Judges: RUWE,COLVIN,COHEN,WELLS,GALE,THORNTON,MARVEL,GOEKE,KROUPA,GUSTAFSON,PARIS,MORRISON,HALPERN,WHERRY,HOLMES
Attorneys: Brian G. Isaacson , for petitioners. Daniel J. Parent , for respondent.
Filed: Jul. 08, 2010
Latest Update: Nov. 21, 2020
Summary: 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 VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00001
Summary: 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 VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00001 ..
More
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00001 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00002 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00003 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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%.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00004 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00005 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00006 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00007 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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).
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00008 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00009 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00010 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00011 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00012 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00013 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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).
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00014 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00015 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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).]
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00016 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00017 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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. * * *
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00018 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00019 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00020 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00021 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00022 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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).
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00023 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.’’
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00024 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00025 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00026 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00027 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00028 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00029 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00030 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00031 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00032 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00033 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00034 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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-
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00035 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(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
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00036 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
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, ‘‘Margin: Borrowing
Money To Pay for Stocks’’, http://www.sec.gov/investor/pubs/
margin.htm; see also supra note 4. And the majority’s
holding is also inconsistent with the current form of most
stock ownership. In the case of stock that is held through an
intermediary such as Cede & Co., the U.C.C. refers to the
stock owner as the ‘‘entitlement holder’’ and refers to the
interest in the stock as the ‘‘security entitlement.’’ U.C.C. sec.
8–102(a)(7), (17) (1994). As discussed above, if a stock
owner—or ‘‘entitlement holder’’––wishes to borrow against
his ‘‘security entitlement,’’ the secured lender must take ‘‘con-
trol’’ to maintain priority over other creditors. Borrowers can
give a lender control by transferring their position to the
lender on the books of the securities intermediary, id. sec. 8–
106(d)(1), or by arranging for the securities intermediary to
act on instructions directly from the lender, id. sec. 8–
106(d)(2). In essence, a lender has control when he takes
‘‘whatever steps are necessary, given the manner in which
the securities are held, to place itself in a position where it
5 A common instance of this is borrowing against the value of life-insurance policies. The tax
treatment of this phenomenon is easy to understand and (one hopes, even after today) settled
as a matter of law. Atwood v. Commissioner, T.C. Memo. 1999–61, is a good example. In 1986
and 1988 the Atwoods purchased single-premium life insurance policies. After experiencing some
financial difficulty, they decided to borrow against their policies with loans from the insurance
company. They received cash immediately and tax free. They had the option to repay the loan
plus interest, walk away by surrendering their life insurance policies, or (by paying the pre-
miums) keep the loan outstanding until the policy paid out at their death.
The Atwoods didn’t pay premiums or loan payments, so the insurer allowed the loan to re-
main outstanding until 1995, when its balance reached the policy’s cash surrender value. At
that time the insurance company cashed in the Atwoods’ policy, but instead of sending a check
to them, it paid itself back first. Because this payment otherwise would have been a cash dis-
tribution to them, the Atwoods were charged with income when the loan was repaid with their
policy proceeds. The lack of an enforceable obligation to repay—beyond surrendering pledged col-
lateral—didn’t turn the initial transaction into a sale instead of a loan.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00037 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(26) CALLOWAY v. COMMISSIONER 63
can have the securities sold, without further action by the
owner.’’ Id. sec. 8–106 cmt. 1. Therefore, a secured lender
customarily has a contractual right to sell without notice or
demand, subject to its exercise in good faith. 6 See, e.g.,
Kaplan v. First Options of Chi. Inc., 143 F.3d 807, 818 (3d
Cir. 1998) (then-Circuit Judge Alito).
The majority’s holding—what I fear it could be boiled down
to—is that this transaction was a sale because the advance
of money was nonrecourse and Derivium had the authority
to sell after taking possession of the stock. Given modern
conditions in which a lender’s authority to sell stock is rou-
tine and even necessary, the real effect of the holding would
be to treat all nonrecourse lending against stock collateral as
sales. The majority does not appear to realize how startling
that would be.
V.
The Grodt & McKay test, like other transaction tests, also
notes that the intention of the parties governs the true
nature of a transaction. Grodt & McKay, 77 T.C. at 1237; see
also Welch, 204 F.2d at 1230; United Natl., 33 B.T.A. at 794;
Fisher, 30 B.T.A. at 440. Intent is seen by courts ‘‘as evi-
denced by the written agreements read in light of the
attending facts and circumstances’’. Grodt & McKay, 77 T.C.
at 1237 (citation omitted). If the test is stated that generally,
no one can disagree. But in addition to the problems caused
by this test in this case, the majority does not analyze the
effect of deception. We are confronted here with one party
who was not being honest with the other about its intentions.
(The Commissioner admits generally that Derivium told its
customers that it intended to hold the stock and hedge
6 Even under the majority’s analysis, giving another party the right to sell is not always a
taxable disposition. If the parties’ agreement follows the guidelines in section 1058(b) then the
Code says no gain or loss need be recognized by the stock owner at the time of the initial trans-
fer. Sec. 1058(a). This section generally is applied to allow margin brokers to engage in short
sales without tax consequences to the stock owners.
Section 1058 would mitigate the effect of the majority’s holding if the right to sell was com-
monly limited to short sales or other transactions that fit into the confines of section 1058(b).
But as discussed above, stock owners also customarily give a secured lender the right to sell
for the lender’s own protection—e.g., to cover margin calls or repay a loan in default. If a se-
cured lender sells the underlying stock for one of these reasons, then any obligation to return
identical securities is typically replaced with an obligation to apply the proceeds of the sale to
the outstanding debt. See, e.g., U.C.C. sec. 9–207(c)(2) (2000). This rips the transaction from the
protection of section 1058, see sec. 1058(b)(1), and renders the initial transfer taxable under the
majority’s analysis.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00038 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
64 135 UNITED STATES TAX COURT REPORTS (26)
against the upside risk via a proprietary trading strategy.
Reqs. for Admis. 264, 276.) Despite the importance of intent
in these tests, the majority doesn’t address what effect decep-
tion has on the characterization of the transaction.
Deception should have been considered at a minimum
under the Grodt & McKay factor regarding the parties’ treat-
ment of the transaction, but the majority merely notes that
the parties’ treatment was inconsistent with a loan because
Calloway admitted that he knew he had authorized Derivium
to sell his stock. This knowledge, however, is not inconsistent
with a nonrecourse loan secured by fungible collateral—such
a provision is standard in brokerage and custodian account
agreements where stock secures a loan. See supra note 4.
The majority fails to mention that Calloway testified that he
did not know Derivium had sold the stock and that Derivium
sent out quarterly lies that it still held the collateral and
credited the amount of dividends paid to reduce Calloway’s
interest obligation. That, too, however, was part of the con-
duct of the parties.
The majority similarly notes that Calloway was never
required to repay any principal or interest, but this also is
consistent with the loan terms—a nonrecourse loan with a
balloon payment at the end. We have recognized parties’
rights to structure loans as they see fit, even allowing for
zero interest. Welch, 204 F.3d at 1230 (quoting Commissioner
v. Valley Morris Plan, 305 F.2d 610, 618 (9th Cir. 1962),
revg. 33 T.C. 572 (1959) and Morris Plan Co. v. Commis-
sioner, 33 T.C. 720 (1960)); see also Robinson, supra at 9
(‘‘Nonrecourse loans created by contract can take whatever
form meets the needs of the parties’’). And we note that even
if the taxpayer does not pay interest during the loan term,
upon satisfaction of the debt the full amount of the non-
recourse debt extinguished becomes part of the gain under
Tufts, 461 U.S. at 308–09, Crane, 331 U.S. at 12–13, and sec-
tion 1.1001–2(a), Income Tax Regs. Accord Allan v. Commis-
sioner, 86 T.C. 655, 666–67 (1986), affd.
856 F.2d 1169 (8th
Cir. 1988). Therefore the taxpayer pays taxes on discharged
interest, so it remains of economic importance.
Finally, the majority notes that the parties did not treat
this as a loan because the exact loan amount was not fixed
until after Derivium determined the proceeds it would
receive from selling the stock. This factor should not impute
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00039 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(26) CALLOWAY v. COMMISSIONER 65
knowledge to Calloway that Derivium was selling the stock,
however, because it was consistent with the terms of the
agreement. Schedule A–1, Property Description and Loan
Terms, stated that the total loan amount would be ‘‘90% of
the market value on closing’’ and closing was to take place
‘‘upon receipt of securities and establishment of * * *
[Derivium’s] hedging transactions.’’ This is no different from
a home equity line of credit whose precise limit depends on
an appraisal and subsequent loan-to-value calculation.
VI.
A.
Even if we didn’t want to accept Calloway’s deal as a loan
on its face, we should at least use a more sensible multifactor
test here. Taking the factors from Welch and the old BTA
cases would yield a different result:
Existence of Promissory Note. 7 While there is no promis-
sory note, the ‘‘Master Agreement to Provide Financing and
Custodial Services’’ bears the markings of a loan agreement.
The recitals in the contract use loan language, specifying:
‘‘This Agreement is made * * * to provide or arrange
financing(s) and to provide custodial services to * * * [peti-
tioner], with respect to certain properties and assets * * * to
be pledged as security.’’ The services promised in Section 1
include ‘‘[p]roviding or arranging financing by way of one or
more loans’’ and ‘‘[h]olding cash, securities, or other liquid
assets * * * as collateral,’’ actions indicating initial treat-
ment as a loan. Section 9 binds the parties and their assigns.
Schedule A–1 lists the interest rate, maturity date, and other
terms of the loan. This document therefore acts at least for-
mally as a debt instrument.
Observing Formalities of Loan. 8 The parties’ continuing
course of dealing also supports a finding that they intended
to create a loan because they followed through with the loan
formalities. Derivium sent Calloway quarterly account state-
ments showing the amount of interest accrued, the loan bal-
ance, the maturity date, and the projected balance at matu-
7 Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000) (existence of debt instrument),
affg. T.C. Memo. 1998–121; Fisher v. Commissioner, 30 B.T.A. 433, 440 (1934) (contents of debt
instrument).
8 See United Natl. Corp. v. Commissioner, 33 B.T.A. 790, 794 (1935).
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00040 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
66 135 UNITED STATES TAX COURT REPORTS (26)
rity. Those statements show that Derivium actually did add
interest to the loan balance. The quarterly statements and
the end-of-quarter loan balance reflect interest accruing at
the agreed rate. Derivium even sent Calloway a notice that
the loan term was ending and inquired as to what Calloway
intended to do. Calloway responded that he intended to sur-
render his collateral.
Interest Payments or Loan Repayment. 9 It’s certainly true
that Derivium’s loans were structured to provide for a bal-
loon payment. But we have seen loans without interim
interest payments before. At one time, lenders tried to get
away from paying income tax on interest income by giving
‘‘original issue discounts’’ instead of charging interest.
Lenders would extend a supposedly interest-free $95 loan, for
example, but then require the borrower to repay $100 at the
end of the term. See Travelers Ins. Co. v. United States, 25
Cl. Ct. 141, 143 (1992). Congress caught on and enacted sec-
tion 1281(a), which imputes interest income to holders of
original-issue-discount securities, demonstrating that interest
can accrue without actual payment during the loan term and
without turning the loan into a sale. See also United States
v. Midland-Ross Corp., 381 U.S. 54, 57–58, 66 (1965). A loan
isn’t even required to bear any interest at all if the parties
agree. Welch, 204 F.3d at 1230 (citations omitted). The
Commissioner may have a stronger point if the terms of the
purported loan called for interest payments and Calloway
didn’t pay. But nonpayment of interest according to the
terms of the agreement is unpersuasive.
Duty to Repay and Reasonable Prospect of Repayment. 10
The Commissioner says Derivium’s transactions weren’t
loans because the customers had the right to walk away. But
Calloway didn’t have the right to walk away scot free––he
had to surrender his collateral. As discussed above, the duty
to repay and reasonable prospect of repayment are analyzed
differently for a nonrecourse loan. See supra pt. IV.A. Non-
recourse loans have satisfied these tests if, at the beginning
of the loan, it makes economic sense for the borrower to
repay. Tufts, 461 U.S. at 312.
9 Welch, 204 F.3d at 1230–31.
10 Id.; United Natl., 33 B.T.A. at 796.
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00041 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(26) CALLOWAY v. COMMISSIONER 67
Sufficient Funds to Make Loan. 11 Our cases also tell us
that if a lender doesn’t have sufficient funds to make the
loan at hand, then the transaction is more like a sale. Welch,
204 F.3d at 1230; see also Gouldman, 165 F.2d at 690. But
after its scam got going, Derivium had sufficient funds on
hand until the whole thing collapsed. The record is clear that
Derivium sent Calloway funds before it received the proceeds
from the IBM stock, so the loan could not have been funded
by the sale. See majority op. p. 31 (‘‘On August 21, 2001,
Derivium sent to petitioner a letter informing him that the
proceeds of the loan were sent to him * * *. On that same
date, a $93,586.23 wire transfer was received and credited to
petitioner’s account’’); majority op. p. 30 (‘‘On August 22,
2001, the net proceeds from the sale of the IBM stock settled
into Derivium’s Morgan Keegan account.’’).
Ratio of Price Paid to Property Value. 12 Without other evi-
dence, if a lender lends full price for the purported collateral
it looks like a sale. United Natl. Corp., 33 B.T.A. at 797. But
at what discount should the court infer that the parties
intended a loan? In Fisher, the Board of Tax Appeals noted
that a purchase for substantially less than fair market value
may allow the Court to rescind a sale from an oppressive
‘‘lender’’, but a small discount coupled with the right to
repurchase ‘‘does not signify that a loan was intended.’’ 30
B.T.A. at 441. The discount in that case was not enough to
recharacterize the purported sale as a loan. This is admit-
tedly a closer question, but when one of Derivium’s cus-
tomers didn’t receive full price for his shares and doesn’t ask
us to change the formal characterization of the transaction,
I think this factor is consistent with intent to take out a
loan, or at least insufficient to recharacterize the loan as a
sale.
Derivium’s Intent and Conduct. 13 We should be mindful
that the various tests in the caselaw require us to consider
the conduct of both parties. But ‘‘intent’’ is not exactly the
right word for what we think we should be looking for when
one of the parties to a deal is trying to deceive another.
Derivium’s promises of a secret hedging strategy and its con-
11 Welch,
204 F.3d at 1230.
12 United
Natl., 33 B.T.A. at 797; Fisher, 30 B.T.A. at 441.
13 Welch, 204 F.2d at 1230; United Natl., 33 B.T.A. at 794; Fisher, 30 B.T.A. at 440; see also
Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981).
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00042 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
68 135 UNITED STATES TAX COURT REPORTS (26)
tinual flow of false statements to its customers, suggest to
any reasonable observer in hindsight that its intent was not
to make either a loan or a sale, but a quick theft of 10 per-
cent of the stock’s value. But Derivium’s actions in other
litigation show a desire to at least publicly represent their
transactions as loans. E.g., Derivium Capital LLC v. United
States Trustee, 97 AFTR 2d 2006–2582 (S.D.N.Y. 2006)
(stating that California court granted summary judgment
motion declaring transactions were loans and that Derivium
intended to file bankruptcy motion to get determination that
transactions were loans, not sales).
B.
There’s no doubt that the facts of this case are ugly.
Calloway relied on a promoter in entering the transaction,
testified the transaction was tax motivated, and didn’t report
consistently with his own characterization of the transaction
by failing to recognize dividends paid on the collateral as
income during the loan term and the disposition of the stock
as a sale for the amount of the accrued debt at the close of
the loan. These facts, while supporting the result in this
case, may differ significantly from cases where Derivium’s
customers were dupes rather than, at least to some degree,
in on the con. Never mind, says the majority, in both classes
of case, the initial transfer of stock from a customer’s account
to Derivium’s is a sale for tax purposes. 14
But to return to where I began, this case and all the
Derivium cases should be easy. If there was a bona fide non-
recourse loan, followed by the sale of collateral, the tax rules
are clear. According to section 1.1001–2(a)(4)(i), Income Tax
Regs., ‘‘the sale * * * of property that secures a nonrecourse
liability discharges the transferor from the liability.’’ And
when a nonrecourse liability is discharged by sale of collat-
eral, the borrower must recognize income at that point—the
amount realized is the amount of nonrecourse liability dis-
charged as a result of the sale. 15 Tufts, 461 U.S. at 308–09;
14 These worries are somewhat alleviated by the majority’s appropriately narrow application
of the penalties. In finding for the Commissioner on that issue, the majority relies exclusively
on Calloway’s personal treatment of the transaction—including his failure to report consistently
with a loan, his reliance on a promoter, and his failure to prove reasonable reliance on other
professionals.
15 The timing of the recognition event would be the same if the loan were a recourse loan,
but there are some differences in tax treatment when a recourse loan is satisfied by the sale
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00043 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
(26) CALLOWAY v. COMMISSIONER 69
Crane, 331 U.S. at 12–13; Fisher v. Commissioner, T.C.
Memo. 1986–141 (treating stamp collection as sold by tax-
payer in year pawnbroker sold it as opposed to year taxpayer
received money from pawnbroker). The first transaction,
then, would not be a recognition event for Calloway but
Derivium’s sale—even its secret sale—would. 16 In this case,
because the two events were nearly simultaneous, the tax
consequences to Calloway would be remarkably similar to
those flowing from the result reached by the majority. 17
There are, finally, some potentially odd consequences of
this opinion. Consider first an easy variation—a simple
collateralized loan subject to the same standard contract lan-
guage as in Derivium’s forms. The stock stays in the lender’s
electronic equivalent of a desk drawer, the borrower repays
the loan and regains control of the stock. Does this become
a sale on the initial transfer? And a repurchase when the
loan is repaid?
Or consider the example of subordination loans—stocks
transferred by an owner to a broker or dealer. The transferor
keeps his voting rights and dividends, but gives the trans-
feree the right to sell the transferred stock and retain the
proceeds. (This sort of deal is beneficial to the transferor
because he gets a stream of payments equal to a percentage
of the value of the securities he’s transferred. And it’s bene-
ficial to the broker or dealer because such securities count
toward his minimum net-capital requirements.) Courts have
always called these loans rather than sales, despite the right
of the transferee to sell. See, e.g., Cruttenden v. Commis-
of collateral for less than the debt amount. In that case the stock owner would recognize gain
or loss of the sale price less his basis, plus cancellation-of-debt income in the amount of the debt
forgiven less the sale price. See Gehl v. Commissioner, 102 T.C. 784, 789–90 (1994), affd. with-
out published opinion 50 F.3d 12 (8th Cir. 1995); sec. 1.1001–2(a), Income Tax Regs.; Rev. Rul.
90–16, 1990–1 C.B. 12. The cancellation-of-debt income would potentially be subject to an insol-
vency exclusion. See sec. 108(a)(1)(B).
16 The U.C.C. also seems to agree with this outcome. As noted above, while a secured party
holds securities, as between the two the debtor is considered the owner of the securities. U.C.C.
sec. 9–207 cmt. 6 (Example). But if the secured party sells the underlying securities ‘‘by virtue
of the debtor’s consent or applicable legal rules’’ then ‘‘the debtor normally would retain no in-
terest in the securit[ies] following the purchase [by a third party] from the secured party.’’ Id.
sec. 9–314 cmt. 3.
17 Because of a small amount of accrued interest, from the time the loan was made until the
stock was sold, Calloway would actually have a slightly higher deficiency if we found his trans-
action to be a bona fide loan. The Commissioner hasn’t made any claim for this little bit of extra
deficiency, so he wouldn’t get it. See Baker v. Commissioner, T.C. Memo. 2008–247 (citing Estate
of Petschek v. Commissioner, 81 T.C. 260, 271–72 (1983), affd.
738 F.2d 67 (2d Cir. 1984), and
Koufman v. Commissioner, 69 T.C. 473, 475–76 (1977)).
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00044 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
70 135 UNITED STATES TAX COURT REPORTS (26)
sioner, 644 F.2d 1368, 1374–75 (9th Cir. 1981), affg.
70 T.C.
191 (1978); Lorch v. Commissioner,
605 F.2d 657, 660 (2d
Cir. 1979), affg. 70 T.C. 674 (1978).
Or, perhaps especially, consider the increasingly complex
financial instruments like repos and customized derivatives.
All of these alter the ‘‘benefits and burdens’’ of ownership,
but some that take on the form of sales are treated as loans.
Kleinbard, supra at 798 & n.79 (‘‘For tax purposes, repos
traditionally have been treated as secured loans of money.’’
(citing Rev. Rul. 79–108, 1979–1 C.B. 75, Rev. Rul. 77–59,
1977–1 C.B. 196, and Rev. Rul. 74–27, 1974–1 C.B. 24)); see
also Neb. Dept. of Revenue v. Loewenstein, 513 U.S. 123, 130–
31 (1994) (finding repos are loans for purposes of 31 U.S.C.
section 3124(a)). Must all now be subject to the uncertainty
of the Grodt & McKay test?
I respectfully concur in the result in this case and even the
imposition of penalties (because Calloway did not respect his
own characterization of the transaction as a loan). But unless
future courts treat our analysis today as a limited-time ticket
good only on Derivium cases, we may be creating more prob-
lems than we’re solving.
f
VerDate 0ct 09 2002 10:37 May 29, 2013 Jkt 372897 PO 20009 Frm 00045 Fmt 2847 Sfmt 2847 V:\FILES\CALLOWAY.135 SHEILA
