By Jeffrey A. Galant, Counsel to Meltzer, Lippe, Goldstein & Breitstone, LLP Business & Real Estate Taxation practice group.
Great artists, including the likes of Rodin, Munch, Klimt and Schiele, have portrayed in various ways the simple and very human act of kissing. Behind the scenes, of course, one can imagine the complex nature of things.
Admittedly, it is an imperfect metaphor for promoting an adherence to the KISS principle (i.e., keeping it simple), especially when engaging in tax sensitive transactions such as trading foreign currency contracts. The case of the Wrights suggests its relevance. (Wright v. Commissioner, TC Memo 2024-100)
While being careful to dot their “i’s” and cross their “t’s” with respect to the complicated rules of section 1256 of the Internal Revenue Code, this attention to detail only took the Wrights so far in their quest to offset substantial capital gains that they had realized in 2002. They apparently gave little thought to section 165(c)’s limitation on an individual’s ability to deduct losses. More about this shortly.
In a nutshell, while section 1256 requires unrealized gains and losses on certain foreign currency contracts to be realized for federal income tax purposes, the deductibility by an individual of any such losses is subject to the loss limitation rules of section 165. An individual pursuant to section 165(c) may deduct losses incurred in a trade or business, or in a transaction entered into for profit, as well as certain theft and casualty losses.
In a year like 2024, when the S & P 500 has so far risen by more than 25%, year-end tax planning may require harvesting losses to offset some or all of the gains that have been realized. A legitimate endeavor to be sure when a loss is realized due to the disposition of property that has declined in value. Taxpayers may feel pressure to find losses in the current environment but should remain wary of proposals that appear too good to be true.
The Hunt for Losses: Major-Minor Euro Straddles
The case of the Wrights provides an interesting take on the hunt for losses. Terry and Cheryl Wright sought capital losses in 2002, a year during which substantially appreciated shares of C-COR Electronics, which they either owned directly or through their 50-50 owned pass-through tax partnership, Cyber Advice, LLC (“Cyber Advice”), were sold for long-term capital gains of approximately $3.5 million. Apparently, at the time the Wrights did not have sufficient depreciated assets at hand to offset such capital gains.
Based upon the recommendations of their accountant and estate planning lawyer, the Wrights decided to pursue euro straddle transactions as part of a strategy involving so-called major-minor foreign currency option transactions. The straddles were of euro/dollar options, i.e., options which were connected to the exchange rate between the euro and the dollar, and of Danish krone (DKK)/dollar options, i.e., options which were connected to the exchange rate between the DKK and the dollar.
Essential to the strategy, at the time the DKK was basically tied to the euro due to actions of the European and Danish Central Banks, the key result being that any movement in the euro/dollar exchange rate would be mirrored in the DKK/dollar exchange rate.
Engaging in these mirrored straddle transactions, although very large in nominal dollar terms, led to a quite small out of pocket loss for the Wrights, since the gains and losses realized were basically offset against each other in the straddle transactions. Not to get too bogged down in the technicalities, the straddles consisted of the purchase on Dec. 20, 2002 by Cyber Advice of a euro put option and a euro call option, and a sale by Cyber Advice to a counterparty of a DKK put option and DKK call option, each option having a nominal premium of approximately $36 million for the right to either acquire or sell, as the case may be, on June 13, 2003 certain currency for $1.26 billion.
In short, Cyber Advice assigned the euro put option and the rights associated with the DKK put option to a charitable organization to trigger a termination of the euro put option and thereby realized a loss. The Wrights claimed that the minor gains in the DKK put option was not realized under section 1256 since the DKK, being traded over the counter, was a so-called “minor” currency, and therefore the section 1256 mark-to-market rule, discussed shortly, did not apply. To finish the loop, Cyber Advice offset the euro call option against the DKK call option and thereby netted the gains and losses.
The results of these transactions were that Cyber Advice realized short-term capital loss of approximately $3.1 million in December of 2002 on the euro put option, deferred the gain on the DKK put option and netted out the call options without any further realization of gain or loss. The $3.1 million short-term capital loss passed through Cyber Advice to the Wrights and was used by them to offset a substantial part of the $3.5 million capital gain realized on the sale of their C-COR Electronics shares.
Realization and Section 1256
The Wrights tried to take advantage of the section 1256 mark-to-market rule. Section 1256 requires that with respect to certain foreign currency contracts held at year-end, the unrealized gain or loss in such contracts be marked to market so that gain or loss is realized. Additionally, gain or loss is required to be realized on contracts which are “terminated” during the year (i.e., where the taxpayer’s obligation or rights regarding any such contract are terminated) or otherwise transferred during the year.
Furthermore, in all such cases gains or losses are treated as 40% short-term capital gain or loss and 60% long-term capital gain or loss. With respect to the preliminary issue of whether the options involved were foreign currency contracts for the purposes of section 1256, the Sixth Circuit held that the euro put option was a foreign currency contract for such purposes. Wright v. Commissioner, 809 F.3d 877 (6th Cir. 2016).
Good news for the Wrights! They were now able to apply the mark-to-market rules of section 1256 with respect to their euro put option. Pushing ahead with their strategy, the Wrights claimed that the mark-to-market rules did not apply to their DKK put option since it did not constitute a foreign currency contract for section 1256 purposes due to the Danish krone being a minor currency traded over the counter.
Accordingly, the Wrights took the position that the gain inherent in the option remained unrealized. This resulted in the Wrights realizing a large enough loss to offset most of the gain realized on their sale of the C-COR Electronics shares. Most significant is that notwithstanding all the machinations, the Wrights did not suffer an economic loss.
To be sure the Sixth Circuit, while just dealing with the legal issue of whether the euro put option was a foreign currency contract for section 1256 purposes, was clearly frustrated with the Wrights aggressive manipulation of section 1256 to obtain a loss without economic risk.
The Sixth Circuit mused, this interpretation of §1256 seems to allow the Wrights to engineer a desired tax loss by paying only a minimal cash outlay and by engaging in major-minor transactions that subject the Wrights to little actual economic risk. Although these transactions involve large sums of dollars, euros, and krones, these transactions appear to have subjected the Wrights to little actual economic risk because the four options in the major-minor transactions offset each other.
Further, when the premium payments are netted against each other, the transactions subjected the Wrights to a short-term capital loss of only $25,200. Accordingly, the Wrights were able to pay $50,200 out of pocket—based upon the Wrights’ short-term capital loss of $25,200 and payment of $25,000 to a tax attorney for a tax opinion—in order to reduce their taxes by at least the $603,093 deficiency upheld by the Tax Court.
Moreover, the Wrights did not plausibly explain how engaging in transactions involving transfers of offsetting foreign currency options that opened and closed over the course of three days could accomplish the Wrights’ stated goals of investment diversification and realization of a significant economic return. Accordingly, the Wrights appear to have engaged in the major-minor transactions primarily to generate the desired tax loss.
Profit Motive and Section 165
Unfortunately for the Wrights, section 1256 was only part of the story, and clearly did not ultimately provide for the relief sought. In fact, the Tax Court, on remand from the Sixth Circuit, did not think it necessary to further delve into the intricacies of section 1256 because of the threshold need to overcome section 165’s limitation on the deduction of losses.
Apparently neglected by the Wrights and their advisers was the profit motive requirement of section 165(c). The Wrights argued that in the case of capital gain-type transactions as in issue here, the profit motive requirement of section 165(c) did not apply and cited sections 1211(b) and 1256(a) as support. The Tax Court rejected the argument.
Cyber Advice was not engaged in a trade or business, so the issue was whether the straddle transactions were entered into for profit. The inquiry into profit motive allowed the Tax Court to avoid dwelling on the section 1256 weeds since the Wrights were unable to prove that Cyber Advice entered the December 2002 foreign currency option transactions with the primary motive of making a profit.
Judge Marval set out the guidelines that the Tax Court typically applies in determining whether a taxpayer has entered a transaction primarily for profit, as follows:
- The ultimate issue is profit motive and not profit potential. However, profit potential is a relevant factor to be considered in determining profit motive.
- Profit motive refers to economic profit independent of tax savings.
- The deductibility or non-deductibility of a loss is determined by the overall scheme, not merely by the losing legs of a position.
- 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.
- 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.
What about the Arbitrage Possibility?
To further complicate things, the euro and DKK straddles each contained a so-called “digital kicker.” The digital kickers provided a theoretical opportunity to realize a profit (a so-called “sweet spot payment”) based on an arbitrage between the euro and DKK rates. As previously noted, the Wrights neither suffered economic loss nor were able to show a profit motive for the straddle transactions. Judge Marval, while acknowledging the potential arbitrage opportunity, described credible expert testimony to the effect that there was a low probability of any profit being realized due to the way the straddles were structured and the fact that Cyber Advice, when it was bargaining with the counterparty, failed to protect its own economic interest with respect to the digital kickers.
Nice try by the Wrights, but the digital kickers did not provide enough of an expectation of profit to impress Judge Marval.
Jeffrey A. Galant is counsel to Meltzer, Lippe, Goldstein & Breitstone’s business & real estate taxation, trusts and estates, tax exempt organizations and private wealth and taxation practice groups.
Read the full article here.
Reprinted with permission from the New York Law Journal, An ALM Publication