrine, and the "for profit" language, to the facts of this case. See Bob Jones University v. United States, 461 U.S. 574, 596, 103 S. Ct. 2017, 2031, 76 L. Ed. 2d 157 (1983) (Supreme Court has "long recognized the primary authority of the IRS ... in construing the Internal Revenue Code"); Jewett v. Commissioner, 455 U.S. 305, 318, 102 S. Ct. 1082, 1090, 71 L. Ed. 2d 170 (1982) (Commissioner's interpretation of tax code is "entitled to respect"); Connor v. Commissioner of Internal Revenue, 847 F.2d 985, 989 (1st Cir. 1988). Moreover, the case law and the record in this case provide ample support for the Tax Court's application of the sham in substance doctrine, as well as for the alternative ruling that the losses would not be deductible under Sec. 108, for the following reasons, taken together.
We can imagine investors (or commodities dealers) engaging in a strategy of real contango speculation through straddle trading, and we can also imagine the IRS picking out a subset of these real trades which, by chance, happened to resemble Jane's transactions described at pp. 24-28, supra. And, we agree that taxpayers may lawfully structure transactions that seek real gains in a way that also maximizes tax advantages. See Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (L. Hand, J.), aff'd, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935) (a taxpayer lawfully "may so arrange his affairs that his taxes shall be as low as possible"). But this is not such a case. We cannot imagine that the case before us could be an instance of real contango speculation that, by chance, worked out adversely to the investors to the extent of losing their margin deposit. We cannot imagine this because none of the 1,100 London options investors' trading records shows any evidence of the real risks, profits, and losses that genuine contango speculation would create. And the odds against the trades of 1,100 genuine speculators, seeking real profits, just happening to fit the pattern of Jane's trading, and just happening to lose exactly the amount of their margin deposits, must be phenomenal. It might not be reasonable to think a coin was unbalanced because it lands "heads" once, but that conclusion becomes far more reasonable when "heads" turns up 1,100 times in a row.
These features of the case are sufficient, in our view, to permit the Tax Court to find these transactions to be "shams," and also to defeat the Deweeses' "reasonable prospect of profit" argument. Every circuit court that has considered the London options cases agrees. In Yosha v. Commissioner of Internal Revenue, 861 F.2d 494 (7th Cir. 1988), the Seventh Circuit reviewed a London options case companion to this one. The court concluded that the transactions were not entered into for profit, because, among other things,
Id. at 500-501. See also Killingsworth v. Commissioner of Internal Revenue, 864 F.2d 1214, 1218 (5th Cir., 1989) ("viewed objectively," the London options transactions "appear to be devoid of profit making potential"); Ratliff v. Commissioner of Internal Revenue, 865 F.2d 97, 98 (6th Cir. 1989) (accord with Yosha; investors had no profits or losses beyond initial margin deposits, and all received ordinary losses in year one and capital gains in year two with "minimal" risk); Kirchman v. Commissioner of Internal Revenue, 862 F.2d 1486, 1493 (11th Cir. 1989) (all taxpayers closed out their option straddles in the first year and incurred ordinary losses, regardless of effect on overall profitability; no taxpayer incurred a net gain or loss at the end of the trading; promotional materials stressed tax benefits; despite "incidental and minimal risks of actual gains and losses," the "sole function of these transactions was to obtain [tax] deductions").
The same words, "transaction entered into for profit" appear in the tax code's basic loss provision, Sec. 165. And there, they have a well-established meaning. They mean that the taxpayers, in entering into the transaction, must have been primarily motivated by the desire to make a profit. This "profit motive" test originated in Helvering v. National Grocery Co., 304 U.S. 282, 289 n. 5, 58 S. Ct. 932, 936 n. 5, 82 L. Ed. 1346 (1938), where the Supreme Court said that "the deductibility of losses under Sec. 23(e)" (the predecessor of Sec. 165(c)) "may depend on whether the taxpayer's motive in entering into the transaction was primarily profit." Since then, the courts have consistently applied this test in construing Sec. 165(c). See, e.g., United States v. Generes, 405 U.S. 93, 105, 92 S. Ct. 827, 834, 31 L. Ed. 2d 62 (1972) (Sec. 165 requires dominant profit motive); King v. United States, 545 F.2d 700, 708 (10th Cir. 1976) (under Sec. 165(c) taxpayer must show profit was primary motivation); Knetsch v. United States, 348 F.2d 932, 936, 172 Ct. Cl. 378 (1965) (primarily for profit test); United States v. Keeler, 308 F.2d 424, 434 (9th Cir. 1962) (provision for deduction of losses has always been construed "in terms of the taxpayer's state of mind"); Austin v. Commissioner of Internal Revenue, 298 F.2d 583, 584 (2d Cir. 1962) (in determining deductibility of loss, primary motive must be ascertained); Ewing v. Commissioner of Internal Revenue, 213 F.2d 438, 439 (2d Cir. 1954) (primary profit motive test). See also Fox v. Commissioner, 82 T.C. 1001 (1984) (applying "primarily for profit" test to straddle transactions, under Sec. 165(c)).
It is difficult, indeed impossible, to think Congress meant something different when it used the words "transaction entered into for profit" in Sec. 108. For one thing, Congress, in enacting Sec. 108, not only used language identical to that in Sec. 165(c), but it apparently did so in order to make clear that taxpayers could take Sec. 165(c)-type deductions in the year that the loss first took place. Miller, 836 F.2d at 1283. When Congress uses a term of art that has an established meaning, a heavy presumption arises that it intends to incorporate that meaning. Morissette v. United States, 342 U.S. 246, 263, 72 S. Ct. 240, 249, 96 L. Ed. 288 (1952); see also Miller, 836 F.2d at 1283 (a statute using language that has received "a long and consistent judicial interpretation in similar contexts is not a likely candidate for ambiguity").
Tax Reform Act of 1986, Pub. L. No. 99-514 Sec. 1808, 100 Stat. 2085, 2817 (1986); cf. Sec. 165(c) (1 & 2). Congress apparently enacted this language in part to make clear that it had intended the two provisions to receive similar interpretations. Landreth v. Commissioner of Internal Revenue, 845 F.2d 828, 832-33 (9th Cir. 1988) (vacated on rehearing, on other grounds); see H.R.Rep. No. 99-426, 99th Cong., 1st Sess. at 911 (Dec. 17, 1985) ("Section 108 also restated the general rule that losses from the disposition of a position in a straddle are only allowable if such position was part of a transaction entered into for profit. A majority of the United States Tax Court in Miller interpreted section 108 as providing a new, less stringent profit standard.... It was not the intent of Congress in enacting section 108 to change the profit-motive standard of section 165(c) (2) or to enact a new profit motive standard for commodity straddle activities. This technical correction is necessary to end any additional uncertainty created by the Miller case").
Finally, the two circuits that have considered the question now agree that the "primary profit motive" test applies to Sec. 108 as well as Sec. 165. The Ninth Circuit, which had previously interpreted Sec. 108 as the Deweeses advocate here, now agrees with the Tenth Circuit's holding in Miller, reversing the Tax Court, that the language means the same in both statutes. Landreth v. Commissioner of Internal Revenue, 859 F.2d 643, 648 (9th Cir. 1988) (on rehearing); Miller, 836 F.2d at 1281 (conference report not conclusive as to meaning of Sec. 108, because it is internally inconsistent and conflicts with other expressions of legislative intent).
Although we think that Sec. 108 may well govern the transactions (for the reasons stated at p. 34, supra), that Sec. 108 does incorporate the "primarily for profit" test (for the reasons stated at pp. 33-34, supra), and that the Deweeses did not have a fair opportunity to present profit motive testimony, we nonetheless reject their conclusion. That is to say, we believe the law does not require the Tax Court to give the Deweeses a hearing on their subjective motives. And, we have found three different lines of legal reasoning--three different legal lenses through which one might view this question--that support this result.
First, there is authority indicating that the Tax Court need not always take subjective testimony on motives underlying a loss transaction, even where the question is governed by the "primarily for profit" test. Where the objective features of the situation are sufficiently clear, that court has the legal power to say that self-serving statements from taxpayers could make no legal difference, and that it would find the transaction was not "primarily for profit," regardless of any such statements. See, e.g., Keats v. United States, 865 F.2d 86, 88 (6th Cir. 1988) (taxpayer "has produced affidavits which state that he possessed a profit motive for entering into the transactions," but "those affidavits do not explain the curious symmetry of the premiums paid and received" by the taxpayer); Yosha, 861 F.2d at 502 (although issues are often framed in terms of taxpayer's state of mind, analysis should focus on objective inquiry as to "whether any non-tax goals or functions were or plausibly could have been served" by the transactions); Keane v. Commissioner of Internal Revenue, 865 F.2d 1088, 1092 (9th Cir. 1989) (losses were not deductible under Sec. 108 because the transactions, considered objectively, "were designed and executed so as to have no economic effect other than the generation of tax benefits").
And, the Tax Court, in related cases, has indicated that the objective features of transactions like those here at issue are sufficient to overcome a taxpayer's own account of his profit-seeking state of mind. See Miller v. Commissioner, 84 T.C. 827, 836-37 (1985), rev'd on other grounds, 836 F.2d 1274 (10th Cir. 1988) (transactions were primarily tax motivated, due to "pattern of switches" that realized tax losses while decreasing the possibility of obtaining a profit, despite taxpayers' self-serving testimony); Smith v. Commissioner, 78 T.C. 350 (1982) (petitioners' uncorroborated profit-motive testimony was "of no probative value"); Siegel v. Commissioner, 78 T.C. 659, 699 (1982) (greater weight is to be accorded objective facts than self-serving statements as to intent); Bessenyey v. Commissioner, 45 T.C. 261, 273-74 (1965), aff'd, 379 F.2d 252 (2d Cir. 1967) (record of continued losses or unlikelihood of profit may be an important factor bearing on taxpayer's true intention); see also Fleischer v. Commissioner, 403 F.2d 403, 406 (2d Cir. 1968) (in ascertaining taxpayers' intent, court is not bound by their assertions of proper motive, even if uncontradicted).
Second, the Tax Court explicitly, and lawfully (see pp. 30-33, supra), found that the Deweeses' transactions were "shams in substance." Case law makes clear that a taxpayer cannot deduct a "sham transaction" loss, irrespective of his subjective profit motive. See Knetsch, 364 U.S. at 365, 81 S. Ct. at 134 (court "put aside" district court's finding concerning motive, in determining whether transaction was sham); Gregory, 293 U.S. at 469, 55 S. Ct. at 267 (under sham in substance analysis, court must look at "what was done," apart from the taxpayer's "motive"); Kirchman, 862 F.2d at 1490 ("whether a transaction is a substantive sham ... does not necessarily require an analysis of a taxpayer's subjective intent;" "transactions whose sole function is to produce tax deductions are substantive shams, regardless of the motive of the taxpayer").
And, one need not view the "sham in substance" doctrine as always taking a transaction entirely outside its statutory framework. One could view it more simply and more generally as an interpretive tool that helps courts read tax statutes in a way that makes their technical language conform more precisely with Congressional intent. Thus, one could view this type of "sham" transaction as a special subset of transactions not "entered into for profit" within the meaning of Sec. 108. The conceptual virtues of doing so are: (1) permitting Sec. 108(c) to govern the treatment of other portions of the transaction; and (2) conforming to Congress' apparent object in writing Sec. 108, namely, to create a provision that would govern cases such as the one before us. Doing so interferes with no Congressional objective; it is not reasonable, given the history and language of Sec. 108, to believe that Congress, in enacting that provision, wished to weaken the "sham in substance" doctrine by mandating the consideration of subjective factors. That is to say, we need not accept the dilemma: 'Either (1) the "sham in substance" doctrine applies, or (2) Sec. 108 applies and "subjective motive" is relevant.' Rather, we see no conceptual difficulty in saying that both the "sham in substance" doctrine and Sec. 108 apply, the former doctrine defining a special subset of transactions that are not "entered into for profit" under the latter statute. Under this view, "sham" transactions would lie inside, not outside, the "plain intent of the statute." Gregory, 293 U.S. at 470, 55 S. Ct. at 268. We need not authoritatively underwrite this point of view, for there is still a third approach.
Considering the likelihood that this scenario might be repeated, action by the Congress or the Judiciary are both imperative. Fortunately, there is a model of Congressional-Judicial collaboration in the establishment and operation of the multi-district panel. 28 U.S.C. § 1407.
Dewees v. Commissioner, 870 F.2d 21 (1st Cir. 1989)
Killingsworth v. Commissioner, 864 F.2d 1214 (5th Cir. 1989).
Keats v. U.S., 865 F.2d 86 (6th Cir. 1988).
Ratliff v. Commissioner, 865 F.2d 97 (6th Cir. 1989).
Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988).
Keane v. Commissioner, 865 F.2d 1088 (9th Cir. 1989).
Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989).
See the one and only ever conference of all United States Circuit Judges held in Washington, D.C. (Oct. 23-26, 1988). See also Federal Courts Study Act, Pub. L. No. 100-702, Sec. 102-09, 102 Stat. 4644, 4644-46 (1988) (establishing the Federal Courts Study Committee)