Opinion ID: 515178
Heading Depth: 2
Heading Rank: 1

Heading: The Sham Losses

Text: 17 The primary issue in this appeal turns on section 165, the general loss provision of the Internal Revenue Code, and section 108(a) 5 of the Tax Reform Act of 1984, which governs the deductibility of losses from commodity straddles claimed for tax years prior to 1982. The basic rule of law is that taxation is based upon substance, not form. Gregory v. Helvering, 293 U.S. at 469-70, 55 S.Ct. at 267-68; Knetsch v. United States, 364 U.S. 361, 366, 81 S.Ct. 132, 135, 5 L.Ed.2d 128 (1960); Gilbert v. Commissioner, 262 F.2d 512, 513 (2d Cir.), cert. denied, 359 U.S. 1002, 79 S.Ct. 1139, 3 L.Ed.2d 1030 (1959); Treas. Reg. Sec. 1.165-1(b) (as amended in 1977) (Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss.); see also 7 J. Mertens, supra, Sec. 28.26. Losses resulting from sham transactions, therefore, are not deductible under section 165 of the Code. Forseth v. Commissioner, 845 F.2d 746, 748 (7th Cir.1988); see also Higgins v. Smith, 308 U.S. 473, 476-78, 60 S.Ct. 355, 357-58, 84 L.Ed. 406 (1940) (discussing section that was predecessor to section 165). A transaction is a sham if it is fictitious or if it has no business purpose or economic effect other than the creation of tax deductions. Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir.) (sham losses from investments in straddles in forward contracts to buy and sell Ginnie Maes and Freddie Macs), cert. denied, --- U.S. ----, 109 S.Ct. 72, 102 L.Ed.2d 49 (1988); Goldstein v. Commissioner, 364 F.2d 734, 741-42 (2d Cir.1966) (interest deduction disallowed where transaction had no substance or purpose aside from taxpayer's desire to obtain tax benefit of interest deduction), cert. denied, 385 U.S. 1005, 87 S.Ct. 708, 17 L.Ed.2d 543 (1967); Barnett v. Commissioner, 364 F.2d 742 (2d Cir.1966) (per curiam) (interest deduction disallowed where transaction was sham), cert. denied, 385 U.S. 1005, 87 S.Ct. 708, 17 L.Ed.2d 543 (1967). 18 The taxpayer argues first that the transactions were not sham. The Commissioner's findings were presumptively correct and the burden was on the taxpayer to demonstrate that the purported trades were bona fide. See Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933); Schaffer v. Commissioner, 779 F.2d 849, 857 (2d Cir.1985). The Tax Court found that the taxpayer had failed to meet this burden and that the commodity straddles were prearranged, contrived transactions conducted in a market rigged to produce tax losses. We cannot reverse these findings unless they were clearly erroneous. Sochin, 843 F.2d at 355; Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1548 (9th Cir.1987). Here, the Tax Court's conclusions were supported by the evidence, because the NYCE crude oil market was clearly rigged. See Turkish, supra; Lasker v. Bear, Stearns & Co., 757 F.2d 15, 17 (2d Cir.1985); Sundheimer v. Commodity Futures Trading Commission, 688 F.2d 150, 151 (2d Cir.1982), cert. denied, 460 U.S. 1022, 103 S.Ct. 1273, 75 L.Ed.2d 494 (1983). There simply is no need to recount further the ample evidence that indicated that there was no economic substance to the crude oil straddles. 19 The taxpayer's more persuasive argument is based on section 108 of the 1984 Tax Reform Act, supra note 5. In 1984, section 108 created a rebuttable presumption that the pre-1982 straddle trading losses of commodities dealers and those who regularly invested in commodity contracts were incurred in transactions engaged in for profit and thus were deductible. The taxpayer argues, however, that the Service saw the rebuttable presumption as an invitation to rebut and litigation continued. In section 1808(d) of the Tax Reform Act of 1986, Congress amended section 108 to provide that any loss incurred by a commodities dealer in the trading of commodities shall be treated as a loss incurred in a trade or business and as such an allowable deduction. Congress removed from section 108 the provision that a straddle loss should be allowed if such position is part of a transaction entered into for profit and inserted instead the words 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. 20 The words of the statute are so unambiguous, according to the taxpayer, that it is inappropriate to resort to the legislative history to interpret the statute. See Miller v. Commissioner, 836 F.2d 1274, 1282 (10th Cir.1988). Because CI was a commodities dealer within the meaning of the statute, was actively engaged in trading regulated futures contracts, and had registered with several commodities exchanges, the taxpayer argues, his share of the CI trading losses must be deemed incurred in a trade or business. Moreover, these trades did take place, because purchases and sales were cleared with the clearing corporation, and CI lost real money. Finally, the taxpayer suggests, even the legislative history provides some support for his interpretation: the House and Conference Committee reports on section 1808(d) confirm that the bill grants relief to any position disposed of by [a dealer]. H.R.Rep. No. 99-426, 99th Cong., 1st Sess. 911 (1985), reprinted in 1986-3 C.B. (Vol. 2) [hereinafter H.R.Rep. No. 99-426]; H.R.Conf.Rep. No. 99-841, 99th Cong., 2d Sess. 845 (1986), reprinted in 1986-3 C.B. (Vol. 4) and in 1986 U.S.Code Cong. & Admin.News pp. 4075, 4933 [hereinafter H.R.Conf.Rep. No. 99-841]. 21 On the other hand, the same House Report stated that the per se deductibility of section 1808(d) would not apply where the trades were fictitious, prearranged, or otherwise in violation of the rules of the exchange. H.R.Rep. No. 99-426 at 911. The amendment was intended to overrule the sharply divided Tax Court's decision in Miller v. Commissioner, 84 T.C. 827 (1985) rev'd, 836 F.2d 1274 (10th Cir.1988). H.R.Rep. No. 99-426 at 911. In Miller, the Tax Court held that a taxpayer had satisfied the original section 108(a) profit motive test by demonstrating that he had a prospect of deriving any profit from the transaction. The 1986 amendment harmonized the language of section 108(a) with the language of section 165 of the Code to respond to the Tax Court's decision in Miller: Congress eliminated the profit motive inquiry in cases involving dealers because of the inherent difficulty involved in making such an inquiry, but it did not prevent inquiry into the economic substance of a dealer's commodity trading. 22 We agree with the Commissioner that it is appropriate to apply here the basic rule of statutory interpretation that a statute should not be interpreted to produce an absurd or unreasonable result. Haggar Co. v. Helvering, 308 U.S. 389, 394, 60 S.Ct. 337, 339-40, 84 L.Ed. 340 (1940). Moreover, the taxpayer's argument ignores the opening clause of section 108(b), [f]or purposes of subsection (a), which makes the presumption of section 108(b) applicable only when section 108(a) applies to the transaction. Section 108(a) does not apply to straddle transactions that are shams. Sochin, 843 F.2d at 353 n. 6; Enrici v. Commissioner, 813 F.2d 293, 295 n. 1 (9th Cir.1987); Mahoney v. Commissioner, 808 F.2d 1219, 1219-20 (6th Cir.1987); see also Forseth, 845 F.2d at 748. Thus, since section 108(a) has no application here, neither has section 108(b). 23 B. The Taxpayer's Liability for 5% Addition to Tax Upon Underpayment Due to Negligence or Intentional Disregard of Rules and Regulations 24 Under section 6653(a) of the Internal Revenue Code, supra note 4, a taxpayer's negligence or intentional disregard of rules and regulations exposes him to a penalty of 5% of the underpayment. See Neely v. United States, 775 F.2d 1092, 1095 (9th Cir.1985); Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir.1967), cert. denied, 389 U.S. 1044, 88 S.Ct. 787, 19 L.Ed.2d 835 (1968). The Tax Court's finding that the taxpayer was at least negligent is thoroughly supported in the record: there was testimony by the broker, Hamilton, that he met with the taxpayer, the taxpayer's partner, and Turkish, and that they discussed the use of crude oil futures straddles to produce artificial tax losses. Turkish's assistant, Alfred Perlmutter, also testified that he had conversations to this effect with the taxpayer's partner and Turkish. Finally, the trading records showed such a lack of movement in the straddle differentials that the taxpayer, a long-time professional commodity trader, must have known what was going on. 25 C. The Retroactive Application of Section 6621 of the Internal Revenue Code, as Amended 26 For certain types of underpayments listed in section 6621, supra note 2, interest is calculated at 120% of the usual rate of interest. This occurs when a substantial underpayment of tax is attributable to tax motivated transactions. The statute has always listed straddles as tax motivated transactions, but, as previously noted, Judge Korner originally held that section 6621 was inapplicable to DeMartino. He held that DeMartino's straddles didn't meet the technical definition of straddle because they were sham. The Tax Reform Act of 1986 added shams to the list of tax motivated transactions, 6 and Congress indisputably intended to make the amendment retroactive. The Conference Committee Report named Judge Korner's first opinion in this case and Forseth v. Commissioner, 50 T.C.M. (CCH) 111 (1985), in which the Tax Court had also held that section 6621 did not apply to sham transactions, and the Report stated that the intent of the conferees [was] to reverse the holding of these Tax Court cases on this issue. H.R.Conf.Rep. No. 99-841 at 796, 1986 U.S.Code Cong. & Admin.News p. 4884. The Tax Court applied the amendment on motion of the Commissioner. 27 Its application, the taxpayer argues, gives effect to an unconstitutional congressional assumption of judicial power and unconstitutionally imposes a retroactive penalty. First, relying on Marbury v. Madison, 5 U.S. (1 Cranch) 137, 178, 2 L.Ed. 60 (1803), and United States v. Klein, 80 U.S. (13 Wall.) 128, 20 L.Ed. 519 (1872), as well as a passage in United States v. Sioux Nation of Indians, 448 U.S. 371, 398, 100 S.Ct. 2716, 2732, 65 L.Ed.2d 844 (1980) (quoting Nock v. United States, 2 Ct.Cl. 451, 457-58 (1867)), which said that the Constitution has invested Congress with no judicial powers, the taxpayer argues that Congress here invaded the judicial power. 28 We approve the Tax Court's application of the penalty. One can certainly agree with the conferees that the Tax Court's holdings in Forseth and the original DeMartino were anomalous in that a genuine transaction (lacking the proper profit motive) would be subject to a higher interest rate, while a sham transaction, which is significantly more abusive, would escape the higher interest rate simply because it is a sham. See H.R.Conf.Rep. No. 99-841 at 796, 1986 U.S.Code Cong. & Admin.News p. 4884. Beyond this, Congress added sham or fraudulent transactions to the list of transactions subject to the higher interest rate regardless of the taxpayer's identity. Congress did not simply aim its arrow of increased interest penalty at the individual taxpayers in Forseth and DeMartino, and it indicated that the clarification did not apply to any underpayment with respect to which there was a final court decision (either through exhausting all appeals rights or the lapsing of the time period within which an appeal must be pursued) before the date of enactment of this Act. Id. Here, no final decision had been entered under the Tax Court rules, so application of the amendment was proper. See Temple Univ. v. United States, 769 F.2d 126, 134 n. 4 (3d Cir.1985) (no separation of powers violation where Congress did not desire to effect a rule of decision only in a particular case), cert. denied, 476 U.S. 1182, 106 S.Ct. 2914, 91 L.Ed.2d 544 (1986). 29 That the legislation was retroactive does not make it unconstitutional. Pension Benefit Guar. Corp. v. R.A. Gray & Co., 467 U.S. 717, 729, 104 S.Ct. 2709, 2717, 81 L.Ed.2d 601 (1984) ([R]etroactive application of a statute ... supported by a legitimate legislative purpose furthered by rational means is proper in the economic field.). Indeed, tax legislation has regularly been upheld even though it contained elements of retroactivity. United States v. Darusmont, 449 U.S. 292, 296-300, 101 S.Ct. 549, 551-54, 66 L.Ed.2d 513 (1981) (per curiam); Welch v. Henry, 305 U.S. 134, 146-50, 59 S.Ct. 121, 125-27, 83 L.Ed. 87 (1938); Milliken v. United States, 283 U.S. 15, 20-24, 51 S.Ct. 324, 326-28, 75 L.Ed. 809 (1931). Only where the retroactive application is so harsh and oppressive as to transgress the constitutional limitation, Welch v. Henry, 305 U.S. at 147, 59 S.Ct. at 126, may such a statute be found to violate due process. We agree with the Commissioner that Congress intended simply to avoid giving sham taxpayers a windfall that they otherwise would have obtained from an anomalous decision of the Tax Court. See generally Hochman, The Supreme Court and the Constitutionality of Retroactive Legislation, 73 Harv.L.Rev. 692, 706-11 (1960). 30 Nor was the 1986 amendment violative of the ex post facto clause of the Constitution, as this is a civil, not a criminal case. Harisiades v. Shaughnessy, 342 U.S. 580, 594-95, 72 S.Ct. 512, 521-22, 96 L.Ed. 586 (1952); Helvering v. Mitchell, 303 U.S. 391, 401, 404-05, 58 S.Ct. 630, 635-36, 82 L.Ed. 917 (1938) (upholding, as civil penalty, a 50% additional tax imposed where payment was deficient due to intentional fraud). This is simply not so punitive as to be criminal either in purpose or effect, see United States v. Ward, 448 U.S. 242, 248-49, 100 S.Ct. 2636, 2641-42, 65 L.Ed.2d 742 (1980), particularly because we are increasing an interest rate rather than the tax liability itself. Thus, 120% of a 10% interest rate is only 12%, or an additional 2% penalty. 31 JUDGMENT AFFIRMED.