T.C. Memo. 1996-86
UNITED STATES TAX COURT
ROBERT G. LESLIE AND MARILYN B. LESLIE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9814-87. Filed February 28, 1996.
Elliott H. Kajan and Steve Mather, for petitioners.
Roger L. Kave, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FAY, Judge: By notice of deficiency dated February 20,
1987, respondent determined deficiencies in petitioners' Federal
income taxes and additions to tax and increased interest as
follows:
Additions to Tax and Increased Interest
Sec. Sec. Sec. Sec.
Year Deficiency 6621(d) 6653(a)(1) 6653(a)(2) 6661
1
1980 $1,064,080 $53,204 -- --
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1 1
1981 49,501 2,475 --
1 1
1982 366,677 18,334 $91,669
1
To be determined.
All section references are to the Internal Revenue Code in
effect for the taxable years in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated.
This case involves Robert G. Leslie's (petitioner's) invest-
ments in gold straddle transactions through the futures commis-
sion merchant F.G. Hunter & Associates (Hunter). This is the
same Hunter tax straddle program that was at issue in Ewing v.
Commissioner, 91 T.C. 396 (1988), affd. without published opinion
940 F.2d 1534 (9th Cir. 1991).
On August 30, 1993, respondent filed a Motion for Order to
Show Cause why petitioners' case is different than Ewing v.
Commissioner, supra. On October 18, 1993, petitioners filed
Petitioners' Response To Order To Show Cause. In their response,
petitioners submit that their primary motive for engaging in gold
futures transactions with Hunter is distinguishable from that of
the taxpayers in Ewing v. Commissioner, supra. Based on peti-
tioners' response, on December 6, 1993, this Court issued an
order discharging the order to show cause. A trial was held
January 10 and 11, 1995, in Los Angeles, California, to resolve
the following issues for decision:
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(1) Whether certain transactions in gold futures were
entered into by petitioners for profit. We hold that they were
not.
(2) Whether fees paid by petitioners with respect to such
transactions are deductible. We hold that they are not.
(3) Whether petitioners are entitled to a deduction for the
taxable year 1982 for the amount by which the Hunter straddle
losses for the years at issue exceed the straddle gains for the
years at issue. We hold that they are not.
(4) Whether petitioners, with regard to the Hunter straddle
transactions, are liable for increased interest pursuant to
section 6621(d). We hold that they are.
Respondent concedes that, based on the holding in Ewing v.
Commissioner, supra, petitioners are not liable for additions to
tax pursuant to section 6653(a)(1) and (2). Respondent further
concedes that petitioners are not subject to an addition to tax
for the taxable year 1982 pursuant to section 6661.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation and exhibits associated therewith are incorpo-
rated herein by reference.
At the time petition was filed, petitioners resided in Santa
Paula, California. Petitioners' joint Federal income tax returns
for the years in issue were filed with the Office of the Internal
Revenue Service at Fresno, California. Petitioners' returns were
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prepared utilizing the cash receipts and disbursements method of
accounting.
On their joint Federal income tax returns for the 1980
taxable year, petitioners claimed ordinary losses from Hunter
transactions for the cancellation of long gold futures contracts
in the amount of $1,530,268, and short-term capital gains for
offset transactions of $198,030. Petitioners also claimed as
miscellaneous itemized deductions for the taxable year ending
December 31, 1980, the following costs relating to their partici-
pation in Hunter transactions: Investment advisory fees in the
amount of $14,000 and legal fees related to investments in the
amount of $3,500.
On their joint Federal income tax return for the 1981
taxable year, petitioners claimed an ordinary loss from Hunter
transactions for the cancellation of long gold futures contracts
in the amount of $55,302 and net long-term capital gains from the
assignment and offset of Hunter gold futures contracts in the
amount of $97,160.
On their joint Federal income tax returns for the 1982
taxable year, petitioners claimed net long-term capital gains
from Hunter transactions for the assignment and offset of gold
futures contracts in the amount of $1,172,950.
All of the above claimed tax results purportedly occurred
with respect to transactions in gold futures conducted during
1980, 1981, and 1982 in the manner hereinafter described on
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behalf of petitioners by Hunter. Petitioners did not engage in
the transactions as dealers.
Trading in Commodities Futures in General
A gold futures contract1 is an agreement to either deliver
(a short position2) or receive (a long position3) a specified
amount of gold during a designated month at a price negotiated
when the contract is made. The futures contract is ultimately
fulfilled when the commodity bought is delivered to the buyer by
the seller or when the contract is offset. Less then 5 percent
of all futures contracts actually result in the delivery of the
underlying commodity. Instead, most futures contracts are offset
rather than being executed by delivery. Ewing v. Commissioner,
supra at 400. An offset is the acquisition of an offsetting
contract of purchase or sale of the same quantity of the
commodity.
A gold spread consists of a long position and a short
position, with each position having a different delivery date.
Each of the two positions constitutes a simple spread, often
1
Since modern gold futures trading began in 1974, gold
futures have been traded on four domestic exchanges: (1) The
Chicago Board of Trade (CBOE); (2) the International Monetary
Market (IMM), which is associated with the Chicago Mercantile
Exchange; (3) the Commodity Exchange, Inc. (COMEX), and (4) the
MidAmerica Commodity Exchange. The dominant exchange is COMEX.
2
A short position is held by a person who has sold one or
more futures contracts without having previously bought them.
3
A long position is held by a person who has bought and
holds one or more futures contracts.
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referred to as a "leg". Id. If a trader merely bought a long
position or sold a short position, he would be said to have
acquired a "simple net position", and the trader would hope to
profit by a rise in the price of the commodity underlying the
long position or fall in the price of commodity underlying the
short position. Traders who invest utilizing spread positions
hope to profit by a favorable change in the price relationship or
differential between their long and short positions. The price
differential is a function primarily of the changes in short-term
interest rates and the value of the underlying commodity4 and,
secondarily, of storage and commission costs. Since storage
costs for precious metals are trivial, the major forces affecting
gold futures spreads are gold prices and short-term interest
rates. Id.
A simple commodity spread that has one short leg with a
nearby delivery date and one long leg with a more distant
delivery date is often referred to as a "backward spread" since
it is profitable when the dollar difference between the price of
the two contracts increases after the position is established.
Since prices generally increase in a rising or bull market, back-
4
For example, if spot gold is $400 per ounce, and the
interest rate is 1 percent per month, a 6-month delivery will be
priced at $424 [$400 + (1 percent x 6 months x $400)]. Thus,
when the number of long contracts equals the number of short
contracts, the difference in price between the long and short
legs is entirely a function of the interest cost of carrying gold
from one futures delivery month to the other.
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ward spreads are also referred to as "bull spreads". Conversely,
a simple commodity spread that has a long leg with a nearby
delivery date and one short leg with a more distant delivery date
is referred to as a "forward spread" since it is profitable if
the dollar difference between the two contracts declines after
the position is established. Since prices generally decline in a
falling or bear market, forward spreads are also referred to as
"bear spreads".
Since a forward spread profits when the difference between
the two contracts narrows, a forward spread will profit when the
interest rates decline. Conversely, a backward spread would
suffer a loss from the same change in interest rates. Addition-
ally, since a forward spread profits when the spread difference
narrows, a forward spread will profit from a reduction in the
price of gold even if the interest rates do not change. Con-
versely, a backward spread would suffer a loss from the same
reduction in the price of gold.
Whenever a leg of a straddle is closed out by an offset, or
in any other manner, tax consequences normally will result in the
holder realizing either a gain or a loss. Generally, in a tax-
motivated straddle trading, the loss leg will be closed out first
in order to generate a tax loss for the holder. When this
occurs, the remaining leg of the initial straddle containing an
unrealized gain, which is usually almost identical to the amount
of loss in the closed leg, constitutes an open position for the
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holder and thus is subject to the increased risk of being
directly subject to the market. To minimize this increased risk,
the holder would obtain a new position similar to the one in the
closed loss leg, except for a different month. This substitution
of one position for a similar position in a different month
(switching) of the loss leg in the initial year in order to
generate a tax loss which is offset by the unrealized gain in the
other leg of the straddle is a pattern usually found in the
trading of tax straddles. Ewing v. Commissioner, 91 T.C. at 401.
A "butterfly spread" has three legs maturing at different
times. If the first and third legs are long, then the middle
position is short. If the first and third legs are short, then
the middle position is long. The outlying positions (first and
third legs) are referred to as wings and the center position as
the body, hence the term "butterfly".
The center position or body of a butterfly spread is twice
as large as either wing, and the time periods for the delivery of
the commodity from the first wing to the body and from the body
to the second wing are equal. Essentially, a butterfly spread
creates two spreads, one bullish and one bearish. Thus, a
butterfly spread presents less chance of either an adverse or a
favorable spread movement and is, therefore, less likely to
result in a different loss or gain than an ordinary straddle. An
example of a butterfly spread would be as follows:
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WING WING
Short 50 Contracts of June Gold Short 50 Contracts of October Gold
BODY
Long 100 Contracts of August Gold
A "condor trade" is similar to a butterfly spread but has
four or more elements rather than three. An example would be as
follows:
WING WING
Short 50 Contracts of June Gold Short 50 Contracts of December Gold
BODY
Long 50 Contracts of August Gold
Long 50 Contracts of October Gold
The purpose of butterfly or condor spreads is to establish a
position that will create a significant profit or loss on the
long or short position if there is a major move in the price of
gold so a tax benefit can be achieved. At the same time, such a
spread establishes a position that creates a complementary profit
or loss on the other side of the position, thereby creating tax
benefits while eliminating the possibility of gaining or losing
significant equity.
The Hunter Program
Hunter was organized in late 1979 or early 1980 as a Nevada
limited partnership with its principal place of business in
Newport Beach, California. On February 20, 1980, Hunter first
registered with the Commodities Futures Trading Commission (CFTC)
as a Futures Commission Merchant (FCM) and remained an FCM for
all years relevant hereto. All regulated futures transactions
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must be executed through an FCM which is a member of an exchange.
Since Hunter was not a member or clearing member of the Commodity
Exchange of New York (COMEX) or the International Money Market
(IMM), Hunter was not authorized to execute gold futures con-
tracts on the floor of either exchange. Accordingly, Hunter
contracted with A.G. Becker, Inc., a clearing member of the
exchanges, to execute and clear the gold futures transactions
involved herein.
Hunter delivered promotional literature to prospective
clients. A majority of the promotional material was devoted to
showing clients the "significant tax advantages" they could
obtain through the Hunter investment program.
Most of the "Questions and Answers" portion of the Hunter
promotional material relates specifically to tax benefits that
can be received by participating in the Hunter program. Specifi-
cally, the materials state:
3. Can I lose my investment?
Yes. As with any investment, the risk of loss is
commensurate with the opportunities for profit.
However, the opportunity for profit can be con-
siderably enhanced, and the risk of loss substan-
tially reduced by the proper choice of alternative
methods of liquidating your contracts.
* * * * * * *
8. How can the probability of gain be increased by
choice of liquidation methods (?) (See #3)
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Income tax treatment of your gains or losses on
each contract will be different depending upon the
way your contract is closed out. There are ways
to close out a contract in which you have a gain
so that it will be taxed as a long term capital
gain. For the contract in which you have a loss,
you may liquidate so as to have ordinary loss.
Depending upon your tax bracket, your risk of
after tax loss on both of these contracts will be
very substantially reduced and will quite possibly
be converted into an after tax gain. Any net pre-
tax profit will be significantly increased.
9. Can you give me an example ?
On February 15, 1978, the price of November 1978
gold was $188.30 per ounce (Wall Street Journal,
February 15, 1978 CMX). On the same date, the
price of February 1979 gold was 192.30 per ounce.
Seven months later on September 20, 1978, the
price of November 1978 gold was $212.70, and the
price of February 1979 gold was $217.90. If you
had sold November 1978 gold on February 15, 1978,
and bought February 1978 gold at the same time
then liquidated each contract on September 20,
1978, you would have incurred a loss of $24.40
($212.70 - $188.30) per ounce on your short posi-
tion and realized a gain of $25.60 per ounce on
your long position. Based on current tax rates,
and upon the assumption that you close out your
positions as described above, your net after tax
gain on your February 15, 1979 gold would have
been approximately $20.48 per ounce, and your net
after tax loss on November 1978 gold would have
been approximately $12.20 per ounce. The combined
after tax gain would have been $8.28 per ounce.
Considering there are 100 ounces of gold per
contract your net dollar profit would be $828.00
per spread. These figures do not include sales
and administrative fees which will be discussed
later.
10. What would have happened if I had bought November
1978 gold and sold February 1979 gold instead?
On your long (November) contract, you would have a
before tax gain of $24.40 per ounce, and on your
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short (February) position a before tax loss of
$25.60 per ounce. Your after tax gain on the long
contract would be approximately $19.52 per ounce,
and your after tax loss on your short contract
would have been approximately $12.80 per ounce, if
you follow the liquidation principles described in
the answer to question #9 above. The combined
after tax gain would be $6.72 per ounce, or
$672.00 net after tax profit per spread.
11. Would the same results be realized with other
choices of dates?
The results that would have been achieved with
other choices of dates would be different.
However, the principles are the same if these
conditions apply. (1) The contracts are closed
out after the expiration of the six months capital
gains holding period. (2) The contract on which
you have a gain is closed out in a way which will
qualify for capital gains tax treatment, and (3)
the contract on which you have a loss is closed
out in a way which will qualify for ordinary
income tax treatment.
12. Precisely how do I meet conditions (2) and (3) in
question # 11?
If there is a gain in your long position, you
should qualify for capital gains treatment by
going short in the same delivery month. If you
have a gain in your short position, you could sell
it to an unrelated third party and qualify for
capital gains treatment. If you have a loss in
either your long or short contract, you should
cancel it. If you do, your loss will be an
ordinary loss rather than a capital loss.
* * * * * * *
15. Will I be required to close out my long and short
positions simultaneously?
By no means. They are separate contracts. You
may choose to liquidate them in other ways. For
example, you may wish to actually take delivery of
the gold on your long contract and close out your
short position by offsetting it with an identical
long contract. Other combinations of liquidation
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are possible. You should select the one that ful-
fills your economic goals and personal require-
ments. Get the advice of your tax adviser.
Included with the promotional material are four graphs which
show pre- and post-tax analyses of contract liquidation. The
promotional material also contained a "Worksheet" which specifi-
cally allows for calculating the "Tax Savings" of contract
liquidation.
Also provided with the Hunter promotional material was a
four-page document entitled "Summary of Federal Income Tax
Consequences of F.G. Hunter & Associates Investment Program",
giving a synopsis of the different tax implications of various
gold futures contract liquidation methods.
The Hunter promotional materials included a 24-page opinion
letter, dated March 24, 1980, written by Attorney Avram Salkin.
The opinion letter was supplemented on June 13, 1980, and
modified on August 17, 1981, in light of the provisions of the
Economic Recovery Tax Act of 1981, Pub. L. 97-34, 95 Stat. 172.
The opinion letter described in detail, with supporting citations
of case law and statutes, the tax consequences, which in, the
opinion of Mr. Salkin, could be expected by Hunter investors from
the liquidation of the component positions of their future
straddles.
Petitioner's Business and Investment History
At the time of trial, petitioner was 62 years old. Peti-
tioner graduated from high school in 1950 and enlisted in the
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U.S. Army. After being honorably discharged from the Army in
1953, petitioner entered the construction business. Petitioner
eventually became the president and sole shareholder of R&H
Paving, Inc., a paving contractor.
Prior to making the commodity trades with Hunter, petitioner
held various investments during the 1970's and early 1980's.
Petitioner's basic requirement in an investment was a good cash-
flow, in order to counter the cyclical nature of his construction
business. Petitioner was not averse to risk in an investment
since he was accustomed to a considerable amount of risk from the
construction industry.
Generally, petitioner relied on either Roy Tolson, an
accountant and business adviser, or Joe Rasey, a business
associate, to locate investments which satisfied his investment
criteria. Before making an investment, petitioner would
personally analyze the transaction.
In June 1980, petitioner hired Donald Short (Short) to be
his personal business adviser and controller for R&H Paving, Inc.
Short was a certified public accountant (C.P.A.), licensed to
practice in California. Prior to being hired by petitioner,
Short was employed by Edward White & Co., the C.P.A. firm that
prepared petitioners' tax returns. While Short worked at Edward
White & Co., he prepared petitioners' tax returns. Short
testified that he was well aware of petitioner's tax position
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during the years he prepared petitioners' tax returns at Edward
White & Co. and for all the taxable years at issue.
Petitioner relied on Short to find investments that satis-
fied his investment criteria because petitioner did not have time
to personally investigate all of the potential investments in
which he was interested. As part of Short's investigation of
potential investments for petitioner, Short read books, articles,
and periodicals relating to commodity trading which led Short to
believe that this type of investment met petitioner's investment
requirements.
Since neither Short nor petitioner had prior experience with
commodity investments, Short searched for brokerage firms that
had commodity departments. Short searched for a commodity broker
by contacting brokerage houses and persons he had worked for in
the past, including Edward White & Co. These sources led Short
to Hunter and, in particular, to Russ Klein (Klein), who was
employed by and in charge of Hunter.
Short met with Klein on three occasions before investing
with Hunter. Petitioner only attended the last meeting. The
initial meeting with Klein focused on commodity trading methods
and a projected potential return of 25-47 percent. Short
believed that the Hunter trading methods met all of petitioner's
investment criteria. Additionally, Short believed that Klein
would be able to educate him in commodity trading strategies in
order to enable him to assume increasing degrees of control over
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trading decisions in the future on behalf of petitioner. Short
was very interested in the Hunter program and advised petitioner
of the substance of the initial meeting with Russ Klein. Short
testified that he did not receive the promotional material nor
learn about the favorable tax benefits of straddle trading in the
Hunter program until his final meeting with Klein, which peti-
tioner attended.
Petitioner testified that he reviewed the Hunter promotional
material, including "Summary of Federal Income Tax Consequences"
and discussed the tax consequences of the Hunter program with
Short prior to making his actual Hunter investment. Petitioner
did no further research regarding the Hunter program. Petitioner
testified that he did not check into any of the credentials of
the individuals who wrote the Hunter promotional material.
Petitioner decided to make his investment with Hunter in
December 1980 based on the information Short obtained from his
meetings and conversations with Klein and due to repeated calls
from Klein urging him to make an investment with Hunter immedi-
ately. Klein's reason for wanting petitioner to invest at that
time was that the volatility of the gold market presented an
opportunity for immediate tax benefits. Short testified that
some of the considerations for investing in Hunter programs at
that time were to maximize profits during a volatile market and
to take advantage of the tax benefits.
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Petitioner, as a participant in the Hunter gold futures
spread program, would have been required to sign the following
Hunter forms: (a) New Account Application; (b) Account Agreement
and Risk Disclosure; (c) Risk Disclosure Statement; and
(d) Current Policies and Fees, setting forth the commissions and
fees payable by petitioner to Hunter. Petitioner testified that
it was normal practice in his business to keep copies of signed
documents. However, at trial, petitioner could not provide
signed copies of any of the Hunter documents listed above.
Petitioner's initial commodity positions were created on
December 1, 1980, when he made the investment. Petitioner paid
an initial deposit of $178,500. Out of his initial deposit,
petitioner incurred the following costs:
Legal fee $3,500
Management fee 35,000
Commission to establish
initial spread positions 17,500
Total costs 56,000
Thus, petitioner's initial margin was $122,500 ($178,500 -
$56,000).
Petitioner's trades with Hunter were initiated by FAX, Inc.
(FAX), a registered trading adviser. In order for FAX to
initiate trades between petitioner and Hunter, petitioner would
have been required to sign both an "Investment Advisory Agree-
ment" and a "Special Power of Attorney" authorizing FAX to trade
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commodities. At trial, petitioner was unable to provide signed
copies of these documents and testified that he did not recall
signing either of the documents.
The $35,000 management fee incurred by petitioner on
December 1, 1980 (see above), was for FAX's services. Short
testified that he never investigated FAX because he felt that FAX
was just part of Hunter and that the $35,000 fee was just being
paid to Hunter.
Through Hunter, petitioner established two spreads on
December 1, 1980. The first was a simple bear spread consisting
of a long position of 30 contracts of October 1981 100-ounce gold
at a price of $723.80 per ounce and a matching short position of
30 contracts of February 1982 gold at $762. The second position
was an imperfect butterfly spread. The first wing consisted of
70 contracts of April 1982 gold bought at $785.10. The body was
145 short June 1982 gold, of which 70 contracts were sold at
$804.50 on COMEX and 75 contracts at $803.50 on IMM. The second
wing was comprised of 75 contracts of September 1982 gold bought
on IMM at $834. The slight imperfection in the butterfly
occurred because there were only 2 months between the first wing
and the body, whereas there were 3 months between the second wing
and the body; and because the June/September part of the spread
consisted of 75 contracts, whereas the April/June part consisted
of 70 contracts.
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On December 10, 1980, petitioner's spread positions were
modified as a result of a recommendation from Klein that the
market was moving and that, by making additional trades, peti-
tioner could realize substantial tax losses and be in a better
position to later profit from the market movement. Short and
petitioner approved the trades that resulted in a substantial tax
loss on December 10, 1980.
On December 10, 1980, the three long positions (175 gold
contracts) established on December 1, 1980, were all canceled,
resulting in losses totaling $1,506,000. Petitioner's original
equity in his Hunter account, however, was not significantly
affected because the value of the three remaining short positions
dropped about as much as the three liquidated long positions.
The result was a total "open" profit that approximately equaled
petitioner's closed transaction loss. Petitioner's open profit
was protected by immediately replacing, on December 10, 1980, the
175 canceled long contracts with 175 new long contracts.
The new long positions established on December 10, 1980,
consisted of 75 contracts of March 1982 gold at $685 and 100
contracts of August 1982 gold at $739.70. The resulting position
in the account was an imperfect condor spread consisting of two
long outside wings of 75 contracts of March 1982 at $685 and 100
contracts of August 1982 at $739.70 and the body consisting of
two short positions, 30 contracts of February 1982 at $762 and
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145 contracts of June 1982, of which 70 were established at
$804.50 on COMEX and 75 at $803.50 on IMM.
Upon canceling the 175 gold positions on December 10, 1980,
Hunter charged petitioner a cancellation fee totaling $15,520.14.
As a result of the $1,506,000 tax loss, petitioner, for the tax
year 1980, was able to offset net ordinary income from numerous
sources totaling $1,449,151 and offset capital gains totaling
$56,849.
On December 30, 1980, petitioner's position with Hunter was
reduced by selling 21 contracts of March 1982 long position while
at the same time liquidating 21 contracts of the June 1982 short
position.
Short and petitioner were dissatisfied with the investment
advisory services rendered by FAX, and in February 1981 they
requested and obtained a refund of the $35,000 management fee,
which was recredited to petitioner's account by Hunter in incre-
ments of $28,000 and $7,000.
Short and petitioner continued to be dissatisfied with the
services provided by Hunter. Accordingly, Short contacted Bill
Kearney at Merrill Lynch to determine what commodity advising
services were available from Merrill Lynch. Petitioner retained
Merrill Lynch and invested $100,000 in an oil and gas investment
in late 1981. Merrill Lynch earned a $6,000 commission from the
investment.
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Short left petitioner's employ for approximately 1 year
during the second half of 1981 and early 1982. During Short's
absence, petitioner continued his commodity trading activity
through Merrill Lynch and expanded into trading bonds, stocks,
and other commodities futures contracts.
Also during Short's absence, petitioner continued to
maintain his accounts with Hunter, and, on December 31, 1981,
four of the March 1982 long positions were sold at $409, creating
a total loss in the amount of $110,400. Two of the contracts
were disposed of by sale, for which petitioners claimed a long-
term capital loss in the amount of $55,200 on their 1981 Federal
income tax return. Two of the contracts were disposed of by
"cancellation", for which petitioners claimed an ordinary loss
deduction in the amount of $55,302 on their 1981 Federal income
tax return.
To keep the number of long and short positions of the condor
position balanced after the December 31, 1981, disposal of four
long contracts, four short contracts of June 1982 gold were
purchased at $422.55 for petitioner's account with Hunter. This
purchase yielded a realized profit of $152,380. The December 31,
1981, liquidation of four short positions was treated by
petitioner as an "assignment" to a third party, and the gain was
treated as a $152,380 long-term capital gain on petitioners' tax
return.
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In January 1982 petitioner and Hunter continued to reduce
the condor position. This was made necessary by the fact that
all the remaining gold contract positions consisted of 1982
contracts and would have to be settled by delivery if held much
longer. As a result of the impending delivery dates, petitioner
liquidated 30 of the remaining long August positions on Janu-
ary 26, 1982. The repositioning resulted in an offset loss of
$1,007,100, which petitioner treated as a long-term capital loss.
Also on January 26, 1982, an equivalent short position
consisting of 30 contracts of February 1982 gold was liquidated,
but, instead of being offset by a direct purchase on the trading
floor of COMEX, the short position was "assigned". This assign-
ment resulted in a profit of $1,149,450, which petitioners
reported as a long-term capital gain on their 1982 Federal income
tax return.
The liquidation continued on February 24, 1982, when 25 long
March contracts were sold, and 25 short June contracts were
assigned. Petitioner recognized an $802,500 loss from the offset
of the March position, which he treated as a long-term capital
loss. Simultaneously, petitioner recognized a $1,067,625 profit
from the assigned short June position, which petitioner treated
as a long-term capital gain.
On February 25, 1982, an additional 25 contracts on each
side of the remaining spread position in the account were
liquidated. Twenty-five long March 1982 contracts were offset at
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a loss in the amount of $797,500. Petitioner reported the loss
as a long-term capital loss. Twenty-five short June 1982
contracts were liquidated by assignment at a gain in the amount
of $1,062,125. Petitioner treated the gain as a long-term
capital gain.
Petitioner liquidated his final positions with Hunter on
May 26, 1982. This resulted in an offset loss of $2,814,700 from
the remaining long contracts and a gain from the assignment of
the remaining short contracts of $3,315,550. The loss was
treated by petitioner as a long-term capital loss, and the gain
was treated as a long-term capital gain.
Petitioners claimed on their 1982 joint Federal income tax
returns that the results of their 1982 Hunter trades were net
long-term capital gains from the assignment and offset of gold
futures contracts in the amount of $1,172,950.
OPINION
Losses on Straddle Transactions
The primary issue in this case is whether petitioners are
entitled to deduct losses on the Hunter straddle transactions as
claimed on their Federal income tax returns for the taxable years
1980, 1981, and 1982. Resolution of the issue turns on the
effect of section 108(a) of the Deficit Reduction Act of 1984
(DEFRA), Pub. L. 98-369, 98 Stat. 494, 630, as amended by section
1808(d) of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat.
- 24 -
2817. Hereinafter, our references to "DEFRA section 108" are to
that section as amended, unless otherwise stated.
DEFRA section 108(a) provides as follows:
(a) General Rule. -- For purposes of the Internal
Revenue Code of 1954, in the case of any disposition of
1 or more positions--
(1) which were entered into before 1982 and
form part of a straddle, and
(2) to which the amendments by title V of the
Economic Recovery Tax Act of 1981 do not apply,
any loss from such disposition shall be allowed for the
taxable year of the disposition 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.
By notice of deficiency, respondent determined that
petitioner's straddle losses are not deductible under section
165(c)(2) because the transactions were not entered into for
profit. Petitioners contend that their entire course of conduct
before the investment, during the commodity trading with Hunter,
and after the initial Hunter investment through the time of the
investment with Merrill Lynch all reflect that petitioner's gold
straddle transactions were entered into for profit.
Petitioners contend that all of petitioner's investment and
commodity trades were consistent with his long-standing invest-
ment history. They argue that petitioner's commodity spread
trading was motivated primarily by petitioner's desire to find
investments with a modicum of risk in exchange for a large cash
- 25 -
return on investment, and that tax benefits were purely coinci-
dental. We disagree.
This Court in Ewing v. Commissioner, 91 T.C. 396 (1988),
stated that the phrase "entered into for profit" as used in DEFRA
section 108(a) is to be interpreted by reference to the standard
applied under section 165(c)(2). Ewing v. Commissioner, supra at
417. The Court in Ewing used the guidelines provided in Fox v.
Commissioner, 82 T.C. 1001 (1984), to determine whether the
Hunter gold straddle transactions were entered into primarily for
profit. Id.
In Fox v. Commissioner, supra at 1021, this Court concluded
that section 165(c)(2) requires that profit be the primary motive
if a loss from a straddle transaction is to be deductible. The
Court stated that profit need not be the sole motive for engaging
in a straddle transaction, but that a mere incidental profit
motive would be insufficient. Id. at 1019 (citing Ewing v.
Commissioner, 20 T.C. 216, 233 (1953), affd. 213 F.2d 438 (2d
Cir. 1954)). To determine whether a straddle transaction was
entered into for profit, Fox provides the following guidelines:
(1) The ultimate issue is profit motive and not profit
potential. However, profit potential is a relevant factor to be
considered in determining profit motive.
(2) Profit motive refers to economic profit independent of
tax savings.
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(3) The determination of profit motive must be made with
reference to the spread positions of the straddle and not merely
to the losing legs, since it is the overall scheme which
determines the deductibility or nondeductibility of the loss.
(4) If there are two or more motives, it must be determined
which is primary, or of first importance. The determination is
essentially factual, and greater weight is to be given to
objective facts than to self-serving statements characterizing
intent.
(5) Because the statute speaks of motive in "entering" a
transaction, the main focus must be at the time the transactions
were initiated. However, all circumstances surrounding the
transactions are material to the question of intent. Ewing v.
Commissioner, 91 T.C. at 418 (citing Fox v. Commissioner, supra
at 1018, 1022).
Although petitioner testified that his sole motive for
investing with Hunter was to obtain a profit, a majority of the
circumstances surrounding the transactions points to the conclu-
sion that petitioner's primary motive was tax benefits.
In determining petitioner's primary motive for entering the
Hunter program, "greater weight is to be given to objective facts
than to self-serving statements characterizing intent." Ewing v.
Commissioner, 91 T.C. at 418; Fox v. Commissioner, supra at 1022.
The objective facts indicate that petitioner's primary motive was
tax considerations. Thus, after applying the Fox guidelines to
- 27 -
the facts of this case, we find, for the reasons discussed below,
that petitioner did not enter into his straddle transactions
primarily for profit.
First, although petitioner testified that Hunter representa-
tives never told him that canceling a commodities position would
give him an ordinary tax loss or that he could get long-term
capital gain treatment on the disposition of a short sale
position, it is clear that the objective facts contradict this
testimony.
A majority of the promotional material was devoted to show-
ing clients the significant tax benefits that could be achieved
through the Hunter "cancellation" and "assignment" closing
procedures. Petitioner testified that he read and received the
Hunter promotional material which explained the tax benefits to
Hunter's liquidation procedures. Also, many of the "Questions
and Answers" portion of the Hunter promotional material related
specifically to tax benefits that can be achieved through the
Hunter program. Furthermore, other Hunter promotional material
received and read by petitioner included graphs comparing pre-
and post-tax analyses of contract liquidation, a worksheet
specifically allowing for the calculation of "Tax Savings" of
contract liquidation, and a four-page document entitled Summary
of Federal Income Tax Consequences of F.G. Hunter & Associates
Investment Program.
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The Court in Ewing stated that the 24-page opinion letter,
written by attorney Avram Salkin, was the most influential item
in the Hunter promotional material. Ewing v. Commissioner, 91
T.C. at 418. Petitioner testified that he received and read the
opinion letter along with the other promotional material. In
contrast to the substantial discussion of tax benefits, the
profitability of the Hunter program was neither seriously
discussed nor quantified.
Second, petitioner's trades indicate a greater interest in
the tax advantages of the Hunter program than in obtaining a
profit. Petitioner's expert, Edward Horowitz, testified that the
gold market was very volatile in December 1980 and that there is
a greater potential to profit in a volatile market. Thus, Klein
was correct in advising petitioner to enter the market at that
time. Mr. Horowitz also testified that petitioner's modification
of his straddle position on December 10, 1980, which resulted in
a substantial loss, actually increased petitioner's profit poten-
tial. While the Court does not disagree with Mr. Horowitz's
opinion that the modification of petitioner's straddle increased
his profit position, the Court finds that the modification was
motivated by a desire to obtain a tax benefit. Petitioner placed
his first straddle positions on December 1, 1980, and then, only
9 days later, he modified his positions as a result of a recom-
mendation from Klein that the market was moving and that, by
making additional trades, petitioner could realize substantial
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tax losses and be in a better position to later profit from the
market movement. Petitioner's modifications resulted in a
$1,506,000 loss just before the end of the 1980 tax year.
Petitioner argues that "the mere fact that tax benefits were
realized does not mean the tax benefits were the reason for the
transaction." However, "It is a fundamental legal maxim that the
consequences of one's acts are presumed to be intended." Fox v.
Commissioner, 82 T.C. at 1022. We find that petitioner, like the
taxpayers in Ewing, "chose to 'cancel' the initial losing legs of
his straddles before the close of the 1980 tax year so as to
generate an ordinary loss." Ewing v. Commissioner, 91 T.C. at
419. Then, in the following year, on December 31, 1981, peti-
tioner chose to assign the profitable legs of his straddles which
resulted in a $152,380 long-term capital gain.
Thus, with an initial investment of only $178,500, peti-
tioner attempted to offset $1,449,151 of his net 1980 ordinary
income5 with his $1,506,000 tax loss from the December 10, 1980,
cancellation of his gold futures transactions, and, by closing
out the profitable legs of his straddle positions on December 31,
1981, by means of assignments, petitioner attempted not only to
defer his straddle gains to 1981 but also to convert ordinary
income into 1981 long-term capital gain.
5
Petitioner was also able to offset capital gains (after
such capital gains had already been reduced by the 60-percent
long-term capital gain exclusion) by the amount of $56,849.
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Finally, the alternative liquidation techniques (i.e.,
cancellations and assignments) developed by Avram Salkin were
used by Hunter to sell prospective investors on a scheme to
achieve tax avoidance. Id. Specifically, the "cancellation"
technique was devised so that its proponents could claim ordinary
loss treatment rather than capital loss treatment. The
"assignment" procedure was contrived so that Hunter investors
could characterize straddle gains as long-term capital gains
instead of short-term capital gains. However, to utilize these
techniques and obtain their purported tax benefits, petitioner
paid more in commissions and fees than he would have incurred had
he liquidated his futures contract the usual way, by means of
offset. Id. at 400, 419.
For example, under Hunter's "Current Policies and Fees"
statement, petitioner was charged a fee of $15,520.14 for
canceling 175 gold futures contracts on December 10, 1980. Had
petitioner offset his 175 gold contracts instead of "canceling"
those positions, his fee would have only been $1,750. The Court
believes that petitioner was willing to pay substantially more
fees to obtain ordinary loss deductions in the amounts of
$1,506,000 and $55,200 for 1980 and 1981, respectively, espe-
cially since petitioners deducted the fees on their 1980 and 1981
Federal income tax returns.
For the reasons stated above, we hold that petitioners'
motives in entering into these transactions, despite their
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arguments to the contrary, were primarily to obtain substantial
tax benefits. As we stated in Ewing:
"we are cognizant of the fact that tax planning is an
economic reality in the business world and the effect
of tax laws on a transaction is routinely considered
along with other factors, but nevertheless we reiterate
that 'tax straddling * * * transactions can hardly be
said to number among congressionally approved, sanc-
tioned, or encouraged responses to the tax laws."
Ewing v. Commissioner, 91 T.C. at 420 (quoting Fox v. Commis-
sioner, supra at 1025).
Fees Paid With Respect to Straddles
Petitioners deducted the following fees paid to Hunter in
regard to petitioner's Hunter transactions:
1980
Cancellation fees $15,518
Gold futures contract cost 8,750
Offset fees 420
Investment advisory fees 14,000
Legal fees investment related 3,500
1981
Cancellation fees 102
Offset fees 20
Petitioners contend that these fees were incurred in
connection with the purchase and sale of capital assets. As
such, petitioners argue that these fees are capitalized and form
part of the cost basis (for purchase commissions) and an offset
against the selling price (for disposition commissions). Peti-
tioners cite section 1.263(a)-2(e), Income Tax Regs., and the
cases of Spreckles v. Helvering, 315 U.S. 626 (1942), and Soeder
- 32 -
v. Commissioner, a Memorandum Opinion of this Court dated
Mar. 11, 1954. Petitioners state that, as part of the cost basis
and the selling price, such expenses form part of the loss from
the trading which is otherwise allowable under DEFRA section
108(c).
Petitioner's reliance on section 1.263(a)-2(e), Income Tax
Regs., Spreckles v. Helvering, supra, and Soeder v. Commissioner,
supra, is unfounded since both the regulations and the cases
cited deal with taxpayers who were involved in securities or
commodities transactions entered into primarily for profit.
Since we have found that petitioner entered into the Hunter gold
futures program in order to obtain substantial tax benefits, the
above-listed fees paid by petitioner constitute payments to
purchase tax deductions and do not form part of the cost basis of
petitioner's gold contracts or reduce the selling price of those
contracts. Therefore, the fees paid by petitioner are nonde-
ductible personal expenditures. Ewing v. Commissioner, 91 T.C.
at 421; Brown v. Commissioner, 85 T.C. 968 (1985), affd. sub nom.
Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988); Zmuda v.
Commissioner, 79 T.C. 714 (1982), affd. 731 F.2d 1417 (9th Cir.
1984); Houchins v. Commissioner, 79 T.C. 570 (1982); see also
Falsetti v. Commissioner, 85 T.C. 332 (1985).
The 1982 Deduction
Petitioners contend that, if the Court determines that the
spread transactions were not entered into for profit, DEFRA
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section 108(c) allows petitioners to take a net out-of-pocket
loss for 1982. The net out-of-pocket loss would represent the
amount by which petitioner's straddle losses during the subject
years exceeded his straddle gains during the subject years.
Respondent contends that petitioners are only entitled to offset
petitioner's straddle gains by straddle losses to the extent of
his straddle gains. See Ewing v. Commissioner, 91 T.C. at 421.
DEFRA Section 108(c) provides as follows:
(c) Net Loss Allowed.--If any loss with respect
to a position described in paragraphs (1) and (2) of
subsection (a) is not allowable as a deduction (after
applying subsections (a) and (b)), such loss shall be
allowed in determining the gain or loss from disposi-
tions of other positions in the straddle to the extent
required to accurately reflect the taxpayer's net gain
or loss from all positions in such straddle.
Further interpretation of DEFRA section 108(c) is provided
by section 1.165-13T, Q&A-3, Temporary Income Tax Regs., 49 Fed.
Reg. 33445 (Aug. 23, 1984), which states as follows:
Q-3. If a loss is disallowed in a taxable year
(year 1) because the transaction was not entered into
for profit, is the entire gain from the straddle
occurring in a later taxable year taxed?
A-3. No. Under Section 108(c) of the Act the
taxpayer is allowed to offset the gain in the subse-
quent taxable year by the amount of loss (including
expenses) disallowed in year 1.
This Court recently confronted this issue in Nolte v.
Commissioner, T.C. Memo. 1995-57, and held that DEFRA section
108(c) entitles taxpayers to offset straddle losses only to the
extent of straddle gains. The taxpayers in Nolte, like peti-
tioner, were involved in the Hunter program.
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Petitioners argue that Nolte relies on interpretive section
1.165-13T, Q&A-3, Temporary Income Tax Regs., supra, for the
proposition that DEFRA section 108(c) allows the offset of
disallowed losses only against subsequent gains. Petitioners
contend that the holding in Nolte is incorrect for two reasons.
First, petitioners believe that section 1.165-13T, Q&A-3,
Temporary Income Tax Regs., supra, does not imply that disallowed
losses may only offset subsequent gains. Second, section
1.165-13T, Q&A-3, Temporary Income Tax Regs., supra, is invalid
to the extent that it implies a contrary result to the plain
language of DEFRA section 108(c). Petitioners cite Jackson
Family Foundation v. Commissioner, 15 F.3d 917 (9th Cir. 1994),
affg. 97 T.C. 534 (1991), to support the position that an
interpretive regulation is not followed when it "fails to
'implement the congressional mandate in a reasonable manner.'"
Id. at 920 (citing Pacific First Fed. Sav. Bank v. Commissioner,
961 F.2d 800, 803 (9th Cir. 1992), revg. 94 T.C. 101 (1990)
(quoting National Muffler Dealers Association v. United States,
440 U.S. 472, 476 (1979))). We disagree with petitioners'
position.
Petitioners incorrectly contend that section 1.165-13T,
Q&A-3, Temporary Income Tax Regs., supra, does not imply that
disallowed losses may only offset subsequent gains. The plain
language of the regulations states that result. Section
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1.165-13T, Q&A-3, Temporary Income Tax Regs., supra, specifically
states that "the taxpayer is allowed to offset the gain in the
subsequent taxable year by the amount of loss (including
expenses) disallowed in year 1." Thus, the plain language of the
regulations is clear that a taxpayer can offset gain in a
subsequent year but does not state the taxpayer is entitled to a
net loss deduction.
Petitioners also incorrectly contend that the Court's
reliance in Nolte v. Commissioner, supra, on section 1.165-13T,
Q&A-3, Temporary Income Tax Regs., supra, is unfounded; they
argue that the regulation is invalid to the extent it reaches a
result different from the congressional mandate of DEFRA section
108(c). The Court in Nolte found that Congress designed DEFRA
section 108(c) as a relief provision so that the Commissioner
could not obtain a windfall by denying straddle losses and then
having taxpayers recognize straddle gains resulting from the
closing of a straddle. Nolte v. Commissioner, supra. Section
1.165-13T, Q&A-3, Temporary Income Tax Regs., supra, carries out
Congress' mandate to allow straddle losses but only to the extent
of, and against, straddle gains.
Therefore, we find that DEFRA section 108(c) and section
1.165-13T, Q&A-3, Temporary Income Tax Regs., supra, make it
clear that petitioners are only entitled to offset their gains by
the amount of the losses. Nolte v. Commissioner, supra; see also
Ewing v. Commissioner, 91 T.C. at 421. Accordingly, petitioners
- 36 -
are not entitled to an additional deduction for their "net" loss
in excess of straddle gains.
Increased Interest Under Section 6621(c)
Respondent seeks increased interest from petitioners pur-
suant to section 6621(c). Rule 142(a).
Section 6621(c) applies where the Commissioner has estab-
lished that there is an underpayment of at least $1,000 in any
taxable year "attributable to 1 or more tax motivated trans-
actions". Sec. 6621(c)(2). Section 6621(c)(3)(A)(iii) specifi-
cally includes any straddle as a tax-motivated transaction.
Thus, since petitioner's Hunter straddle transactions were not
entered into for profit, they are subject to increased interest
under section 6621(c).
To reflect the foregoing, and the concessions made by the
parties,
Decision will be entered
under Rule 155.