Opinion ID: 531872
Heading Depth: 1
Heading Rank: 1

Heading: trade or business of trading in securities

Text: 7 The facts as stipulated and found by the tax court are not in dispute. 3 Yaeger graduated Phi Beta Kappa from Columbia University in 1921 having studied business and finance. Upon graduation he went to work as an accountant and subsequently became employed as an auditing agent for the Internal Revenue Service. He left this employ in 1923 and went to work as a bond salesman in New York City, eventually becoming an investment counselor. 8 Commencing in the mid-1920s, Yaeger began actively trading stocks and bonds on the stock market on his own account in addition to conducting his investment consulting business. In the 1940s, Yaeger gave up his investment consulting business because the management of his own account had grown so demanding. Thereafter, he devoted himself exclusively to trading on his own account, which was his sole occupation until the day he died. 9 Prior to 1979, Yaeger maintained accounts with several brokerage firms in New York, including H. Hentz & Co. His account at H. Hentz & Co. was the largest account that firm had maintained for a United States citizen. During the period between 1979 and his death, Yaeger maintained accounts with three brokerage firms and occasionally dealt with two others. 10 The following chart describes the trading activity in Yaeger's various accounts throughout the years in issue: 11 Year Purchase Sales Number Shares Bought Number Shares Transactions Transactions Sold 1979 1,176 86 1,453,555 822,955 1980 1,088 39 1,658,841 173,165 12 Yaeger maintained an office at H. Hentz & Co. from which he conducted most of his trading activity. For a brief period of time he also conducted his activity from another brokerage firm. H. Hentz & Co. provided Yaeger with an assistant, a telephone, use of the secretarial pool, and access to the research staff and facilities. Yaeger spent a full day at his office, researching investment opportunities and placing orders, and then returned home to read more financial reports late into the night. He worked every day of the week. When he was out of town, he maintained telephone contact with the brokers who handled his accounts. Yaeger was trading on the stock market the day before he died. 13 Yaeger subscribed to a distinct investment strategy. His trading strategy was to buy the stock of companies in which the stock prices were extremely undervalued and hold the stock until it reached a price that reflected the underlying value of the company. He rarely purchased blue chip stocks and many of the stocks he held did not pay dividends. Instead, Yaeger constantly looked for companies that were experiencing financial distress but whose underlying value was not recognized. 14 This strategy required thorough research that extended beyond the study of mainstream publications. He also poured over annual reports and brokerage house reports. Once Yaeger determined that the targeted company was experiencing temporary difficulties, he began to accumulate the stock. He would buy stock as it became available, although some of the stock was not frequently or actively traded and was difficult to acquire. He would initially buy small quantities of stock to avoid attracting attention from other investors. Once he obtained a sizeable amount of stock he would let his position be known. Yaeger took whatever steps he thought necessary to improve the position of the companies in which he invested, often supplying unsolicited business advice to the managers and occasionally attempting to arrange mergers or acquisitions. 4 15 In addition to selecting financially troubled companies in which to invest, Yaeger increased his gain on his investments by using margin debt. Yaeger financed his purchases by borrowing to the maximum extent allowable under law and the custom of the brokerage houses, which was generally 50 percent. If the value of his stock rose he would use that increased value as equity to support more debt. From time to time Yaeger shifted accounts from one brokerage house to another in order to maximize the volume of margin debt he could carry. Once or twice during his career Yaeger was overleveraged and suffered substantial losses when he was forced to sell enough stock to maintain his margin debt. 16 During the years 1979 and 1980, the ratio of Yaeger's margin debt to portfolio value was 47 percent and 42 percent, respectively. Yaeger's total stock market related debt equalled $42,154,048 in 1979 and $54,968,371 in 1980. When he died, his portfolio was subject to debt in the amount of $70,490,018. 17 In 1979 and 1980 Yaeger reported income in the following amounts on his federal tax return: 18 1979 Character of Income Amount Long-term capital gain $13,839,658 Short-term capital gain 184,354 Dividends 2,339,080 Interest 57,958 ----------- $16,421,050 19 1980 Character of Income Amount Long-term capital gain $1,099,921 Short-term capital gain 728,404 Dividends 3,648,441 Interest 91,717 Director's fees 10,600 ----------- $5,579,083 20 Of the stock which Yaeger sold in taxable years 1979 and 1980, the percentage of total sales of securities which he had held for twelve months or more was 88 percent and 91 percent, respectively. The purchase dates of the securities sold in 1980 ranged from March 1970 to December 1979. In 1979, Yaeger did not sell any security that had been held for less than three months and, in 1980, did not sell any security that had been held for less than six months. On schedule C of the tax returns, Yaeger deducted interest expense in 1979 and 1980 in the amounts of $5,865,833 and $7,995,010, respectively. 21 The sole issue considered by the tax court was whether the claimed deductions of the interest expenses Yaeger incurred in purchasing securities on margin were subject to the limitation on the deductibility of investment interest set forth in section 163(d). 5 This issue turned on whether Yaeger's stock market activities constituted investment activity or the activity of trading in securities as a trade or business. According to the tax court, the pivotal inquiry was whether Yaeger was interested in deriving income from capital appreciation or from short-term trading. The court determined that Yaeger was an investor, not a trader, because Yaeger held his stocks and bonds for lengthy periods of time anticipating that they would appreciate in value. Thus, the interest expense he incurred was investment interest within the meaning of section 163(d) and subject to the deductibility restrictions of that section.
22 Section 163 of the Internal Revenue Code generally provides for the deduction of interest incurred on indebtedness. As defined in section 163(d)(3)(D), investment interest is interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment. Section 163(d) limits the deductibility of investment interest by a noncorporate taxpayer to the extent of the taxpayer's investment income, plus $10,000. Any amount disallowed is treated as investment interest paid or accrued in the succeeding taxable year. 26 U.S.C. Sec. 163(d)(2). Section 163(d) does not apply to interest paid to buy property for personal use or property for trade or business use. See H.R.Rep. 413, pt. 1, 91st Cong., 1st Sess. 72, reprinted in 1969 U.S.Code Cong. & Admin.News 1645, 1719 (interest on funds borrowed in connection with a trade or business would not be affected by the limitation). 23 The Internal Revenue Code does not define trade or business. Determining whether a taxpayer's trading activities rise to the level of carrying on a trade or business turns on the facts and circumstances of each case. Higgins v. Commissioner, 312 U.S. 212, 217, 61 S.Ct. 475, 477-478, 85 L.Ed. 783 (1941). In determining whether taxpayers who manage their own investments are traders, relevant considerations are the taxpayer's investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the taxpayer's securities transactions. Moller v. Commissioner, 721 F.2d 810, 813 (Fed.Cir.1983), cert. denied, 467 U.S. 1251, 104 S.Ct. 3534, 82 L.Ed.2d 839 (1984). 24 Investors are engaged in the production of income. Purvis v. Commissioner, 530 F.2d 1332, 1334 (9th Cir.1976). Traders are those whose profits are derived from the 'direct management of purchasing and selling.'  Moller, supra, at 813 (quoting Levin v. United States, 597 F.2d 760, 765, 220 Ct.Cl. 197 (1979)). Investors derive profit from the interest, dividends, and capital appreciation of securities. See Moller, supra, at 813; Purvis, supra, at 1334; Liang v. Commissioner, 23 T.C. 1040, 1043 (1955). They are primarily interested in the long-term growth potential of their stocks. Id. Traders, however, buy and sell securities with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short term basis. Purvis, supra, at 1334 (quoting Liang v. Commissioner, 23 T.C. 1040, 1043 (1955)). 25 Thus, the two fundamental criteria that distinguish traders from investors is the length of the holding period and the source of the profit. These criteria coincide with the congressional purpose behind the enactment of section 163(d), which originated in the Tax Reform Act of 1969, Pub.L. No. 91-172, Sec. 221, 83 Stat. 487. Congress was concerned with the prevalent use of borrowed money to purchase investment assets and the distortion of taxable income that often results when the investments produce long-term capital gain rather than ordinary income. 6 As explained in the House Report accompanying the 1969 Act: 26 The itemized deduction presently allowed individuals for interest makes it possible for taxpayers to voluntarily incur substantial interest expense on funds borrowed to acquire or carry investment assets. Where the interest expense exceeds the taxpayer's investment income, it, in effect, is used to insulate other income from taxation. For example, a taxpayer may borrow substantial amounts to purchase stocks which have growth potential but which return small dividends currently. Despite the fact that receipt of the income from the investment may be postponed (and may be capital gains), the taxpayer will receive a current deduction for the interest expense even though it is substantially in excess of the income from the investment. 27 H.R.Rep. 413, supra, at 73, 1969 U.S.Code Cong. & Admin.News 1718. 28 The activity of holding securities for a length of time to produce interest, dividends, and capital gains fits the abuse targeted by section 163(d): investing for postponed income and current interest deduction. 29 The tax court properly concluded that Yaeger was an investor. It is true that Yaeger initiated over 2000 securities transactions in 1979 and 1980 and pursued his security activities vigorously and extensively. And there is no doubt, as the tax court stated, that Yaeger maintained a margin of debt which would have caused a more faint-hearted investor to quail. However, [n]o matter how large the estate or how continuous or extended the work required may be, the management of securities investments is not the trade or business of a trader. Higgins, supra, 312 U.S. at 218, 61 S.Ct. at 478. 7 30 More importantly, most of his sales were of securities held for over a year. He did not sell any security held for less than three months. He realized a profit on the securities through both dividends and interest. Most of his profit, however, came from holding under valued stock until its market improved. This emphasis on capital growth and profit from resale indicates an investment motivated activity. See Miller v. Commissioner, 70 T.C. 448, 457 (1978). In addition, since the income came from long-term appreciation, Yaeger would receive the benefit of favorable capital gains treatment. To disregard the nature of the income and length of his holdings simply because Yaeger was a vigorous investor would defeat the purpose of section 163(d). 8