Calloway v. Commissioner

LIZZIE W. AND ALBERT L. CALLOWAY, PETITIONERS

v. COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Docket No. 8438–07. Filed July 8, 2010.

In August 2001 P entered into an agreement with Derivium

whereby P transferred 990 shares of IBM common stock to

Derivium in exchange for $93,586.23. The terms of the agree-

ment characterized the transaction as a loan of 90 percent of

the value of the IBM stock pledged as collateral. The pur-

26

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(26) CALLOWAY v. COMMISSIONER 27

ported loan was nonrecourse and prohibited P from making

any interest or principal payments during the 3-year term of

the purported loan. The terms of the agreement allowed

Derivium to sell the stock, which it did immediately upon

receipt. At maturity P had the option of either paying the bal-

ance due and having an equivalent amount of IBM stock

returned to him, renewing the purported loan for an addi-

tional term, or satisfying the ‘‘loan’’ by surrendering any right

to receive IBM stock. At maturity in August 2004 the balance

due was $40,924.57 more than the then value of the IBM

stock. P elected to satisfy his purported loan by surrendering

any right to receive IBM stock. P was not required to and did

not make any payments toward either principal or interest on

the purported loan.

1. Held: The transaction between P and Derivium in August

2001 was a sale. P transferred all the benefits and burdens

of ownership of the stock to Derivium for $93,586.23 with no

obligation to repay that amount.

2. Held, further, the transaction was not analogous to the

securities lending arrangement in Rev. Rul. 57–451, 1957–2

C.B. 295, nor was it equivalent to a securities lending

arrangement under sec. 1058, I.R.C.

3. Held, further, Ps are liable for an addition to tax under

sec. 6651(a)(1), I.R.C., for the late filing of their 2001 Federal

income tax return.

4. Held, further, Ps are liable for the accuracy-related pen-

alty pursuant to sec. 6662, I.R.C.

Brian G. Isaacson, for petitioners.

Daniel J. Parent, for respondent.

RUWE, Judge: Respondent determined a $30,911 deficiency,

a $6,583 addition to tax under section 6651(a)(1) 1 for failure

to timely file, and a $6,182.20 accuracy-related penalty under

section 6662(a) in regard to petitioners’ 2001 Federal income

tax. The issues we must decide are: (1) Whether a trans-

action in which Albert L. Calloway (petitioner) transferred

990 shares of International Business Machines Corp. (IBM)

common stock to Derivium Capital, L.L.C. (Derivium), in

exchange for $93,586.23 was a sale or a loan; (2) whether the

transaction qualifies as a securities lending arrangement; (3)

whether petitioners are liable for an addition to tax under

section 6651(a)(1) for failure to timely file; and (4) whether

1 All section references are to the Internal Revenue Code as amended, and Rule references

are to the Tax Court Rules of Practice and Procedure.

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28 135 UNITED STATES TAX COURT REPORTS (26)

petitioners are liable for an accuracy-related penalty pursu-

ant to section 6662(a).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulated facts and the attached exhibits are incor-

porated herein by this reference. At the time the petition was

filed, petitioners resided in Georgia.

After petitioner graduated from college in 1964, he began

a successful career with IBM. While employed at IBM peti-

tioner purchased shares of IBM stock.

During 2001 petitioner’s financial adviser, Bert Falls,

introduced him to Derivium and its 90-percent-stock-loan

program. 2 Under that program Derivium would purport to

lend 90 percent of the value of securities pledged to Derivium

as collateral. Derivium was not registered with the New York

Stock Exchange or the National Association of Securities

Dealers/Financial Industry Regulatory Authority. Charles D.

Cathcart was president of Derivium.

On or about August 6, 2001, Derivium sent to petitioner a

document entitled ‘‘Master Agreement to Provide Financing

and Custodial Services’’ (master agreement) with attached

‘‘Schedule D, Disclosure Acknowledgement and Broker/Bank

Indemnification’’ (schedule D). The master agreement pro-

vides, in pertinent part:

This Agreement is made for the purpose of engaging * * * [Derivium] to

provide or arrange financing(s) and to provide custodial services to * * *

[petitioner], with respect to certain properties and assets (‘‘Properties’’) to

be pledged as security, the details of which financing and Properties are

to be set out in loan term sheets and attached hereto as Schedule(s) A

(‘‘Schedule(s) A’’).

The schedule D to be executed in connection with the master

agreement states that the transaction was to ‘‘Provide

Financing and Custodial Services entered into between

Derivium * * * and * * * [petitioner]’’. Paragraph 3 of

schedule D, relating to the pledge of securities, provides, in

pertinent part:

2 The use of the terms ‘‘loan’’, ‘‘collateral’’, ‘‘borrow’’, ‘‘lend’’, ‘‘hedge’’, and ‘‘maturity’’ with all

related terms throughout this Opinion is merely for convenience in describing what petitioners

contend the transaction represents.

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(26) CALLOWAY v. COMMISSIONER 29

[Petitioner] understands that by transferring securities as collateral to

* * * [Derivium] and under the terms of the * * * [master agreement],

* * * [petitioner] gives * * * [Derivium] the right, without notice to * * *

[petitioner], to transfer, pledge, repledge, hypothecate, rehypothecate, lend,

short sell, and/or sell outright some or all of the securities during the

period covered by the loan. * * * [Petitioner] understands that * * *

[Derivium] has the right to receive and retain the benefits from any such

transactions and that * * * [petitioner] is not entitled to these benefits

during the term of a loan. * * * [Emphasis added.]

Derivium also sent to petitioner a document entitled

‘‘Schedule A–1, Property Description and Loan Terms’’

(schedule A–1), which sets forth the essential terms of the

transaction. Schedule A–1 provides:

This Schedule A * * *, dated August 6th, 2001, is executed in connection

with the Master Agreement to Provide Financing and Custodial Services

entered into between Derivium * * * and [petitioner] * * * on 8/6/01.

1. Property Description: 990 shares of International Business Ma-

chines Corporation (IBM).

2. Estimated Value: $105,444.90 (as of 8/6/01, at $106.51 per

share).

3. Anticipated Loan 90% of the market value on closing, in part

Amount: or in whole.

4. Interest Rate: 10.50%, compounded annually, accruing

until and due at maturity.

5. Cash vs. Accrual: All Dividends will be received as cash pay-

ments against interest due, with the balance

of interest owed to accrue until maturity

date.

6. Term: 3 years, starting from the date on which

final loan proceeds are delivered on the loan

transaction.

7. Amortization: None.

8. Prepayment Penalty: 3 year lockout, no prepayment before matu-

rity.

9. Margin Requirements: None, beyond initial collateral.

10. Non-Callable: Lender cannot call loan before maturity.

11. Non-Recourse: Non-recourse to borrower, recourse against

the collateral only.

12. Renewable: The loan may be renewed or refinanced at

borrower’s request for an additional term, on

the maturity date, within * * * [Derivium’s]

prevailing conditions and terms for loans at

the time of renewal or refinancing. On the

renewal or refinancing of any loan for which

90% of the collateral value at maturity does

not equal or exceed the payoff amount, there

will be a renewal fee, which will be cal-

culated as a percentage of the balance due at

maturity of this loan. The percentage will

vary according to the market capitalization

of the securities at the time of the renewal

or refinancing, as follows: Large Caps at

4.5%, Mid Caps at 5.5%, Small Caps at 6.5%.

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30 135 UNITED STATES TAX COURT REPORTS (26)

13. Closing: Upon receipt of securities and establishment

of * * * [Derivium’s] hedging transactions.

Before entering into the agreement with Derivium, peti-

tioner reviewed a memorandum dated December 12, 1998,

from Robert J. Nagy, who claimed to be a certified public

accountant, to Mr. Cathcart regarding the ‘‘Tax Aspects of

First Security Capital’s 90% Stock Loan’’ that was requested

by Mr. Cathcart. In the memorandum Mr. Nagy describes a

potential client as one who owns publicly traded stock with

a low basis, which if sold would result in significant gain to

the client. Mr. Nagy describes the primary issue as whether

the 90-percent-stock-loan transaction is a sale or a loan and

opines that, although there is no ‘‘absolute assurances that

the desired tax treatment will be achieved’’, there is a ‘‘solid

basis for the position that these transactions are, in fact,

loans.’’ Petitioner relied on Mr. Nagy’s memorandum to Mr.

Cathcart in deciding whether to enter into the agreement.

Petitioner testified that a loan versus a sale transaction

made economic sense to him because the loan proceeds given

to him were 90 percent of the value of the IBM stock whereas

if he had sold the stock he would have had to pay 20 percent

for taxes.

Petitioner decided to enter into the 90-percent-stock-loan

program (transaction) with Derivium. Petitioner signed the

master agreement, the schedule D, and the schedule A–1 on

August 8, 2001. Charles D. Cathcart, as president of

Derivium, signed the master agreement and the schedule A–

1 on August 10, 2001.

On or about August 9, 2001, petitioner instructed Brian J.

Washington of First Union Securities, Inc., to transfer 990

shares of IBM common stock (IBM stock or collateral) to

Morgan Keegan & Co. (Morgan Keegan) and to credit

Derivium’s account. On August 16, 2001, Morgan Keegan

credited Derivium’s account with the IBM stock transferred

from petitioner. The following day, August 17, 2001,

Derivium sold the 990 shares of IBM stock held in its Morgan

Keegan account for $103,984.65 (i.e., $105.035 per share of

IBM common stock). The net proceeds from Derivium’s sale of

the IBM stock were $103,918.18 (i.e., $103,984.65 minus a

$3.47 ‘‘S.E.C. Fee’’ and a $63 ‘‘Commission’’). On August 22,

2001, the net proceeds from the sale of the IBM stock settled

into Derivium’s Morgan Keegan account.

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(26) CALLOWAY v. COMMISSIONER 31

On or about August 17, 2001, Derivium’s operations office

sent to petitioner two documents. The first document, enti-

tled ‘‘Valuation Confirmation’’, indicates that Derivium had

received the IBM stock into its Morgan Keegan account val-

ued at $104,692.50 (at a ‘‘Price per Share for Valuation’’ of

$105.75). Thus, Derivium projected the amount it would lend

to petitioner as $94,223.25. The second document, entitled

‘‘Activity Confirmation’’, however, indicates that as of August

17, 2001, Derivium had ‘‘hedged’’ the IBM stock for a ‘‘hedged

value’’ of $103,984.70. 3 On the basis of the ‘‘hedged’’ value

Derivium determined petitioner’s actual ‘‘loan’’ amount as

$93,586.23 (i.e., 90 percent of $103,984.70). Thus, the ‘‘loan’’

amount was not determined until after Derivium sold the

IBM stock.

On August 21, 2001, Derivium sent to petitioner a letter

informing him that the proceeds of the loan were sent to him

according to the wire transfer instructions he had provided

a few days earlier. On that same date, a $93,586.23 wire

transfer was received and credited to petitioner’s account at

IBM Southeast Employees Federal Credit Union.

During the term of the ‘‘loan’’ Derivium provided petitioner

with quarterly and yearend account statements. The quar-

terly account statements reported ‘‘end-of-quarter collateral

value’’ and dividends such that it appeared that Derivium

still held the IBM stock (i.e., Derivium appears to have

reported the value of the collateral on the basis of the fair

market value of the IBM stock at the end of each calendar

quarter rather than the $103,984.65 of sale proceeds, and

further reported dividends on the IBM stock, which it credited

against the interest accrued during the quarter, as if it

continued to hold all 990 shares of IBM stock). Petitioner nei-

ther received a Form 1099–DIV, Dividends and Distributions,

nor included any IBM dividend income from the alleged divi-

dends paid on the IBM stock on petitioners’ 2001, 2002, 2003,

or 2004 Federal income tax return.

In a letter dated July 8, 2004, Derivium informed peti-

tioner that the loan ‘‘will mature on August 21, 2004’’ and

3 Derivium’s Morgan Keegan account statement reflects a sale price of $103,984.65 for the 990

shares of IBM common stock. The difference between Derivium’s ‘‘hedged value’’ of $103,984.70

and the $103,984.65 reported on Derivium’s Morgan Keegan account statement appears to be

due to rounding. The Morgan Keegan statement reports the share price at the time of sale at

$105.035, whereas Derivium’s ‘‘Activity Confirmation’’ report indicates the share price at the

time the shares were ‘‘hedged’’ at $105.03505.

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32 135 UNITED STATES TAX COURT REPORTS (26)

that the ‘‘total principal and interest that will be due, and

payable on the Maturity Date is $124,429.09’’. The letter also

informed petitioner that, as of July 8, 2004, the value of 990

shares of IBM stock was $83,318.40. Derivium also reiterated

to petitioner that, pursuant to the terms and conditions of

the master agreement, he was entitled to elect one of the fol-

lowing three options at maturity: (1) ‘‘Pay the Maturity

Amount and Recover Your Collateral’’; (2) ‘‘Renew or

Refinance the Transaction for an Additional Term’’; or (3)

‘‘Surrender Your Collateral’’.

On July 27, 2004, petitioner responded to Derivium’s July

8, 2004, letter, stating that ‘‘I/we hereby officially surrender

my/our collateral in satisfaction of my/our entire debt obliga-

tion’’; i.e., petitioner relinquished the right to acquire the IBM

stock valued at $83,326.32 4 and never made any payments

of principal or interest on the $124,250.89 balance due on the

‘‘loan’’.

On September 8, 2004, Derivium sent to petitioner a letter

notifying him that the loan matured on August 21, 2004, and

that the balance due was $40,924.57 more than the value of

the IBM stock on the maturity date. The parties stipulate

that the price per share of IBM stock was $105.03 on August

17, 2001, and approximately $84.16 on July 8, 2004.

On February 11, 2004, petitioners filed their 2001 joint

Federal income tax return. Petitioners did not report the

$93,586.23 received from Derivium in exchange for the IBM

stock on their 2001 Federal income tax return, nor did they

report the termination of the transaction with Derivium on

their 2004 Federal income tax return.

Petitioner’s cost basis in the 990 shares of IBM stock was

$21,171. 5

OPINION

The primary issue is whether the transaction, in which

petitioner transferred his IBM stock to Derivium and received

$93,586.23, was a sale or a loan. Surprisingly, this case pre-

4 The Sept. 8, 2004, letter indicates that the collateral, the IBM stock, was valued at

$83,326.32 ‘‘using the average of the closing prices, as reported by the Wall Street Journal, for

the ten trading days prior to the maturity date.’’

5 In the notice of deficiency respondent’s determination was made using a cost basis of $10,399

for petitioner’s 990 shares of IBM stock.

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(26) CALLOWAY v. COMMISSIONER 33

sents an issue of first impression in this Court. 6 Neverthe-

less, there are many cases that provide us with guiding prin-

ciples.

The master agreement between petitioner and Derivium

refers to the transaction as a loan; however, ‘‘Federal tax law

is concerned with the economic substance of the transaction

under scrutiny and not the form by which it is masked.’’

United States v. Heller, 866 F.2d 1336, 1341 (11th Cir. 1989);

see also Commissioner v. Court Holding Co., 324 U.S. 331,

334 (1945) (‘‘The incidence of taxation depends upon the sub-

stance of a transaction. * * * To permit the true nature of

a transaction to be disguised by mere formalisms, which

exist solely to alter tax liabilities, would seriously impair the

effective administration of the tax policies of Congress.’’);

Gregory v. Helvering, 293 U.S. 465, 470 (1935) (finding the

economic substance of a transaction to be controlling and

stating: ‘‘To hold otherwise would be to exalt artifice above

reality and to deprive the statutory provision in question of

all serious purpose.’’).

Whether the Transaction Was a Sale of IBM Stock

‘‘The term ‘sale’ is given its ordinary meaning for Federal

income tax purposes and is generally defined as a transfer of

property for money or a promise to pay money.’’ Grodt &

McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237

(1981) (citing Commissioner v. Brown, 380 U.S. 563, 570–571

(1965)). Since the economic substance of a transaction, rather

than its form, controls for tax purposes, the key to deciding

whether the transaction was a sale or other disposition is to

determine whether the benefits and burdens of ownership of

the IBM stock passed from petitioner to Derivium. Whether

the benefits and burdens of ownership have passed from one

taxpayer to another is a question of fact that is determined

from the intention of the parties as established by the writ-

ten agreements read in the light of the attending facts and

circumstances. See Arevalo v. Commissioner, 124 T.C. 244,

251–252 (2005), affd. 469 F.3d 436 (5th Cir. 2006). Factors

6 There are now other cases pending in the Tax Court involving Derivium transactions. We

understand that from 1998 to 2002 Derivium engaged in approximately 1,700 similar trans-

actions involving approximately $1 billion. Derivium Capital L.L.C. v. United States Trustee, 97

AFTR 2d 2006–2582, at 2006–2583 to 2006–2584 (S.D.N.Y. 2006). The Government estimated

the total tax loss associated with Derivium’s scheme to be approximately $235 million. Com-

plaint, United States v. Cathcart, No. 07–4762 (N.D. Cal. filed Sept. 17, 2007).

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34 135 UNITED STATES TAX COURT REPORTS (26)

the courts have considered in making this determination

include: (1) Whether legal title passes; (2) how the parties

treat the transaction; (3) whether an equity interest in the

property is acquired; (4) whether the contract creates a

present obligation on the seller to execute and deliver a deed

and a present obligation on the purchaser to make payments;

(5) whether the right of possession is vested in the pur-

chaser; (6) which party pays the property taxes; (7) which

party bears the risk of loss or damage to the property; and

(8) which party receives the profits from the operation and

sale of the property. See id. at 252; see also Grodt & McKay

Realty, Inc. v. Commissioner, supra at 1237–1238.

Applying the above factors leads us to the conclusion that

petitioner sold his IBM stock to Derivium in 2001.

(1) Whether Legal Title Passed

On August 16, 2001, petitioner transferred the IBM stock to

Derivium’s Morgan Keegan account. The master agreement

provides that once Derivium received the IBM stock,

Derivium was authorized to sell it without notice to peti-

tioner. Derivium immediately sold the stock. Thus, legal title

to the stock passed to Derivium in 2001 when petitioner

transferred the IBM stock pursuant to the terms of the

master agreement. 7

(2) The Parties’ Treatment of the Transaction

In the master agreement the parties characterize the

transaction as a loan and characterize the IBM shares as

collateral. However, on August 17, 2001, the day after it

received the IBM stock, Derivium sold it. Derivium did not

determine the value of the so-called loan to petitioner until

after it had determined the proceeds it would receive from

the sale of the IBM stock. Although petitioner testified that

he did not know Derivium had sold the IBM stock and that

he believed Derivium was only acting as a custodian of the

stock, petitioner admitted that when he signed the agree-

ment he knew that he had authorized Derivium to sell the

7 Legal title is one of several factors in our test and may not be determinative in every situa-

tion; e.g., brokers holding stock for the accounts of customers or as security for advances under

highly regulated conditions. See Provost v. United States, 269 U.S. 443 (1926). Indeed, Congress

has provided that certain types of security lending arrangements do not have to be recognized

as taxable transactions if they meet the strict requirements of sec. 1058. See infra pp. 42–45.

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(26) CALLOWAY v. COMMISSIONER 35

stock. 8 Petitioners did not report dividends paid on the IBM

stock on their 2001, 2002, 2003, or 2004 Federal income tax

return, and petitioner was never required to repay any of the

principal or interest on the ‘‘loan’’. Indeed, even though peti-

tioners argue that the ‘‘sale’’ of their IBM stock occurred in

2004, they failed to report the ‘‘sale’’ of their IBM shares on

their 2004 Federal income tax return. They also failed to

alternatively report any relief of indebtedness income from

the transaction on their 2004 return. In short, petitioners did

not treat this transaction in a manner consistent with their

own characterization of the transaction.

(3) Equity Inherent in the Stock

Derivium acquired all property interests in the IBM stock,

and the next day all of Derivium’s interest in the stock

was sold. Petitioner retained no property interest in the

stock. At best he had an option to purchase an equivalent

number of IBM shares after 3 years at a price equivalent to

$93,586.23 plus ‘‘interest’’. The effectiveness of the option

depended on Derivium’s ability to acquire and deliver the

required number of IBM shares in 2004.

(4) Obligation To Deliver and Pay

The master agreement obligates petitioner to transfer the

IBM stock to Derivium and Derivium to pay 90 percent of the

fair market value of the stock. The amount Derivium had to

pay was determined after Derivium sold the IBM stock.

8 At trial petitioner testified:

Q What responsibilities do you believe that Derivium, let’s call it DC, Derivium Capital, had

to you?

A They had a responsibility of protecting me throughout that three-year period to ensure

that the stock was there at the completion of the transaction.

Q Would this enable you to the return of your IBM shares?

A That would enable me to buy back my shares, yes.

* * * * * * *

Q Had they sold the shares, what percentage would you have received?

A Had they sold? Well, they had the right to sell it.

Q Wait, wait, hold on a second. Let’s give him a chance to—are we ready? Okay.

A I would not have received anything because they had the right, that was something that

I agreed to, but they also had the responsibility as a custodian to return to me the total number

of 990 shares at the completion of the transaction.

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36 135 UNITED STATES TAX COURT REPORTS (26)

(5) Whether the Right of Possession Passed

Derivium obtained title to, possession of, and complete con-

trol of the IBM stock from petitioner. Derivium immediately

exercised those rights and sold the stock.

(6) Payment of Property Taxes

This factor is inapplicable under the facts of this case.

(7) The Risk of Loss or Damage

Upon receipt of the $93,586.23 from Derivium in 2001,

petitioner bore no risk of loss in the event that the value of

the IBM stock decreased. Petitioner was entitled to retain all

the funds transferred to him regardless of the performance

of the IBM stock in the financial marketplace.

(8) Profits From the Property

The master agreement provides:

[Petitioner] gives * * * [Derivium] the right, without notice to * * * [peti-

tioner], to transfer, pledge, repledge, hypothecate, rehypothecate, lend,

short sell, and/or sell outright some or all of the securities during the

period covered by the loan. * * * [Petitioner] understands that * * *

[Derivium] has the right to receive and retain the benefits from any such

transactions and that * * * [petitioner] is not entitled to these benefits

during the term of a loan. * * *

At best the master agreement gave petitioner an option to

repurchase IBM stock from Derivium at the end of the 3

years; 9 however, this option depended on Derivium’s ability

to acquire IBM stock in 2004. The foregoing factors indicate

that the transaction was a sale of IBM stock in 2001.

In the context of taxation, courts have defined a loan as

‘‘ ‘an agreement, either express or implied, whereby one per-

son advances money to the other and the other agrees to

9 Petitioner testified that he had an option to reacquire 990 shares of IBM stock by paying

the balance due in 2004, but he did not exercise that option:

A I had three options as indicated in the documentation. The option I chose was to relin-

quish the shares in 2004.

Q So there was no requirement that you had to repay the loan?

A There was a choice. I could have extended the loan, I could have relinquished the loan,

but the loan was upside down. There was a debt of $40,000. I chose to relinquish the shares.

That was in payment for the loan becoming a taxable event in 2004.

As previously mentioned, petitioners failed to report a sale of the IBM stock on their 2004

Federal income tax return.

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(26) CALLOWAY v. COMMISSIONER 37

repay it upon such terms as to time and rate of interest, or

without interest, as the parties may agree.’ ’’ Welch v.

Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000) (quoting

Commissioner v. Valley Morris Plan, 305 F.2d 610, 618 (9th

Cir. 1962)), affg. T.C. Memo. 1998–121; see also Talmage v.

Commissioner, T.C. Memo. 2008–34. For a transaction to be

a bona fide loan the parties must have actually intended to

establish a debtor-creditor relationship at the time the funds

were advanced. Fisher v. Commissioner, 54 T.C. 905, 909–

910 (1970). ‘‘Whether a bona fide debtor-creditor relationship

exists is a question of fact to be determined upon a consider-

ation of all the pertinent facts in the case.’’ Id. at 909. ‘‘For

disbursements to constitute true loans there must have been,

at the time the funds were transferred, an unconditional

obligation on the part of the transferee to repay the money,

and an unconditional intention on the part of the transferor

to secure repayment.’’ Haag v. Commissioner, 88 T.C. 604,

615–616 (1987), affd. without published opinion 855 F.2d 855

(8th Cir. 1988).

Courts have considered various factors in determining

whether a transfer constitutes genuine indebtedness. No one

factor is necessarily determinative, and the factors consid-

ered do not constitute an exclusive list. See Ellinger v.

United States, 470 F.3d 1325, 1333–1334 (11th Cir. 2006)

(listing a nonexclusive list of 13 factors); Welch v. Commis-

sioner, supra at 1230. 10 Often it comes down to a question

of substance over form requiring courts to ‘‘ ‘look beyond the

parties’ terminology to the substance and economic reali-

ties’ ’’. BB&T Corp. v. United States, 523 F.3d 461, 476 (4th

Cir. 2008) (quoting Halle v. Commissioner, 83 F.3d 649, 655

(4th Cir. 1996), revg. Kingstowne L.P. v. Commissioner, T.C.

Memo. 1994–630). Our analysis of the factors relevant to this

case leads to the conclusion that even though the documents

prepared by Derivium use the term ‘‘loan’’, the transaction

lacked the characteristics of a true loan.

10 For example the nonexclusive list of factors enumerated in Welch v. Commissioner, 204 F.3d

1228, 1230 (9th Cir. 2000), are: (1) Whether the promise to repay is evidenced by a note or other

instrument; (2) whether interest was charged; (3) whether a fixed schedule for repayments was

established; (4) whether collateral was given to secure payment; (5) whether repayments were

made; (6) whether the borrower had a reasonable prospect of repaying the loan and whether

the lender had sufficient funds to advance the loan; and (7) whether the parties conducted them-

selves as if the transaction were a loan.

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38 135 UNITED STATES TAX COURT REPORTS (26)

The transaction was structured so that petitioner could

receive 90 percent of the value of his IBM stock. Petitioner

would have no personal liability to pay principal or interest

to Derivium, and it would have made no sense to do so

unless the value of the stock had substantially appreciated.

Petitioner transferred ownership of the stock to Derivium,

which received all rights and privileges of ownership and was

free to sell the stock. Derivium did immediately sell the stock

and immediately passed 90 percent of the proceeds to peti-

tioner. The only right petitioner retained regarding shares of

IBM stock was an option, exercisable 3 years later, in 2004,

to require Derivium to acquire 990 shares of IBM stock and

deliver them to him in 2004. Petitioner’s right to exercise

this option in 2004 was wholly contractual because he had

already transferred all of the incidents of ownership to

Derivium, which had immediately sold the 990 shares. 11 See

Provost v. United States, 269 U.S. 443 (1926). Petitioner

engaged in the transaction because he thought that the

‘‘loan’’ characterization would allow him to realize 90 percent

of the value of the stock, whereas a ‘‘sale’’ would have netted

only 80 percent of the stock’s value after payment of tax on

the gain. After the transfer petitioners did not conduct them-

selves as if the transaction was a loan. Petitioners did not

report dividends earned on the 990 shares of IBM stock on

their Federal income tax returns. When petitioners decided

not to ‘‘repay the loan’’ in 2004, they did not report a sale of

the stock on their 2004 Federal income tax return and failed

to report any discharge of indebtedness income. This failure

was totally inconsistent with petitioners’ ‘‘loan’’ characteriza-

tion.

As to Derivium, immediately upon its receipt of petitioner’s

stock, it sold the stock in order to fund the ‘‘loan’’. It did not

hold the stock as collateral for a loan. In an ordinary lending

11 In some instances Derivium’s clients have requested the return of stock. The parties stipu-

lated that Derivium’s failure to return the stock has resulted in a number of lawsuits; e.g., The

Lee Family Trust v. Derivium Capital L.L.C., U.S. District Court, District of South Carolina,

Robert G. Sabelhaus v. Derivium Capital, U.S. District Court, District of South Carolina,

The Hammond Family 1994, L.P. v. Diversified Design, U.S. District Court, District of South

Carolina, Newton Family L.L.C. v. Derivium Capital, U.S. District Court, District of

Wyoming, WCN/GAN Partners, Ltd. v. Charles Cathcart, U.S. District Court, District of Wyo-

ming, Derivium Capital L.L.C. v. General Holdings Inc., U.S. District Court, District of South

Carolina, Grayson v. Cathcart, U.S. District Court, District of South Carolina. On Sept. 1, 2005,

Derivium filed a ch. 11 bankruptcy petition, and on Nov. 4, 2005, the case was converted to

ch. 7 and venue was moved to South Carolina.

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(26) CALLOWAY v. COMMISSIONER 39

transaction the risk of loss to a lender is that the borrower

might not repay the loan. In contrast to the ordinary risk

assumed by a lender, Derivium’s only risk of loss would have

arisen if petitioner had actually repaid the ‘‘loan’’. Petitioner

would very likely have exercised his option to ‘‘repay the

loan’’ if the value of the 990 shares of IBM stock, in August

2004, had exceeded the balance due. However, if petitioner

had exercised his option under those circumstances,

Derivium would have been required to acquire 990 shares of

IBM stock at a cost exceeding the amount it would have

received from petitioner. On the basis of all of these factors

we must conclude that Derivium did not expect or want the

‘‘loan’’ to be repaid. Of course if the value of the IBM stock

had been less than the ‘‘loan’’ balance in 2004, it would have

been foolish for petitioner to pay the ‘‘loan’’ balance. As peti-

tioner explained at trial, he did not exercise his right to ‘‘buy

back my shares’’ because it would have cost more than the

shares were worth.

We hold that the transaction was not a loan and that peti-

tioner sold his IBM stock for $93,586.23 in 2001. 12

This case presents an issue of first impression in this

Court. However, two other Federal courts have recently

considered whether the transfer of securities to Derivium

under its 90-percent-stock-loan program was a sale for Fed-

eral tax purposes. In each of those cases the court, using

essentially the same facts and applying the same legal stand-

ards that are found in cases such as Grodt & McKay Realty,

Inc. v. Commissioner, 77 T.C. at 1237–1238, and Welch v.

Commissioner, 204 F.3d at 1230, found that the 90-percent-

stock-loan-program transactions were sales of securities and

not bona fide loans. See Nagy v. United States, 104 AFTR 2d

2009–7789, 2010–1 USTC par. 50,177 (D.S.C. 2009) (in an

action involving section 6700 promoter penalties, Chief Judge

Norton for the U.S. District Court for the District of South

Carolina granted the Government’s motion for partial sum-

mary judgment, holding that the 90-percent-stock-loan-pro-

gram transactions offered by Derivium were sales of securi-

12 As noted by the U.S. Court of Appeals for the Fourth Circuit when it rejected the taxpayer’s

argument that it had incurred a debt because the arrangement was labeled a ‘‘loan’’: ‘‘In closing,

we are reminded of ‘Abe Lincoln’s riddle . . . ‘‘How many legs does a dog have if you call a tail

a leg?’’ ’ ’’ Rogers v. United States, 281 F.3d 1108, 1118 (10th Cir. 2002). ‘The answer is ‘‘four,’’

because ‘‘calling a tail a leg does not make it one.’’ ’ Id.’’ BB&T Corp. v. United States, 523 F.3d

461, 477 (4th Cir. 2008).

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40 135 UNITED STATES TAX COURT REPORTS (26)

ties, not bona fide loans); United States v. Cathcart, 104 AFTR

2d 2009–6625, 2009–2 USTC par. 50,658 (N.D. Cal. 2009) (in

an action to enjoin defendants from continuing to promote

Derivium’s 90-percent-stock-loan program, Judge Hamilton of

the U.S. District Court for the Northern District of California

granted the Government’s motion for partial summary judg-

ment, holding that the 90-percent-stock-loan-program trans-

actions offered by Derivium were sales of securities, not bona

fide loans). Subsequently, the District Court for the Northern

District of California permanently enjoined Charles Cathcart

from, directly or indirectly, by use of any means or

instrumentalities:

1. Organizing, promoting, marketing, selling, or implementing the ‘‘90%

Loan’’ program that is the subject of the complaint herein;

2. Organizing, promoting, marketing, selling, or implementing any pro-

gram, plan or arrangement similar to the 90% Loan program that purports

to enable customers to receive valuable consideration in exchange for

stocks and other securities that are transferred or pledged by those cus-

tomers, without the need to pay tax on any gains because the transaction

is characterized as a loan rather than a sale;

[United States v. Cathcart, No. 4:07–CV–04762–PJH (N.D. Cal. Nov. 23,

2009).]

We note that Mr. Cathcart stipulated to the entry of this

permanent injunction.

With respect to Derivium, a magistrate judge for the Dis-

trict Court for the Northern District of California rec-

ommended that ‘‘injunctive relief against Derivium is ‘nec-

essary or appropriate for the enforcement of the Internal

Revenue laws.’ ’’ United States v. Cathcart, 105 AFTR 2d

2010–1287, at 2010–1292 (N.D. Cal. 2010). District Court

Judge Hamilton adopted the magistrate judge’s recommenda-

tions, finding that the report was well reasoned and thorough

in every respect. United States v. Cathcart, 105 AFTR 2d

2010–1293 (N.D. Cal. 2010). 13

13 The report and recommendation of the magistrate judge, which was adopted by the District

Court judge, stated:

Section 7408 authorizes a court to enjoin persons who have engaged in any conduct subject

to penalty under § 6700 if the court finds that injunctive relief is appropriate to prevent the

recurrence of such conduct. * * *

* * * * * * *

To establish a violation of § 6700 warranting an injunction under § 7408, the government

must prove that defendant: (1) organized or sold, or participated in the organization or sale of,

an entity, plan, or arrangement; (2) made or caused to be made, false or fraudulent statements

concerning the tax benefits to be derived from the entity, plan, or arrangement; (3) knew or had

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(26) CALLOWAY v. COMMISSIONER 41

reason to know that the statements were false or fraudulent; (4) the false or fraudulent state-

ments pertained to a material matter; and (5) an injunction is necessary to prevent recurrence

of this conduct. United States v. Estate Preservation Servs., 202 F.3d 1093, 1098 (9th Cir. 2000)

citing I.R.C. §§ 6700(a), 7408(b). ‘‘Under § 6700, any ‘plan or arrangement’ having some connec-

tion to taxes can serve as a ‘tax shelter’ and will be an ‘abusive’ tax shelter if the defendant

makes the requisite false or fraudulent statements concerning the tax benefits of participation.’’

United States v. Raymond, 228 F.3d 804, 811 (7th Cir. 2000). ‘‘Congress designed section 6700

as a ‘penalty provision specifically directed toward promoters of abusive tax shelters and other

abusive tax avoidance schemes.’ ’’ United States v. White, 769 F.2d 511, 515 (8th Cir. 1985) (em-

phasis in original). * * *

* * * * * * *

In an order dated September 22, 2009, the district court granted in part and denied in part,

Defendants’ motions for summary judgment. The court found that the undisputed evidence re-

vealed that4: as part of the loan transaction in question, legal title of a customer’s securities

transfers to Derivium USA (for example) during the purported loan term in question, which

vests possession of the shares in Derivium’s hands for the duration of the purported loan term;

that the customer must transfer 100% of all shares of securities to Derivium USA and that once

transferred, Derivium USA sells those shares on the open market, and that once sold, Derivium

USA transfers 90% of that sale amount to the customer as the ‘‘loan’’ amount, keeping 10% in

Derivium USA’s hands; that during the term of the loan, the Master Loan Agreement provides

that Derivium USA has the right to receive all benefits that come from disposition of the cus-

tomer’s securities, and that the customer is not entitled to these benefits; that the customer is

furthermore prohibited from repaying the loan amount prior to maturity and is not required to

pay any interest before the loan maturity date; and that, at the end of the purported loan term,

the customer is not required to repay the amount of the loan (but merely allowed to do so as

one option at the loan’s maturity date) and can exercise the option to walk away from the loan

entirely at the maturity date without repaying the principle; and thus, can conceivably walk

away from the transaction without paying interest at all on the loan.

4The following factual findings are taken directly from Judge Hamilton’s Order dated Sep-

tember 22, 2009. Docket No. 333.

The district court concluded that analysis of these and other undisputed facts pursuant to ei-

ther the benefits/burdens approach outlined in Grodt & McKay Realty, Inc. v. Commissioner of

Internal Revenue, 77 T.C. 1221, 1236 (Tax Court 1981), or the approach outlined in Welch v.

Comm’r, 204 F.3d 1228, 1230 (9th Cir. 2000), compelled the conclusion that the transactions in

question constituted sales of securities, rather than bona fide loan transactions. See e.g., Grodt,

77 T.C. at 1236–37 (applying multi-factor test to determine point at which the burdens and ben-

efits of ownership are transferred for purposes of qualifying a transaction as a sale); Welch, 204

F.3d at 1230 (examining factors necessary to determine whether a transaction constitutes a

bona fide loan).

The district court also found that the ‘‘substance over form doctrine’’ further supported the

conclusion that, in looking beyond the actual language of the Master Loan Agreement to the

totality of the undisputed facts, the substance of the transaction between the parties constituted

a sale, and not a bona fide loan. See, e.g., Harbor Bancorp and Subsidiaries v. Comm’r, 115 F.3d

722, 729 (9th Cir. 1997) (it is axiomatic that tax law follows substance and not form).

* * * * * * *

Reviewing the above evidence and legal authorities cited above, the Court concludes that the

evidence against Defendant Derivium USA is strong and that the merits of the case support

entry of default judgment here. The Court concludes that an injunction against Derivium is nec-

essary or appropriate for the enforcement of the internal revenue laws. See e.g., United States

v. Thompson, 395 F.Supp.2d 941, 945–46 (E.D. Cal. 2005) (‘‘Injunctive relief is appropriate if

the defendant is reasonably likely to violate the federal tax laws again.’’)

[United States v. Cathcart, 105 AFTR 2d 2010–1287, at 2010–1290 to 2010–1291 (N.D. Cal.

2010).]

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42 135 UNITED STATES TAX COURT REPORTS (26)

Securities Lending Arrangement

On brief petitioners argue that the transaction was a non-

taxable securities lending arrangement analogous to the fol-

lowing situation described in Rev. Rul. 57–451, 1957–2 C.B.

295, 296:

(2) The stockholder deposits his stock with his broker in a ‘‘safekeeping’’

account and, at the time of deposit, endorses the stock certificates and

then authorizes the broker to ‘‘lend’’ such certificates in the ordinary

course of the broker’s business to other customers of the broker. The

broker has the certificates cancelled and new ones reissued in his own

name.

In Rev. Rul. 57–451, supra, the Internal Revenue Service

was asked to determine whether the situation described

above was a taxable disposition of stock by the stockholder.

Petitioners urge this comparison because the revenue ruling

concludes that there is no taxable disposition of stock unless

and until the broker satisfies his obligation to the stock-

holder by delivering property that does not meet the require-

ments of section 1036. Section 1036 provides for nonrecogni-

tion if common stock in a corporation is exchanged solely for

common stock in the same corporation. Id., 1957–2 C.B. at

298. By analogy, petitioner seems to argue that his IBM stock

was not disposed of until 2004 when he surrendered his right

to reacquire the IBM stock in satisfaction of his ‘‘debt’’ to

Derivium.

The transaction differs significantly from that described in

the revenue ruling. Derivium was not acting as a broker, and

the arrangement between petitioner and Derivium was not

the type of securities lending arrangement described in the

revenue ruling. In the revenue ruling, the stockholder

authorized his broker, subject at all times to the instructions

of the stockholder, to ‘‘lend’’ his stock to others to satisfy

obligations in a short sale transaction. The ‘‘loan’’ in the rev-

enue ruling required the borrower, ‘‘on demand,’’ to restore

the lender to the same economic position that he had occu-

pied before entering into the ‘‘loan’’. Rev. Rul. 57–451, 1957–

2 C.B. at 297, described the transaction as follows:

In such a case, all of the incidents of ownership in the stock and not mere

legal title, pass to the ‘‘borrowing’’ customer from the ‘‘lending’’ broker. For

such incidents of ownership, the ‘‘lending’’ broker has substituted the per-

sonal obligation, wholly contractual, of the ‘‘borrowing’’ customer to restore

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(26) CALLOWAY v. COMMISSIONER 43

him, on demand, to the economic position in which he would have been as

owner of the stock, had the ‘‘loan’’ transaction not been entered into. See

Provost v. United States, 269 U.S. 443 * * * (1926). * * *

The securities lending arrangement described in Provost

was also terminable on demand by either the lender or the

borrower so that the lender retained all the benefits and

assumed all of the burdens incident to ownership of the

stock. 14

The master agreement did not enable petitioner to retain all

of the benefits and burdens of being the owner of the IBM

stock. Neither petitioner nor Derivium could terminate the

‘‘loan’’ on demand. Petitioner could not repay the ‘‘loan’’ and

demand return of his stock during the 3-year term of the

‘‘loan’’. As a result, petitioner did not retain the benefits and

burdens of ownership. He did not retain the benefit of being

able to sell his interest in the stock at any time during the

3-year period and, therefore, could not take advantage of any

increases in the stock’s value at any given time during the

3-year period. At the same time petitioner bore no risk of loss

in the event that the stock’s value decreased.

In 1978 Congress codified and clarified the then-existing

law represented by Rev. Rul. 57–451, supra, by enacting sec-

tion 1058. Section 1058(a) provides for nonrecognition of gain

or loss when securities are transferred under certain agree-

ments as follows:

In the case of a taxpayer who transfers securities * * * pursuant to an

agreement which meets the requirements of subsection (b), no gain or loss

shall be recognized on the exchange of such securities by the taxpayer for

an obligation under such agreement, or on the exchange of rights under

such agreement by that taxpayer for securities identical to the securities

transferred by that taxpayer.

14 In Provost v. United States, 269 U.S. at 452, the Supreme Court described the transaction

as follows:

During the continuance of the loan the borrowing broker is bound by the loan contract to give

the lender all the benefits and the lender is bound to assume all the burdens incident to owner-

ship of the stock which is the subject of the transaction, as though the lender had retained the

stock. The borrower must accordingly credit the lender with the amount of any dividends paid

upon the stock while the loan continues and the lender must assume or pay to the borrower

the amount of any assessments upon the stock. * * *

The original short sale is thus completed and there remains only the obligation of the bor-

rowing broker, terminable on demand, either by the borrower or the lender, to return the stock

borrowed on repayment to him of his cash deposit, and the obligation of the lender to repay

the deposit, with interest as agreed. * * *

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44 135 UNITED STATES TAX COURT REPORTS (26)

Section 1058(b) requires the securities agreement to meet the

following four requirements in order to qualify for non-

recognition:

SEC. 1058(b). AGREEMENT REQUIREMENTS.—In order to meet the

requirements of this subsection, an agreement shall—

(1) provide for the return to the transferor of securities identical to the

securities transferred;

(2) require that payments shall be made to the transferor of amounts

equivalent to all interest, dividends, and other distributions which the

owner of the securities is entitled to receive during the period beginning

with the transfer of the securities by the transferor and ending with the

transfer of identical securities back to the transferor;

(3) not reduce the risk of loss or opportunity for gain of the transferor

of the securities in the securities transferred; and

(4) meet such other requirements as the Secretary may by regulation

prescribe.

The master agreement does not satisfy the requirements of

section 1058(b)(3).

In order to meet the requirements of section 1058(b)(3), the

agreement must give the person who transfers stock ‘‘all of

the benefits and burdens of ownership of the transferred

securities’’ and the right to ‘‘be able to terminate the loan

agreement upon demand.’’ Samueli v. Commissioner, 132

T.C. 37, 51 (2009). In Samueli we focused on the meaning of

the requirement in section 1058(b)(3).

[W]e read the relevant requirement * * * to measure a taxpayer’s oppor-

tunity for gain as of each day during the loan period. A taxpayer has such

an opportunity for gain as to a security only if the taxpayer is able to effect

a sale of the security in the ordinary course of the relevant market (e.g.,

by calling a broker to place a sale) whenever the security is in-the-money.

A significant impediment to the taxpayer’s ability to effect such a sale

* * * is a reduction in a taxpayer’s opportunity for gain. [Id. at 48.]

Petitioner was bereft of any opportunity for gain during

the 3-year period because he could reacquire the IBM stock

only at maturity. Schedule D of the master agreement not

only provides that Derivium had the ‘‘right, without notice to

* * * [petitioner], to transfer, pledge, repledge, hypothecate,

rehypothecate, lend, short sell, and/or sell outright some or

all of the securities during the period covered by the loan’’,

but also provides that Derivium ‘‘has the right to receive and

retain the benefits from any such transactions and that

* * * [petitioner] is not entitled to these benefits during the

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(26) CALLOWAY v. COMMISSIONER 45

term of a loan.’’ Because petitioner was prohibited from

demanding a return of any stock during the 3-year period,

his opportunity for gain was severely diminished. See

Samueli v. Commissioner, supra at 48. Accordingly, we hold

that the transaction is not analogous to the second situation

in Rev. Rul. 57–451, supra, and is not an arrangement that

meets the requirements of section 1058.

Addition to Tax Under Section 6651(a)(1)

Section 6651(a)(1) provides for an addition to tax where a

failure to timely file a Federal tax return is not due to

reasonable cause or is due to willful neglect. Pursuant to sec-

tion 7491(c), the Commissioner generally bears the burden of

production for any penalty, but the taxpayer bears the ulti-

mate burden of proof. Higbee v. Commissioner, 116 T.C. 438,

446 (2001).

Petitioners filed their 2001 Federal income tax return on

February 11, 2004, more than 21 months after its due date.

Therefore, respondent has met his burden of production

under section 7491(c); and in order to avoid the section

6651(a)(1) addition to tax, petitioners have the burden of

establishing reasonable cause and the absence of willful

neglect for failure to timely file. See Natkunanathan v.

Commissioner, T.C. Memo. 2010–15.

A delay in filing a Federal tax return is due to reasonable

cause ‘‘If the taxpayer exercised ordinary business care and

prudence and was nevertheless unable to file the return

within the prescribed time’’. Sec. 301.6651–1(c)(1), Proced. &

Admin. Regs. The Supreme Court has said that willful

neglect, in this context, means ‘‘a conscious, intentional

failure or reckless indifference.’’ United States v. Boyle, 469

U.S. 241, 245 (1985).

The only explanation petitioners offered for the delay in

filing their 2001 Federal income tax return was that they

reported on their 2001 Federal income tax return that

they ‘‘paid $25,150 in taxes,’’ and that ‘‘without recharacter-

izing the loan as a sale * * * [they] would have been entitled

to a refund of $3,979.’’ Petitioners’ explanation establishes

neither reasonable cause nor the absence of willful neglect.

Accordingly, we sustain respondent’s determination and hold

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46 135 UNITED STATES TAX COURT REPORTS (26)

petitioners liable for the addition to tax pursuant to section

6651(a)(1).

Accuracy-Related Penalty Under Section 6662(a)

Section 6662(a) and (b)(1) and (2) provides that a taxpayer

is liable for a 20-percent accuracy-related penalty on any por-

tion of an underpayment of tax required to be shown on a

return attributable to, inter alia, (1) negligence or disregard

of rules or regulations or (2) a substantial understatement of

income tax. See New Phoenix Sunrise Corp. & Subs. v.

Commissioner, 132 T.C. 161, 189–191 (2009). The Commis-

sioner generally bears the burden of production for any pen-

alty, but the taxpayer bears the ultimate burden of proof.

Sec. 7491(c); Higbee v. Commissioner, supra at 446.

A substantial understatement of income tax is defined as

the greater of ‘‘10 percent of the tax required to be shown on

the return for the taxable year,’’ or ‘‘$5,000.’’ Sec.

6662(d)(1)(A). Negligence is defined as ‘‘any failure to make

a reasonable attempt to comply with the provisions of this

title’’, and disregard includes ‘‘any careless, reckless, or

intentional disregard.’’ Sec. 6662(c).

Respondent has met his burden of production by estab-

lishing that petitioner sold his IBM stock in 2001 and failed

to report the capital gain. Petitioners’ failure to report the

gain from the sale of the IBM stock in 2001 results in a

substantial understatement of income tax because the result-

ant understatement exceeds $5,000 and is more than 10 per-

cent of the correct tax.

The penalty under section 6662(a) shall not be imposed

upon any portion of an underpayment where the taxpayer

shows that he acted with reasonable cause and in good faith

with respect to such portion. See sec. 6664(c)(1); Higbee v.

Commissioner, supra at 448. The determination of whether a

taxpayer acted with reasonable cause and in good faith is

made on a case-by-case basis, taking into account all the

pertinent facts and circumstances. Higbee v. Commissioner,

supra at 448; sec. 1.6664–4(b)(1), Income Tax Regs.

As previously noted, petitioners did not report their annual

dividends from their IBM stock which were, under their

version of the transaction, credited yearly against

their interest due to Derivium. A payment of the dividends

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(26) CALLOWAY v. COMMISSIONER 47

by IBM, under their version of the transaction, would have

created taxable income to them. Further, in 2004 they did

not report the sale of their IBM stock or any gain from that

transaction, nor did they report any relief of indebtedness

income. These failures were inconsistent with petitioners’

version of the transaction.

‘‘Under some circumstances, a taxpayer may avoid liability

for the accuracy-related penalty by showing reasonable reli-

ance on a competent professional adviser.’’ Tigers Eye

Trading, L.L.C. v. Commissioner, T.C. Memo. 2009–121

(citing United States v. Boyle, supra at 250–251, and Freytag

v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011

(5th Cir. 1990), affd. 501 U.S. 868 (1991)). For reliance on

professional advice to excuse a taxpayer from the accuracy-

related penalty, the taxpayer must show that the profes-

sional had the requisite expertise, as well as knowledge of

the pertinent facts, to provide informed advice on the subject

matter. See David v. Commissioner, 43 F.3d 788, 789–790

(2d Cir. 1995), affg. T.C. Memo. 1993–621; Freytag

v. Commissioner, supra at 888; Tigers Eye Trading,

L.L.C. v. Commissioner, supra. ‘‘The validity of the reliance

turns on ‘the quality and objectivity of professional advice

which they obtained’.’’ Tigers Eye Trading, L.L.C. v. Commis-

sioner, supra (quoting Swayze v. United States, 785 F.2d 715,

719 (9th Cir. 1986)).

To be reasonable, professional tax advice must generally be

from a competent and independent adviser unburdened with

a conflict of interest and not from promoters of the invest-

ment. Mortensen v. Commissioner, 440 F.3d 375, 387 (6th

Cir. 2006), affg. T.C. Memo. 2004–279. ‘‘Courts have rou-

tinely held that taxpayers could not reasonably rely on the

advice of promoters or other advisers with an inherent con-

flict of interest such as one who financially benefits from the

transaction.’’ Tigers Eye Trading, L.L.C. v. Commissioner,

supra (citing Hansen v. Commissioner, 471 F.3d 1021, 1031

(9th Cir. 2006) (‘‘a taxpayer cannot negate the negligence

penalty through reliance on a transaction’s promoters or on

other advisors who have a conflict of interest’’), affg. T.C.

Memo. 2004–269, Van Scoten v. Commissioner, 439 F.3d

1243, 1253 (10th Cir. 2006) (‘‘To be reasonable, the profes-

sional adviser cannot be directly affiliated with the promoter;

instead, he must be more independent’’), affg. T.C. Memo.

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48 135 UNITED STATES TAX COURT REPORTS (26)

2004–275, Barlow v. Commissioner, 301 F.3d 714, 723 (6th

Cir. 2002) (noting ‘‘that courts have found that a taxpayer is

negligent if he puts his faith in a scheme that, on its face,

offers improbably high tax advantages, without obtaining an

objective, independent opinion on its validity’’), affg. T.C.

Memo. 2000–339, Goldman v. Commissioner, 39 F.3d 402,

408 (2d Cir. 1994) (taxpayer could not reasonably rely on

professional advice of someone known to be burdened with

an inherent conflict of interest—a sales representative of the

transaction), affg. T.C. Memo. 1993–480, Pasternak v.

Commissioner, 990 F.2d 893, 903 (6th Cir. 1993) (reliance on

promoters or their agents is unreasonable because such per-

sons are not independent of the investment), affg. Donahue

v. Commissioner, T.C. Memo. 1991–181, and Illes v. Commis-

sioner, 982 F.2d 163, 166 (6th Cir. 1992) (finding negligence

where taxpayer relied on person with financial interest in

the venture), affg. T.C. Memo. 1991–449). ‘‘A promoter’s self-

interest makes such ‘advice’ inherently unreliable.’’ Id.

At trial petitioner testified that he relied on the advice of

his financial adviser, Mr. Falls, in deciding to enter into the

transaction. However, petitioners have not made any effort to

establish Mr. Falls’ credentials or qualifications as a finan-

cial or tax adviser, nor have they established what relation-

ship Mr. Falls had with Derivium, if any.

Petitioner also testified that he relied upon his accountant

Sharon Cooper as a tax adviser. Ms. Cooper was not called

as a witness. Petitioner testified that Ms. Cooper provided

him with the memorandum dated December 12, 1998, from

Robert J. Nagy to Charles D. Cathcart regarding ‘‘Tax

Aspects of First Security Capital’s 90% Stock Loan’’. Mr.

Cathcart was also Derivium’s president. 15 In the 1998

memorandum Mr. Nagy opines that First Security Capital’s

90-percent-stock-loan program was designed to create gen-

uine indebtedness for Federal tax purposes. Petitioner testi-

fied that he knew nothing about Mr. Nagy other than that

he apparently wrote the 1998 opinion letter addressed to Mr.

Cathcart concerning another 90-percent-stock-loan trans-

action. In the light of the previously cited cases, we find that

petitioners have failed to establish reasonable reliance upon

15 See supra pp. 39–40 regarding Nagy v. United States, 104 AFTR 2d 2009–7789, 2010–1

USTC par. 50,177 (D.S.C. 2009).

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(26) CALLOWAY v. COMMISSIONER 49

a competent professional adviser. Accordingly, we sustain

respondent’s determination to impose an accuracy-related

penalty under section 6662(a).

In reaching our holdings herein, we have considered all

arguments made and, to the extent not mentioned above, we

conclude they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155.

Reviewed by the Court.

COLVIN, COHEN, WELLS, GALE, THORNTON, MARVEL,

GOEKE, KROUPA, GUSTAFSON, and PARIS, JJ., agree with this

majority opinion.

MORRISON, J., did not participate in the consideration of

this opinion.

HALPERN, J., concurring in the result only:

Putting aside the addition to tax and penalty, we must

answer two questions. First, did petitioner dispose of his IBM

common stock in 2001 by transferring it to Derivium?

Second, if he did, did the transaction nevertheless remain

open for income tax purposes until 2004 when petitioner

decided whether to demand that Derivium return stock iden-

tical to the transferred stock, so as to invoke the nonrecogni-

tion rule of section 1036? 1 I answer the first question in the

affirmative and the second in the negative, as does the

majority; our reasons differ, however, particularly with

respect to the first question.

Shares of stock of the same class are fungible, and this has

given rise to apparently formalistic rules for determining

questions of ownership (and, by extension, disposition) of

such shares. The traditional, multifactor, economic risk-

reward analysis, as argued by the parties, is appropriate for

determining tax ownership of nonfungible assets, such as

cattle. See Grodt & McKay Realty, Inc. v. Commissioner, 77

T.C. 1221, 1237 (1981). For fungible securities, however, a

more focused inquiry—whether legal title to the assets and

1 Sec. 1036(a) provides: ‘‘General Rule.—No gain or loss shall be recognized if common stock

in a corporation is exchanged solely for common stock in the same corporation, or if preferred

stock in a corporation is exchanged solely for preferred stock in the same corporation.’’

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50 135 UNITED STATES TAX COURT REPORTS (26)

the power to dispose of them are joined in the supposed

owner—has been determinative of ownership for more than

100 years.

In Richardson v. Shaw, 209 U.S. 365 (1908), a nontax case,

a stockbroker, who held title to the securities in a customer’s

margin account, had pledged those securities to secure a

loan. The broker then filed for bankruptcy. The question

before the Court was whether, despite the pledge and the

broker’s authority to cover its obligation to its customer with

securities other than those actually purchased on the cus-

tomer’s behalf, the customer was the owner of the securities

and so, on the broker’s bankruptcy, did not become merely a

creditor of the bankrupt. Focusing on the fungibility of the

securities in question and the broker’s limited authority to

pledge them (and not to sell them except in limited cir-

cumstances), the Court concluded that the broker’s status

was essentially that of a pledgee and that the customer was

and remained the owner of the securities. Legal title and the

power to dispose were not united in the broker, and the

broker was not, therefore, the owner of the securities.

In Provost v. United States, 269 U.S. 443 (1926), a Federal

stamp tax case, the question was whether the transfers of

stock back and forth between a securities lender and a secu-

rities borrower (both stockbrokers) constituted taxable dis-

positions of the stock. The Court assumed that such transfers

usually occurred to facilitate short sales. The securities

lender provided the stock to the securities borrower, who

delivered it in fulfillment of the agreement of his customer

(who was short the stock) to sell it. The lender had the

contractual right, on demand (with notice), to receive equiva-

lent stock from the borrower. The Supreme Court sharply

distinguished the facts in Provost from those in Richardson

v. Shaw, supra. In Richardson, the broker’s status as pledgee

rather than owner rested on the requirement that the broker

have on hand for delivery to its customers stock of the kind

and amount that the customers owned. In a securities loan,

however:

The procedure adopted and the obligations incurred in effecting a loan of

stock and its delivery upon a short sale neither contemplate nor admit

of the retention by * * * the lender of any of the incidents of ownership

in the stock loaned. * * * Upon the physical delivery of the certificates of

stock by the lender, with the full recognition of the right and authority

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(26) CALLOWAY v. COMMISSIONER 51

of the borrower to appropriate them to his short sale contract, and their

receipt by the purchaser, all the incidents of ownership in the stock pass

to him. [Provost v. United States, supra at 455–456.]

Notwithstanding that the securities lender retained full

market risk on the stock lent, the loan (and return) of the

stock were considered dispositions, shifting ownership of

the stock transferred. As one scholar wrote of the Supreme

Court’s analysis in Provost:

The analysis could not be clearer: a pledgee does not become a tax owner

of a pledged stock while a borrower does become a tax owner of a borrowed

stock because the pledgee has a limited control over the pledged securities

while the stock borrower’s control is complete. This result obtains even

though a stock borrower gains no economic exposure to the borrowed stock,

all of which is retained by a lender. In other words, control overrides eco-

nomic exposure in determining tax ownership of a borrowed stock.

[Raskolnikov, ‘‘Contextual Analysis of Tax Ownership’’, 85 B.U. L. Rev.

431, 481–482 (2005); emphasis added. 2]

Derivium was in the position of a securities borrower who

borrows stock to deliver on a short sale, and petitioner was

in the position of the securities lender who lends his stock to

make that delivery possible. It is enough for me that peti-

tioner gave Derivium the right and authority to sell the IBM

common stock in question for its own account, which

Derivium in fact did. 3 The nonrecourse nature of petitioner’s

obligation to repay Derivium, and almost every other factor

considered by the majority to determine who bore the ‘‘bene-

fits and burdens of ownership’’, is beside the point. Petitioner

disposed of the stock in 2001. Without more, that would con-

stitute a realization event in that year. See sec. 1001(a). Peti-

tioner correctly makes no claim that section 1058 saves him

from recognition of income. See Samueli v. Commissioner,

132 T.C. 37, 49 (2009) (section 1058(b)(3) requires that the

lender be able to demand a prompt return of the lent securi-

2 Professor Raskolnikov builds his analysis on a seminal discussion of the fundamental dif-

ference between tax ownership of fungible and nonfungible assets by now Professor Edward

Kleinbard. See Kleinbard, ‘‘Risky and Riskless Positions in Securities’’, 71 Taxes 783 (1993).

3 Apparently, Judge Holmes and I differ on whether petitioner disposed of his stock on Aug.

16, 2001, when Morgan Keegan credited Derivium’s account with the IBM stock petitioner

transferred, or on the next day, Aug. 17, 2001, when Derivium sold that stock. Although I have

no authority addressing that point, I think that, consistent with Provost v. United States, 269

U.S. 443 (1926), petitioner disposed of the IBM stock on the prior date; i.e., the date he gave

Derivium both the right and authority to sell the stock. I do not believe that applying a similar

rule to transactions intended to be securitizations constitutes a change in the law, as Judge

Holmes believes. Holmes op. note 1. In any event, sec. 1058 establishes a broad safe-harbor to

shelter many securitizations.

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52 135 UNITED STATES TAX COURT REPORTS (26)

ties). We need only determine whether the calculation of gain

or loss must remain open, awaiting the determination of

whether petitioner closed the transaction in 2004 by

acquiring IBM common stock from Derivium. I think not.

Petitioner relies on Rev. Rul. 57–451, 1957–2 C.B. 295,

which addresses whether a taxpayer holding stock received

pursuant to the exercise of a restricted stock option makes

a disqualifying disposition of that stock when he ‘‘lends’’ the

stock to a broker in a transaction that would qualify as a dis-

position under the analysis of Provost v. United States,

supra. The ruling concludes that whether there is a disquali-

fying disposition turns on whether, at the end of the loan

transaction, the taxpayer receives from the broker stock that

would qualify for nonrecognition of gain or loss under section

1036. The pertinent facts of the ruling are distinguishable

from the facts of this case because, in consideration for his

stock, the taxpayer in the ruling appears to have received

nothing other than ‘‘the personal obligation, wholly contrac-

tual, of the ‘borrowing’ customer to restore him, on demand,

to the economic position in which he would have been as

owner of the stock, had the ‘loan’ transaction not been

entered into.’’ Rev. Rul. 57–451, 1957–2 C.B. at 297. Perhaps

the Commissioner thought the transaction remained open

because of the distinct possibility that, apart from the bor-

rowing broker’s contractual obligation, the taxpayer would

receive only stock that would qualify any gain (or loss) for

nonrecognition under section 1036. Cf. Starker v. United

States, 602 F.2d 1341, 1355 (9th Cir. 1979) (nonsimultaneous

transfer qualifies as like-kind exchange ‘‘[e]ven if the con-

tract right includes the possibility of the taxpayer receiving

something other than ownership of like-kind property’’).

The ruling may be of limited significance for another rea-

son, since it addresses a definition of ‘‘disposition’’ limited to

purposes of determining whether there has been a disposi-

tion of stock received pursuant to a restricted stock option.

The rules governing restricted stock options were found in

section 421 before its amendment by the Revenue Act of

1964, Pub. L. 88–272, sec. 221, 78 Stat. 63, and subsection

(d)(4) thereof defined ‘‘disposition’’ as a sale, exchange, gift,

or transfer of legal title but not, among other things, an

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(26) CALLOWAY v. COMMISSIONER 53

exchange to which section 1036 applies. 4 The ruling contains

insufficient analysis for me to extend it beyond its unique cir-

cumstances.

I agree with respondent that petitioner realized $103,985

on his disposition of the IBM common stock in 2001. The par-

ties stipulated that the adjusted basis in the stock was

$21,171. Respondent determined that petitioner’s realized

gain, in 2001, was $72,415, because respondent allowed him

to deduct from the amount realized not only his adjusted

basis but also $10,399, denominated in respondent’s calcula-

tion as ‘‘cost of sale’’. Respondent further determined that

petitioner must recognize that gain (as long-term capital

gain) in 2001. I agree that petitioner must recognize his gain

in 2001. It seems to me, however, that the ‘‘cost of sale’’,

$10,399, probably represents not a cost of the sale but the

nondeductible value of the option that allowed petitioner (if

he wished) to buy 990 shares of IBM common stock from

Derivium in 2004 for $124,429 plus, perhaps, Derivium’s

charge for undertaking the transaction.

WHERRY, J., agrees with this concurring opinion.

HOLMES, J., concurring in the result only: Calloway and

Derivium agreed to what Calloway claims was a nonrecourse

loan secured by his stock. In exchange for money, Calloway

transferred control of the stock to Derivium. Derivium sold

the stock on the open market. The tax rules would seem to

be easy to apply. Section 1.1001–2(a)(4)(i), Income Tax Regs.,

provides that ‘‘the sale * * * of property that secures a non-

recourse liability discharges the transferor from the liability.’’

Commissioner v. Tufts, 461 U.S. 300, 308–09 (1983), and

Crane v. Commissioner, 331 U.S. 1, 12–13 (1947), teach that

the amount realized includes any nonrecourse liability

secured by the property sold. Calloway would then have to

recognize the difference between the discharged debt (i.e., the

amount of the loan proceeds plus one day’s accrued interest

minus his basis in the stock).

That would be enough to solve the only substantive issue

in this case. The majority (admittedly at the Commissioner’s

4 A similar rule can now be found in sec. 424(c)(1)(B). Neither rule mentions transfers of secu-

rities for which no gain is recognized pursuant to sec. 1058.

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54 135 UNITED STATES TAX COURT REPORTS (26)

behest) instead goes off on a frolic and detour through an

inappropriate multifactor test, applies it in dubious ways,

and ends up reaching an overly broad holding with poten-

tially harmful effects on other areas of law.

I.

The key mistake the majority makes is analyzing two

transactions as one. These two transactions were the pur-

ported loan as set forth in the Master Agreement and

Derivium’s subsequent secret sale of Calloway’s stock to an

unrelated party. It’s the characterization of the first trans-

action—the one that Calloway actually knew about because

he signed the Master Agreement—that should be our focus.

The subsequent sale, though it must be analyzed for its own

tax consequences, should not affect our characterization of

the purported loan. Accord People v. Derivium Capital, LLC,

No. 02AS05849 (Cal. Super. Ct. Nov. 5, 2003) (‘‘While the

immediate liquidation of the security may have many

untoward impacts upon the parties to the transaction, those

potential impacts have no apparent relevance to the bona

fide nature of the primary transaction.’’).

The majority concludes that the initial transfer of stock

between Calloway and Derivium was a sale without ever

finding that Calloway knew that Derivium would sell the

stock collateralizing the loan. Its holding is that Derivium’s

right to sell was a sale. Collapsing Derivium’s contractual

right to sell into the subsequent sale would be appropriate if

Calloway was splintering one transaction into two for no

other purpose than to avoid taxes—where the transactions

were otherwise ‘‘integrated, interdependent, and focused

toward a particular result.’’ Pierre v. Commissioner, T.C.

Memo. 2010–106 (describing the step transaction doctrine)

(citing Commissioner v. Clark, 489 U.S. 726, 738 (1989)). But

here, where Derivium represented to its clients that it

intended to hold the stock and never told them of the quick

sale, one cannot say that these transactions were integrated

or interdependent.

II.

To arrive at its destination, the majority uses Grodt &

McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). In

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(26) CALLOWAY v. COMMISSIONER 55

Grodt & McKay, we had to distinguish between a sale and

a sham involving the purported sale of cattle. In this case,

the parties aren’t arguing about whether there was a sale or

a sham, but about whether there was a sale or a loan. If we

are going to compare apples to oranges, we could just as

easily use the test for distinguishing a loan from compensa-

tion in Haag v. Commissioner, 88 T.C. 604, 616 n.6 (1987),

affd. without published opinion 855 F.2d 855 (8th Cir. 1988),

or the test for distinguishing a loan from stock redemption

in Rogers v. United States, 281 F.3d 1108 (10th Cir. 2002),

but those tests, too, contain irrelevant factors and are inexact

in capturing the essence of the distinction we need to make

in this case. Grodt & McKay is just the wrong test for ana-

lyzing this transaction.

Of course, if there is no on-point guidance, it is helpful to

borrow from tests that may be otherwise inapplicable, if we

stay alert to any differing circumstances. In this case I

believe there is a more relevant test. Welch v. Commissioner,

204 F.3d 1228 (9th Cir. 2000), affg. T.C. Memo. 1998–121, for

example, sets out the defining characteristics of a loan,

listing seven factors that courts have considered, none of

which would have to be dismissed as inapplicable to this

case.

A good test should also reflect the nature of the property

involved to determine the relevant factors, the proper weight

for each factor, and whether any additional factors would be

useful. See, e.g., Torres v. Commissioner, 88 T.C. 702, 721–

22 (1987); Rev. Rul. 2003–7, 2003–1 C.B. 363. The majority

starts down the right path by excluding payment of property

taxes as a sign of ownership (recognizing its inapplicability

to stock), majority op. p. 36, but then it stops short, not ana-

lyzing the significant differences between the fungible and

intangible property at issue in this case and the nonfungible

and tangible property at issue in Grodt & McKay. 1 One

1 Judge Halpern does recognize this important difference, and (following some quite persuasive

commentators) urges us to adopt ‘‘control’’ as the essential attribute of determining the tax own-

ership of securities. See Halpern op. p. 51. In almost all tax contexts, the concept of control as

the touchstone of ownership seems much better than the ever-pliable multifactor tests that

dominate the field. I also agree with him that it offers a much better path in explaining the

caselaw, at least before today’s result. But it does not adequately distinguish, as I explain below,

between secured interests in stock and outright transfers of ownership. Maybe it makes sense

to obliterate this distinction, and treat all secured interests in securities as sales if there’s been

an effective change in control over them, but that big a change is one for the legislative branch,

Continued

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56 135 UNITED STATES TAX COURT REPORTS (26)

would think from reading the majority’s opinion that this is

a new problem, but it isn’t. See, e.g., United Natl. Corp. v.

Commissioner, 33 B.T.A. 790 (1935) (finding a 100-percent

loan on the value of stock, even though originally character-

ized by the participants as a sale, was in fact a loan); Fisher

v. Commissioner, 30 B.T.A. 433 (1934) (declining to recharac-

terize a purported sale of stock as a loan).

III.

The Grodt & McKay test might be helpful if the majority

adapted it to match the actual facts of this case instead of

applying it without consideration of how shares of stock

differ from livestock and how distinguishing a loan from a

sale is different from distinguishing a sale from a sham. Con-

sider:

Title and Possession. The clumsiness of using Grodt &

McKay is most striking in its focus on title and possession.

These factors don’t jibe well with the way stock is actually

held. As far back as 1908, in Richardson v. Shaw, 209 U.S.

365, 377–78 (1908), the Supreme Court realized that a share-

holder could retain ownership without title or possession

when a broker purchased and held the shares for the share-

holder’s account:

[I]n no just sense can the broker be held to be the owner of the shares of

stock which he purchases and carries for his customer. * * *

* * * * * * *

* * * Upon settlement of the account * * * [the broker] receives the secu-

rities. In this case the broker assumed to pledge the stocks * * * because

by the terms of the contract * * * he obtained the right from the customer

to pledge the securities upon general loans, and in like manner he secured

the privilege of selling when necessary for his protection.

Stock ownership today is even farther removed from tan-

gible-property concepts like title and possession owing to the

rapid evolution of the indirect holding system. The official

title holder of most publicly traded securities, and possessor

of most physical stock certificates, is Cede & Co.—‘‘the

nominee name used by The Depository Trust Company

(‘DTC’), a limited purpose trust company organized under

not us, to make. In the meantime, we should do our best to come up with a way to distinguish

secured loans from sales even when modern conditions make the distinction sometimes hard to

figure out.

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(26) CALLOWAY v. COMMISSIONER 57

New York law for the purpose of acting as a depository to

hold securities for the benefit of its participants, some 600 or

so broker-dealers and banks.’’ U.C.C. art. 8 (1994) (prefatory

note). The U.C.C.’s drafters 2 estimate that somewhere

between 60 and 80 percent of publicly traded securities are

held by the brokers and banks that participate in the DTC. 3

If someone within this large network of brokers sells stock to

a purchaser also within the network, the purchase and sale

are netted against each other and the underlying stock

remains in Cede & Co.’s name. See id. This means that even

when there is an undisputed sale of stock the title holder

often does not change. The majority concludes that legal title

passed when Calloway ‘‘transferred the IBM stock to

Derivium’s Morgan Keegan account.’’ Majority op. p. 34. But

if the IBM shares are titled to Cede & Co.—as most publicly

traded stock is—then title didn’t actually change.

The right of possession similarly makes some sense when

talking of cows. The owner of a cow is likely to be able to put

it in the barn of his choice, but possession is unhelpful to

determine the owner of shares of stock. Consider a true loan

secured by stock. In most cases, creation of a security

interest in stock is no longer delivering a physical certificate

or noting the pledge on the books of the issuing corporation;

it’s a matter of contracting with a lender who is (as a matter

of contract) allowed to sell, repledge, relend, etc. the stock

involved. 4 Under the U.C.C., in fact, a lender with a secured

2 The American Law Institute and the National Conference of Commissioners on Uniform

State Laws have often had to revisit the problems caused by the rapid changes in the securities

industry. Their most recent revision of Article 8 was ‘‘to eliminate * * * uncertainties by pro-

viding a modern legal structure for current securities holding practices,’’ U.C.C. art. 8 (1994)

(prefatory note), and ‘‘to eliminate the uncertainty and confusion that results from attempting

to apply common law possession concepts to modern securities holding practices.’’ Id. sec. 8–106

cmt. 7. It would be wise for courts in other areas of law to acknowledge these parallel efforts

to accommodate changes in the real world.

3 The DTC is now a subsidiary of the Depository & Trust Clearing Corporation, which sells

even more clearinghouse services. The scale of the transactions roiling beneath the placid sur-

face of stable title and possession is mindboggling—annual volume is measured not in trillions,

but quadrillions of dollars. The Depository Trust & Clearing Corp., About DTCC, http://

www.dtcc.com/about/business/index.php; Securities and Exchange Commission, Testimony Re-

garding Reducing Risks and Improving Oversight in the OTC Credit Derivatives Market Before

the Subcommittee on Securities, Insurance, and Investment of the Senate Committee on Bank-

ing, Housing, and Urban Affairs, James A. Overdahl, Chief Economist (July 9, 2008), available

at http://www.sec.gov/news/testimony/2008/ts070908jao.htm.

4 Consider the following language, often found in margin account agreements, where the Bor-

rower gives the Lender the right to ‘‘pledge, repledge, hypothecate or re-hypothecate, without

notice to me, all securities and other property that you hold, carry or maintain in or for any

of my margin or short Accounts * * * without retaining in your possession or under your control

Continued

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58 135 UNITED STATES TAX COURT REPORTS (26)

interest in shares of stock must obtain effective ‘‘control’’ over

them to maintain priority—that is, he must take all steps so

that he may sell the securities without further permission of

the borrower. Id. sec. 8–106 cmt. 1. One accepted way to

obtain control is to have the borrower transfer his position to

the lender on the books of the securities issuer or broker. Id.

sec. 8–106(d)(1). When this happens, so far as the broker, the

securities issuer, or the rest of the outside world is con-

cerned, the secured party is the registered owner entitled to

all rights of ownership, but the debtor remains the owner as

between him and the secured party. See id. sec. 9–207 cmt.

6 (Example) (2000). This makes secured lending

collateralized by securities look very similar to a sale if

measured by title and possession. See, e.g., id. sec. 8–106

cmt. 4.

Obligation To Deliver Deed. Perhaps the most striking

proof of the inaptness of Grodt & McKay for this case is its

attention to ‘‘whether the contract creates a present obliga-

tion on the seller to execute and deliver a deed and a present

obligation on the purchaser to make payments.’’ Grodt &

McKay, 77 T.C. at 1237. The majority construes this to mean

an obligation by Calloway to transfer control of his stock and

of Derivium to transfer money. Majority op. p. 35. A focus on

whether there are current obligations to deliver and pay

makes perfect sense in distinguishing between a sale of

cattle and a sham transaction. As between those two

characterizations, if there is a current obligation to exchange

money for possession of cattle the transaction is more likely

a sale. But this factor only shows how little use the Grodt

& McKay test can be in distinguishing a loan from a sale,

where there is of course an obligation for Derivium to

transfer money—that’s the whole point of a loan. And every

pledge loan includes a transfer of possession of a chattel (i.e.,

collateral). That doesn’t make pawnshops the buyers of every

bit of their collateral. See, e.g., R. Simpson & Co. v. Commis-

sioner, 44 B.T.A. 498, 499 (1941) (noting that pawnbroker’s

business was lending money on personal property), affd. 128

for delivery the same amount of similar securities or other property. The value of the securities

and other property that you may pledge, repledge, hypothecate or re-hypothecate may be greater

than the amount I owe you.’’ TD Ameritrade, Client Agreement, http://www.tdameritrade.com/

forms/AMTD182.pdf; see also Pershing, Credit Advance Margin Agreement, https://

www.uvest.com/pdf/Margin%20Account%20Agreement.pdf; Zecco Trading, Margin Application,

https://www.zecco.com/forms/margin-application/DownloadForm.aspx.

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(26) CALLOWAY v. COMMISSIONER 59

F.2d 742 (2d Cir. 1942). And in the case of stock, where the

concept of possession has become so illusory, the usefulness

of execution of a ‘‘deed’’ seems even less helpful than the con-

cept of passing ‘‘title’’.

The rest of the factors don’t much help either.

Whether an Equity Was Acquired in the Property. The

majority refers to this as ‘‘Equity Inherent in the Stock’’,

majority op. p. 35, but it isn’t clear what ‘‘inherent equity’’

is or how that concept would apply to stock, which is not only

intangible and fungible, but divisible. As used in Grodt &

McKay, this factor describes not rights, but value. Grodt

& McKay, 77 T.C. at 1238 (‘‘Petitioners ostensibly paid

$6,000 per head for cows they knew were worth far less and

which we find had a fair market value not in excess of $600

per head.’’). If anything, this suggests that Calloway retained

an equity in the stock for the short time before Derivium sold

it. After all, he got only 90 percent of its fair market value.

And in finding that this factor weighs in favor of a sale, the

majority states that the effectiveness of the arrangement

depended on Derivium’s ability to acquire and deliver the

required number of shares in 2004 but fails to note how this

is inconsistent with a loan—the success of every term loan

depends on the ability of the parties to perform at the end

of the term. (It also assumes that from Calloway’s perspec-

tive, Derivium wasn’t going to keep the collateral in its

account and hedge against fluctuations in its value.)

Perhaps the majority intends to suggest that there is a due

diligence requirement on the part of the borrower that was

not completed here. This makes sense—an apparent inability

to return collateral, repay a loan, or fund a loan in the first

place would weigh against finding the parties truly intended

a loan. See, e.g., Gouldman v. Commissioner, 165 F.2d 686,

690 (4th Cir. 1948), affg. a Memorandum Opinion of this

Court. But there is no explanation of this point and no

indication whether there was anything at the time that

should have warned Calloway that Derivium would not be

able to perform.

Risk of Loss and Receipt of Profits From the Operation and

Sale of the Property. In today’s world, when dealing with

intangible, fungible securities, I agree with Judge Halpern

that the benefits and burdens of ownership are ‘‘beside the

point’’ in determining who is the owner for tax purposes.

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60 135 UNITED STATES TAX COURT REPORTS (26)

Halpern op. p. 51. Stock owners who want to keep their stock

but hedge against risk or sell benefits have long had various

methods available to trade away the benefits and burdens of

ownership without affecting tax ownership. See Kleinbard,

‘‘Risky and Riskless Positions in Securities,’’ 71 Taxes 783,

786 (1993) (‘‘The economic risk/reward analysis applicable in

determining tax ownership under a sale-leaseback of a

building or other tangible property is difficult to apply sen-

sibly in the context of publicly traded securities.’’). In some

cases, ‘‘the traditional determination of who bears market

risk is more than simply not dispositive, it in fact is nega-

tively correlated to the tax conclusion.’’ Id. at 794. This is

consistent with our correlative holding that an option to pur-

chase stock, even though entitling the holder to the benefits

of appreciation, isn’t a present interest in stock. Hope v.

Commissioner, 55 T.C. 1020, 1032 (1971), affd. 471 F.2d 738

(3d Cir. 1973). If the majority’s analysis is applied broadly,

stockowners will be surprised to find out that they unwit-

tingly sold their stock by engaging in common hedging trans-

actions.

As a practical matter, the majority also seems to overlook

that Calloway bore the risk of the first 10 percent of loss in

that he realized only 90 percent of the stock’s value in 2001.

It appears to treat the remaining 10 percent as the price of

an option (used colloquially, rather than as a derivative

instrument of the sort traded in the options markets). The

majority also glosses over the fact that Calloway theoretically

retained most of the stock’s upside via his power to repay the

loan for a return of collateral coupled with his right to divi-

dend payments.

IV.

A.

The majority’s approach has the potential to wreak some

havoc on the unsuspecting. For instance, the majority seems

to say that a nonrecourse loan—that is, a loan where the bor-

rower has the option to surrender collateral instead of

repay—does not include an obligation to repay. Particularly

relevant here, the majority notes that for a loan to exist,

‘‘ ‘there must have been, at the time the funds were trans-

ferred, an unconditional obligation on the part of the trans-

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(26) CALLOWAY v. COMMISSIONER 61

feree to repay the money, and an unconditional intention on

the part of the transferor to secure repayment.’ ’’ Majority op.

p. 37 (quoting Haag, 88 T.C. at 615–16. The majority con-

tinues: ‘‘Often it comes down to a question of substance over

form requiring courts to ‘look beyond the parties’ terminology

to the substance and economic realities.’ ’’ Majority op. p. 37.

From there the majority concludes that the transaction

lacked the characteristics of a true loan because ‘‘[p]etitioner

would have no personal liability to pay principal or interest

to Derivium, and it would have made no sense to do so

unless the value of the stock had substantially appreciated.’’

Majority op. p. 38.

That’s way too broad a statement of the law if taken seri-

ously. Before this case, nonrecourse loans have satisfied the

obligation-to-repay test if, at the beginning of the loan, it

would make economic sense for the borrower to pay it off.

Tufts, 461 U.S. at 312. In other words, if the loan is

overcollateralized at its inception, courts find an obligation to

repay and a reasonable prospect of repayment. See

Odend’hal v. Commissioner, 748 F.2d 908, 912 (4th Cir.

1984), affg. 80 T.C. 588 (1983). Events that occur after that

time are immaterial to this initial characterization. See

Lebowitz v. Commissioner, 917 F.2d 1314, 1318 (2d Cir.

1990), revg. T.C. Memo. 1989–178. On the facts of this case,

Calloway—whose loan was overcollateralized by 10 percent—

had a bona fide obligation to repay.

Nonrecourse financing is a perfectly normal part of the

business world. See Robinson, ‘‘Nonrecourse Indebtedness,’’

11 Va. Tax Rev. 1, 10 (1991) (‘‘The legitimacy of financing

with nonrecourse indebtedness is widely recognized’’). Some

states have nonrecourse financing for residential mortgages,

e.g., Cal. Civ. Proc. Code sec. 580b (West 1976 & Supp.

2010), and of course the entire pawnshop industry is built

on it. See National Pawnbrokers Association, ‘‘Pawnbroking

Industry Overview’’ (2008–09), available at http://www.

nationalpawnbrokers.org/files/Industry%20Overview%207–7–

09.pdf. A general statement about the unconditional obliga-

tion to pay as a key characteristic of debt shouldn’t be read

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62 135 UNITED STATES TAX COURT REPORTS (26)

to say that such secured, but nonrecourse, financing isn’t a

species of loan. 5

B.

A second way in which the majority’s holding is too broad

is that it implies that giving a secured lender the right to sell

underlying stock without notice to the borrower turns a loan

into a sale. But this is common in margin accounts, as the

SEC warns: ‘‘Some investors have been shocked to find out

that the brokerage firm has the right to sell their securities

that were bought on margin—without any notification’’.

Securities and Exchange Commission, ‘‘Mar

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