Opinion
Docket Nos. 29929-82 2313-83 3083-83 3503-83.
1985-10-24
DENNIS S. BROWN, ET AL., 1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
JOSEPH WETZEL, RUSSELL SANDOR, for the petitioners. RALPH C. JONES, JOYCE BRITT, for the respondent.
JOSEPH WETZEL, RUSSELL SANDOR, for the petitioners. RALPH C. JONES, JOYCE BRITT, for the respondent.
SHIELDS, JUDGE:
Respondent determined deficiencies in petitioners' Federal income tax as follows:
After concessions, the issues remaining for decision are: (1) whether petitioners realized deductible losses under section 165(c)(2) on forward contracts as claimed on their income tax returns for 1979, 1980, and/or 1981; (2) whether the fees paid by petitioners with respect to such contracts are deductible; (3) whether petitioners, Ellison C. Morgan and Linda Morgan, are liable for additions to tax under section 6653(a); and (4) whether any of the petitioners are liable for damages under section 6673.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations and exhibits associated therewith are incorporated herein by reference.
All of the petitioners resided in Oregon at the time their petitions were filed and all of them filed income tax returns for 1979, 1980, and 1981 with the Internal Revenue Service Center at Ogden, Utah. On the returns, petitioners claimed to have suffered losses in the following amounts from the cancellation of forward contracts for the purchase or sale of certain mortgage certificates:
All of the above losses allegedly occurred with respect to activities promoted by Gregory Government Securities, Inc. and Gregory Investment and Management, Inc. Over 1,400 other cases now pending before this Court have been identified as involving similar issues and factual situations. Upon learning of the number of such cases, the Chief Judge assigned all of them to this Division of the Court. With the assistance of respondent and his counsel, and most of the 1,400 petitioners and their counsel, these four cases were selected as being generally representative with respect to the issues common to all the cases. An Order was then entered consolidating these four cases and setting them for trial of the common issues while all activity in the other cases was suspended pending the decision herein.
Gregory Government Securities, Inc. (‘GGS‘) and Gregory Investment and Management, Inc. (‘GIM‘) were incorporated in 1979 by William H. Gregory under the laws of the State of Oregon. At all times material to these cases all of the stock outstanding in both corporations was owned by Mr. Gregory and his wife and their corporate activities were conducted under his general supervision and control. Prior to 1979, Mr. Gregory had been the tax partner and a specialist in accounting for wood products with Arthur Andersen and Company, an international accounting firm. He was also the chairman of the firm's steering committee on tax shelters. He left Arthur Andersen in July of 1979 in order to establish GGS and GIM. Shortly after its organization, GGS was registered with the Oregon Department of Commerce as a broker-dealer in securities. The registration continued through the balance of 1979 and throughout 1980 and 1981. No such registration was required of GIM in Oregon. Neither corporation was required to be registered as a broker-dealer under the Securities Exchange Act of 1934.
The promotion undertaken in 1979 by Mr. Gregory was purportedly to offer to ‘a limited number of knowledgeable, sophisticated investors, * * * who understand both the economic and tax ramifications of the transactions,‘ investments in forward contracts to purchase or to sell certificates issued by Government National Mortgage Association and Federal Home Loan Mortgage Corporation. These certificates are exempt from federal registration under the Securities Act of 1933. His program contemplated that GIM would serve as a financial advisor to the prospective investors and GGS, as a registered broker-dealer, would serve as either a seller or a buyer on every transaction entered into with the investors.
Government National Mortgage Association (‘GNMA‘) is a corporation wholly owned by the government through the Department of Housing and Urban Development. From time to time GNMA issues registered certificates which represent undivided interests in a specified pool of mortgages guaranteed by GNMA as well as by the Veterans Administration, the Federal Housing Administration, or the Farmers Home Administration. These certificates are referred to in the market as Ginnie Maes.
The Federal Home Loan Mortgage Corporation (‘FHLMC‘) is a corporation whose capital stock is owned by the Federal Home Loan Bank Board and whose directors are appointed by the President with the advice and consent of the Senate. The directors of the Federal Home Loan Bank Board act as the directors of FHLMC.
FHLMC also sells mortgage certificates which are known as participation certificates and which are referred to in the market as Freddie Macs. Each of these certificates represents an undivided fractional interest in a pool of conventional (non-VA and non-FHA) mortgages.
Each prospective investor, including petitioners herein, was given a disclosure memorandum by GIM in which the investment strategy developed by Mr. Gregory was described as follows:
Gregory Investment assists investors in profiting from changes in yields on U.S. Government securities. The investor provides us with his forecast of interest rates. We recommend a portfolio of U.S. Government securities that we believe will result in a gain, if the investor's forecast is correct.
The investment usually involves the purchase and sale of securities under arrangements that delay the actual delivery of the security for several months. This type of arrangement is referred to as a forward contract.
A forward contract is a bilateral executory agreement pursuant to which one party agrees to deliver a designated amount of an item at a certain price and time to another party, who agrees to acquire such item at such price and time. The forward contract does not require delivery until the settlement date designated in the contract. A forward contract is similar in concept to a futures contract. However, a futures contract is consummated through a board of trade or an exchange and contains standardized terms and conditions. The securities purchases and sales through forward contracts are limited to obligations of, or obligations guaranteed by, the United States Government, and securities issued by or guaranteed by United States Government corporations or agencies; e.g., Government National Mortgage Association (GNMA) or Federal Home Loan Mortgage Corporation (FHLMC). The customer is required by the contract to make delivery to, or take delivery from, the dealer of the security specified in the forward contract at settlement date.
It is contemplated that a customer will enter into several forward contracts with the dealer, some of which will require the customer to make forward delivery to the dealer of securities, while others will require the customer to take forward delivery from the dealer of securities. The forward contracts entered into by a particular customer will reflect a market strategy and interest rate forecast and could result in substantial gain or loss to the customer, depending on the volume of transactions and whether interest rate movement is in accordance with, or adverse to, his expectations.
The investment risk is diminished by the simultaneous purchase and sale of a forward contract. This purchase and sale is called a spread. The profit and loss potential of a spread results from the purchase of securities and the sale of securities with different coupon interest rates.
A change in interest rates affects the price of a low-coupon security a greater percentage than a high-coupon security. However, the low-coupon security costs less, so even though its price varies at a greater percentage rate, the total change in price is less.
The usual investment strategy to profit from rising interest rates is to PURCHASE LOW-COUPON and SELL HIGH-COUPON securities. An opposite strategy would be used for a projected decline in interest rates.
For example
Assume a 9% current yield to maturity on a security paying interest semi-annually and maturing in ten years. The investor forecasts interest rates to rise to 10%. This spread results in a profit:
The profit would be reduced by transaction costs.
In the event a customer desires to be released from obligations under a particular forward contract, the customer may attempt to arrange for the cancellation of the obligations under the contract prior to settlement date. If the dealer agrees to cancel the contract, it will charge or credit the customer's account with an amount equal to the profit or loss that the customer is entitled to receive. In consideration for the release of the customer from his obligation to perform the contract the customer will also pay a fee to the dealer for risk and administrative costs created by the cancellation of the contract.
Alternatively, if the customer does not desire to be released from the obligations under a particular forward contract (original contract), but wants to eliminate the risk created by such contract, he may enter into a forward contract bearing the position opposite that of the original contract. The customer may request that the dealer offset the newly acquired contract against the original contract or he may keep both positions open and either offset at a later date or close out the position in some other manner.
The tax and economic results of various types of transactions are summarized below. The federal income tax results should be discussed with your tax advisor and you should not rely on the chart. The results could be challenged for various reasons by the Internal Revenue Service, as explained in the tax aspects section of this memorandum.
The memorandum stated that the forward contracts were not listed on any security or commodity exchange; that each contract was between the investor as one party and GGS as the other; that the investor could not sell or assign his interest in any contract without the consent of GGS; that if the investor wished to be released from the obligations of a particular forward contract before its settlement date, he had the right to request that GGS cancel the contract; and that if GGS agreed to do so, the investor's account would be credited by GGS with an amount equal to any profit the investor was entitled to receive or charged with any loss he had suffered on the contract plus a fee for the ‘risk and administrative costs created by the cancellation of the contract.‘
The memorandum also stated that each investor was required to have on deposit with GGS a sufficient amount to cover his investment risk which amount would vary with the size of the portfolio and the risk involved but the initial deposit would be a minimum of $10,000 or .125 percent of the face value of the portfolio, whichever was greater. An advisory fee of .001 percent per month was to be paid out of the deposit with GGS to GIM. In addition, an origination fee of .04 percent of the contract's face value was payable on the trade date and the fee for the cancellation of a contract was stated to be .02 percent of the face value on the cancellation date. GGS could also include a markup or a discount on any security covered by a contract.
Potential investors were warned by the disclosure memorandum that they could lose all of their deposit in a relatively short period of time and that in order to achieve a profit the market would have to move in the direction forecast and by an amount that covered all fees plus or minus any markup or discount.
GIM's disclosure memorandum contained fourteen pages, four of which were devoted to the tax treatment that Mr. Gregory thought an investor could expect as a result of entering into a transaction with GGS and GIM. Briefly, the transaction would proceed as follows: (1) The investor would make his deposit and furnish GIM with an interest rate forecast for the next three, twelve and fifteen months. (2) Using the interest forecast GIM, acting as an investment advisor, would prepare a portfolio of forward contracts on Ginnie Maes and Freddie Macs in the face amount required by the deposit and which, if the investor's prediction proved to be correct, would supposedly result in a profit. (3) Each of the forward contracts were entered into by the investor with GGS. In each case the original portfolio for an investor constituted a spread or straddle since 50 percent of the contracts were long positions (contracts to purchase securities) and 50 percent were short positions (contracts to deliver securities). (4) As time passed and it became apparent which leg of the straddle would result in a loss, that leg would be locked in by entering into an offsetting or opposing contract to purchase or sell until such time as the investor wished to realize his gain (presumably after it became a long term capital gain).
According to GIM's memorandum, the tax result of the above transaction would be an ordinary loss for the investor in the year of the cancellation of the loss contracts and a long term capital gain in the year the gain was realized by the sale or assignment of the gain contracts. The memorandum, however, did contain the following caveat:
Due to the tax deferral and conversion of tax characteristics (i.e., capital versus ordinary) involved in the transactions described in this memorandum, the Service may take a strong stance contrary to the opinions expressed herein. Additional legislative action or Service rulings or regulations could also be enacted or issued negating any tax benefits that would otherwise be available to the investor as discussed in this memorandum. Further, if a court should feel that tax deferral or conversion is involved, it might be inclined to hold in favor of the Service, even though the opinions expressed in this memorandum are technically correct. The investor should review the tax treatment of the transactions discussed in this memorandum with his tax advisor and rely only upon the advice of his own tax advisor. The opinions expressed herein are only for purposes of providing information and analysis to the investor and his tax advisor. Attached to the disclosure memorandum is a copy of the Service's Revenue Ruling 77-185, 1977-1 C.B. 48, 50. This ruling holds that ‘(n)either a short-term capital loss created to minimize the tax consequences of an unrelated short-term capital gain through a series of transactions in silver futures contracts, which result in no real economic loss, nor the related out-of-pocket expenses incurred in connection with creating the loss are deductible under section 165(a) of the Code.‘
In spite of the caveat, prospective investors were advised that with a minimum deposit of $10,000 they could obtain forward contracts with GGS having a total face value of $8,000,000. They were also advised that for the minimum deposit, one or the other of the long or short positions (depending on the direction of the movement in the interest rate) would result in an ordinary loss in the approximate amount of ten times the deposit or $100,000.
Each investor was required to sign a client or customer agreement which provided, among other things, that whenever GGS ‘considered it necessary for (its) protection,‘ GGS could liquidate any open position or cancel any order through public or private action with or without notice to the investor; and in the event of death or incapacity of an investor, GGS could take any step it deemed appropriate to cancel or complete any open position. A power of attorney was also obtained from every investor. Under the power of attorney, GGS was authorized to follow the investment instructions of GIM in every respect, and GIM was authorized to act for the investor and perform in his behalf any act which he could perform in person. The power of attorney also contained a provision to the effect that the investor ‘ratified and confirmed any and all transactions with (GGS) heretofore or hereafter made by (GIM) or for (his) account.‘
Even though GGS was a party to each of the forward contracts entered into by petitioners and had the right to include a markup or discount in any transaction, Mr. Gregory and David Solberg, the vice- president and later president of GGS, admitted that neither GGS nor GIM made any profit from the contracts. Instead, their profits were generated from the advisory, origination, cancellation and other fees.
GGS was required by the Deputy Corporation Commissioner for the State of Oregon to establish and maintain a hedging program in publicly traded Ginnie Maes to insure its performance on forward contracts. GGS supposedly satisfied this requirement by hedging its net exposure on the total of its forward contracts by an offset with publicly traded Ginnie Maes.
Under the client agreement, GGS had the authority to determine any price required under the contracts including cancellation prices. In order to arrive at a price, GGS purportedly used an elaborate formula consisting of approximately 20 steps. The first step was the receipt of a quotation in the open market for the then current 8 percent Ginnie Maes. This price was then converted to a yield stated as a percentage which was used in computing a comparable value for the security being priced. The formula contained several other adjustments to be made in arriving at a price for a contract. Surprisingly enough, these included a step which allowed GGS to make any adjustment it felt was appropriate. At trial Mr. Gregory admitted that on more than one occasion price concessions had been made to an investor if he felt that the investor's pricing expectations would be ‘disappointed‘ by adhering too strictly to market quotations or pricing formulas.
Following generally the procedure outlined in GIM's disclosure memorandum, petitioners and all other investors in the program made their respective deposits and furnished their interest forecasts to GIM and in return received documents which indicated their entry into forward contracts with GGS to purchase and sell Ginnie Maes and Freddie Macs. The documents included copies of the interest forecasts, forward contracts, powers of attorney and client agreements referred to in the memorandum. The documents consisted of standard preprinted forms provided by GIM and no negotiation or alterations by the investors was permitted as to their terms except with respect to the interest forecasts. The forms were executed by the investors or were executed for them by GIM pursuant to the powers of attorney. For the most part investors in the Gregory program first became aware of the terms of their contracts when they received the copies from GGS.
The interest rate forecasts made by petitioners for 1979 were as follows:
For illustration purposes, Brown's forecast which was made on October 3, 1979 was to the effect that the 10.9 percent rate at which 8 percent Ginnie Maes were then trading on the Chicago Board of Trade would increase in three months by 40 basis points (.04 percent), decrease in 12 months by 100 basis points (.1 percent), and decrease in 15 months by 150 basis points (.15 percent). Each of the other forecasts can be interpreted in a similar manner.
Each petitioner gave his 1979 forecast to GIM together with his 1979 deposit and shortly thereafter was furnished by GGS with a portfolio containing the forward contracts recommended by GIM and which according to GIM and GGS would generate for petitioner a tax deduction of approximately $10 for each $1 of his deposit plus a gain if petitioner's interest forecast proved to be accurate.
Brown's account number with GGS was 135 and, according to the records of GGS, a transcript of the activity in the account with respect to the 1979 investment is as follows:
The above transcript of Brown's account purportedly indicates that in return for his $10,000 deposit the initial portfolio recommended by GIM for him obtained forward contracts 1-7 (all dated October 4, 1979) of which the first three represented agreements by Brown to buy Ginnie Maes from GGS having a total value of $4,000,000, and the last four of which represented agreements by Brown to sell to GGS Freddie Macs having a total value of $4,000,000. Six days later, on October 10, 1979, the contracts to buy Ginnie Maes (1-3) were cancelled by GGS at an ordinary loss for Brown of $100,160 and the $4,000,000 in Freddie Macs included in the remaining sell contracts (4-7) were offset by contract number 8 to buy Freddie Macs from GGS in the amount of $4,000,000. On October 26, 1979 Brown's position in the buy and sell contracts of 4-8 were locked down by the contracts of 9-13.
On January 22, 1981, both the contracts to buy and the contracts to sell Freddie Macs (4-13) were disposed of at a net long term capital gain to Brown of $106,382 by an assignment to RST Investment Company (‘RST‘), a partnership. RST was an investor with GGS and GIM and its members were business associates of Mr. Gregory. The assignment was executed for Brown by GIM under his power of attorney.
Sochin was a one-sixth participant in GGS's account number 112 which was in the name of Harsh Associates. GGS's transcript of the activity in the account with respect to the 1979 investment is as follows:
The transcript of the Harsh Associates account, in which Sochin was a one-sixth participant, purportedly indicates that for a deposit of $12,000 Harsh Associates received an initial portfolio containing forward contracts 1-7 (all dated September 18, 1979) of which the first three represented agreements by Harsh to buy from GGS Ginnie Maes having a total value of $4,800,000 and the last four represented agreements by Harsh to sell to GGS Freddie Macs having a total value of $4,800,000. Sixteen days later, on October 4, 1979, the contracts to buy Ginnie Maes were cancelled and the contracts to sell $4,800,000 in Freddie Macs as represented by contracts 4-7 were offset by a contract to buy from GGS Freddie Macs in the amount of $4,800,000. On October 23, 1979, Harsh Associates' positions in the buy and sell contracts 4-8 were locked down by contract numbers 9-13. For his proportionate deposit of $2,000 Sochin claimed an ordinary loss from the October 4 cancellation in the amount of $20,080.
On February 12, 1981, both the contracts to buy and the contracts to sell Freddie Macs (4-13) were purportedly disposed of at a net long-term capital gain to Sochin of $21,961 by an assignment to RST. The assignment was executed for Sochin and the other members of Harsh Associates by GIM under its power of attorney.
Morgan was one of six participants in GGS's account number 127. His interest in the account, however, was 31.43 percent. The account was in the name of RMC Associates. The transcript of account number 127 reflects the following activity with respect to the 1979 investment:
OPINION
(1) LOSSES ON FORWARD CONTRACTS
The central issue in these cases is whether the losses claimed by petitioners are bona fide or whether they are based upon an elaborate sham. Respondent contends that the losses were generated in form without any substance, that the underlying transactions were fictitious, and that such transactions existed only within the GGS computer. On the other hand, petitioners contend that the losses were genuine and were the result of bona fide transactions entered into for profit under section 165(c)(2) and are clearly allowable under section 108 of the Tax Reform Act of 1984, Pub. L. 98-369, 98 Stat. 680, or the standard laid down in Smith v. Commissioner, 78 T.C. 350 (1982).
Section 165(a) allows a deduction for a loss sustained during the taxable year that is not compensated for by insurance or otherwise. In the case of individuals, however, the deduction is limited to losses incurred in a trade or business, in a transaction entered into for profit, or as the result of a casualty or theft. Section 165(c). In any event, to be deductible, the claimed loss must be the result of a bona fide transaction, and substance, not mere form, shall be the determining factor. Section 1.165-1(b), Income Tax Regs. See Gregory v. Helvering, 293 U.S. 465 (1935).
Respondent's determination that the underlying transactions are not bona fide is presumptively correct; and petitioners have the burden of proof. Welch v. Helvering, 290 U.S. 111, 115 (1933); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Rule 142(a).
A careful review of the voluminous record leads us to the inescapable conclusion that petitioners have failed to establish that the transactions leading to their alleged losses were bona fide. In fact, from the record as a whole, we are satisfied that petitioners have failed to establish that the entire program from which the losses allegedly arose did not exist solely to provide tax benefits for its investors.
All of the forward contracts promoted by Mr. Gregory were between GGS as one party and one petitioner or some other participant as the other party. Furthermore, each petitioner as well as all other participants executed a power of attorney which authorized GGS and/or GIM to execute and perform any act for the investor with respect to the contracts that GGS and GIM deemed expedient and at a price determined by GGS and adjusted for any reason which GGS considered appropriate. In addition, an ultimate profit obviously could be, and at times was to a nominal extent, manipulated by GGS merely by foregoing a part of the fees cited in the disclosure memorandum or by utilizing its pricing formula.
These cases are analogous to if not factually indistinguishable from the situation recently considered by us in Julien v. Commissioner, 82 T.C. 492 (1984). In Julien v. Commissioner, supra, we disallowed interest deductions on alleged indebtedness incurred to purchase silver bullion in a series of purported cash and carry silver straddles. Having found that the taxpayers never actually purchased any silver nor incurred any real indebtedness, we concluded that the underlying transaction was a factual sham and served no economic purpose beyond generating a tax deduction for interest. Commenting on the lack of risk due to the fixed nature of the straddles involved in Julien, we stated at 508:
It seems self-evident that, in any commodity straddle, a legitimate investor must have some potential of making money as a result of various market forces and, by the same token, be a(t) risk of losing money. One commentator has said that ‘A commodity straddle is held in the expectation of profiting from a change in the 'spread’ or 'premium,' the difference in price between two futures contracts. While the price movements of the two contracts will have some relationship to each other, as the prices will be affected by similar economic conditions, neither in theory nor in practice are the fluctuations identical.‘ See R. Dailey, ‘Commodity Straddles in Retrospect: Federal Income Tax Considerations,‘ 47 Brooklyn L. Rev. 321 (Winter, 1981). Presumably, fluctuations would also occur in a case where the investor holds silver bullion against a forward contract, if the end result were not, as here, prearranged.
In Falsetti v. Commissioner, 85 T.C. 332 (1985), we found that an alleged sale was a ‘sham in substance‘ which we defined as being ‘the expedient of drawing up papers to characterize transactions contrary to objective economic realities and which have no economic significance beyond expected tax benefits.‘
The facts before us are also somewhat similar to those described in United States v. Winograd, 656 F.2d 279, 281 (7th Cir. 1981), affirming defendant's conviction under section 7206(2) of conspiring to impair the collection of income taxes by claiming losses on tax straddles in futures contracts in Mexican pesos which were not entered into through bona fide trades or open bids on an established market but instead were prearranged uncompetitive trades done between various employees of one of the principals involved. See also United States v. Turkish, 623 F.2d 769 (2d Cir. 1980); United States v. Siegel, 472 F. Supp. 440 (N.D. Ill. 1979). The conclusion that the disputed transactions in the cases before us are not bona fide is even more appropriate in view of our finding that GGS was not only a party to each of the forward contracts but also in most instances executed, cancelled and assigned the contracts under powers of attorney for the other parties. Furthermore, the contracts were executed, cancelled and assigned at prices determined solely by GGS and the only third parties to any of the transactions (RST and NIG) were closely associated with Mr. Gregory through business or otherwise.
(2) FEES PAID WITH RESPECT TO FORWARD CONTRACTS
Fees paid by petitioners to GGS were paid so that they could participate in Gregory's program. Inasmuch as we have found that the program was operated solely to provide tax deductions for its participants, the fees constituted payments to purchase such deductions and as such are, at best, personal expenditures which are not deductible under section 162 or section 212. 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).
(3) ADDITIONS TO TAX UNDER SECTION 6653(a)
Respondent determined that an addition to tax is due from petitioners, Ellison C. and Linda Morgan, for negligence under section 6653(a). In view of our finding hereinbefore that the underlying transactions were in fact shams, and in view of our subsequent finding that petitioner, Ellison C. Morgan, knew or should have known at the time that they were shams, it is apparent that he ignored applicable law and regulations in the preparation of his returns. Consequently, respondent's determination that additions to tax are due from Ellison C. Morgan under section 6653(a) is sustained.
(4) DAMAGES UNDER SECTION 6673
Finally, we turn to respondent's request that damages be imposed against petitioners in each of these cases under section 6673. With respect to this issue and from the record as a whole, we are satisfied that, in spite of their protestations to the contrary, petitioners, Dennis S. Brown, James E. Sochin, Ellison C. Morgan and James N. Leinbach, were mature, well educated, and well-read individuals who were sufficiently knowledgeable and sophisticated with respect to business and tax matters to have known, and actually did know, at the time the disputed transactions were entered into, that the transactions were ‘too good‘ to be real and therefore were shams. However, transactions involving forward contracts and especially forward contracts entered into with respect to Ginnie Maes and Freddie Macs are extremely complicated and, during the years under consideration, were relatively new. Furthermore, from the time the petitions were filed in these cases up to and after the date of trial, the law with respect to tax straddles was uncertain. See Miller v. Commissioner, 84 T.C. 827 (1985); Forseth v. Commissioner, 85 T.C. 127 (1985); and Julien v. Commissioner, 82 T.C. 492 (1984). Consequently, we are reluctant to conclude that petitioners were also aware that tax claims stemming from their transactions with Gregory and his associates might constitute a basis for the imposition of damages under section 6673, although the Supreme Court had held for many years that claims based upon unreal and sham transactions were not recognizable for tax purposes. See Gregory v. Helvering, 293 U.S. 465 (1935); Higgins v. Smith, 308 U.S. 473 (1940); and Knetsch v. Commissioner, 364 U.S. 361 (1960), affg. 272 F.2d 200 (9th Cir. 1959). We hereby serve notice, however, that henceforth we will have no such reluctance with respect to petitioners who file petitions or maintain positions based upon transactions which they knew or reasonably should have known to be factual shams.
We feel that such action is warranted because Congress is concerned with the substantial increase in the number of petitions pending before the Tax Court and especially those petitions based upon frivolous or groundless claims. The concern of Congress in this connection is apparent from the Conference Report on the consideration of section 6621(d)(4) dealing with increased interest on substantial underpayments attributable to tax motivated transactions. There it is stated:
The conferees note that a number of the provisions of recent legislation have been designed, in whole or in part, to deal with the Tax Court backlog. Examples of these provisions are the increased damages assessable for instituting or maintaining Tax Court proceedings primarily for delay or that are frivolous or groundless (sec. 6673), the adjustment of interest rates (sec. 6621), the valuation overstatement and substantial understatement penalties (secs. 6659 and 6661), and the tax straddle rules (secs. 1092 and 1256). * * *
The conferees believe that, with this amendment, the Congress has given the Tax Court sufficient tools to manage its docket, and that the responsibility for effectively managing that docket and reducing the backlog now lies with the Tax Court. The positive response that the Court has made to several recent GAO recommendations is encouraging and the conferees expect the Court to implement swiftly these and other appropriate management initiatives. The conferees also note favorably the steps the Court has begun to take in consolidating similar tax shelter cases and dispensing with lengthy opinions in routine tax protester cases. The Court should take further action in these two areas, as well as to assert, without hesitancy in appropriate instances, the penalties that the Congress has provided. (H. Rept. 98-861 (Conf.)(1984), 1984-3 C.B. (Vol. 2) 1, 239.)
Our own concern for the continuing increase in the number of petitions based upon frivolous or groundless claims has been clearly expressed in such opinions as Sydnes v. Commissioner, 74 T.C. 864, 872 (1980), where we stated:
While in the past we have been reluctant to impose damages in cases involving persons other than those who were merely protesting the Federal tax laws, we think the imposition of damages in the circumstances here is fully warranted. Moreover, since the statute does not restrict us to those cases in which a party has requested us to impose damages, we think we should do so, on our own motion, where the facts and circumstances so dictate.
Here, the Court and respondent have been required to consider the same issue twice after it had already been decided by this Court and affirmed by the Court of Appeals. Petitioners with more genuine controversies have been delayed while we considered these cases involving the same issue. In these circumstances, the petitioner, an accountant with some knowledge of the Federal tax laws, cannot and has not shown that he, in good faith, has a colorable claim to challenge the Commissioner's determination. Indeed, he knew when he filed the present case with this Court that he had no reasonable expectation of receiving a favorable decision. No reasonably prudent person could have expected this Court to reverse itself in this situation.
In Oneal v. Commissioner, 84 T.C. 1235, 1243-1244 (1985), we warned such petitioners as follows:
We have frequently found that cases based upon meritless contentions and stale arguments are burdensome both on this Court and upon society as a whole. See Abrams v. Commissioner, 82 T.C. 403 (1984). The time spent upon this case has delayed other cases of merit which could have provided new precedents to the tax system. Petitioners' brief, much like their abusive tax shelter ‘investment,‘ was merely a prepackaged, pro forma presentation.
Upon review of this record, we find that petitioners' positions are frivolous and groundless and that this proceeding was instituted and maintained primarily for delay. We admonish other petitioners and their counsel not to maintain frivolous proceedings before this Court or to maintain them primarily for delay.
The Court of Appeals for the Ninth Circuit has, in a summary and decisive manner, awarded double costs in several tax protester cases on its own motion. On July 7, 1982, in Edwards v. Commissioner, 680 F.2d 1268, 1271 (9th Cir. 1982), affg. per curiam an unreported decision of this Court, the Court said
Meritless appeals of this nature are becoming increasingly burdensome on the federal court system. WE FIND THIS APPEAL FRIVOLOUS. Fed. R. App. P. 38, and accordingly award double costs to appellee (the Commissioner of Internal Revenue). * * * (Citations omitted; emphasis added in 82 T.C.) Accord McCoy v. Commissioner, 696 F.2d 1234 (9th Cir. 1983), affg. 76 T.C. 1027 (1981); Barmakian v. Commissioner, 698 F.2d 1228 (9th Cir. 1982), affg. without published opinion an unreported order and decision of this Court; Martindale v. Commissioner, 692 F.2d 764 (9th Cir. 1982), affg. without published opinion an unreported order and decision of this Court.
It is now certain that all Courts will no longer tolerate the filing of frivolous appeals. On June 13, 1983, the Supreme Court, for the first time, invoked the provisions of its rule 49.2, which the Court adopted in 1980, and ordered an appellant to pay damages for bringing a frivolous appeal. In Tatum, Elmo C. v. Regents of Nebraska-Lincoln (No. 82-6145), the Court issued the following order: ‘The motion of respondents for damages is granted and damages are awarded to respondents in the amount of $500.00 pursuant to Supreme Court Rule 49.2.‘
The direction of this nation's highest court is crystal clear—that no court should permit frivolous or groundless appeals, not only in discrimination suits but in any other area of litigation, including Federal income taxation. The language of amended section 6673 is equally clear. (Footnotes omitted.)