                  T.C. Memo. 2003-299



                UNITED STATES TAX COURT



     HERMAN N. AND VERONICA WELTER, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 5041-01.            Filed October 29, 2003.



     Ps incorporated their farming operations in 1993.
Prior to the incorporation, P-H engaged in commodities
trading activities through several brokerage accounts.
After the incorporation, P-H continued to engage in
such activities through those accounts. Ps treated the
gains and losses from P-H’s commodities trading
activities as ordinary income or loss, as applicable,
on their 1994-96 Federal income tax returns.

     Held: Since P-H’s commodities trading activities
do not constitute hedging transactions, gains and
losses therefrom are capital in nature.

     Held, further, Ps are liable for penalties under
sec. 6662, I.R.C., as determined by R.

Bob A. Goldman, for petitioners.

Lisa K. Hartnett, for respondent.
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             MEMORANDUM FINDINGS OF FACT AND OPINION

     HALPERN, Judge:   By notice of deficiency dated January 22,

2001 (the notice of deficiency), respondent determined

deficiencies in, and penalties with respect to, petitioners’

Federal income tax as follows:

                                             Penalty
          Year      Deficiency           (Sec. 6662(a))

          1994         $25,310              $5,062.00
          1995           3,749                 -0-
          1996          19,408               3,881.60

Petitioners timely filed a petition for redetermination.       The

issues for decision are whether petitioners:       (1) Properly

characterized gains and losses (i.e., as ordinary rather than

capital) attributable to petitioner Herman Welter’s commodities

trading activities during the years at issue and (2) are liable

for the penalties determined by respondent.1

     Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the years at issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.




     1
        The parties stipulated that petitioners improperly
omitted from income in 1995 and 1996 amounts attributable to a
sec. 481 adjustment resulting from a prior audit. The parties
further stipulated: (1) Petitioners are entitled to increased
standard deductions for 1995 and 1996, and (2) respondent’s
adjustments relating to a net operating loss deduction for 1995,
self-employment income for 1995 and 1996, and Social Security
benefits for 1994, 1995, and 1996 are computational. We need not
further discuss those issues.
                                - 3 -



                           FINDINGS OF FACT

     Some facts are stipulated and are so found.   The stipulation

of facts, with accompanying exhibits, is incorporated herein by

this reference.   At the time they filed the petition, petitioners

resided in Onslow, Iowa.

     For many years prior to the years at issue, petitioners

engaged in farming operations in Jones County, Iowa.   In 1993,

petitioners incorporated their farming operations by transferring

their farming equipment, grain, and livestock to two subchapter C

corporations:   Welter Seed & Honey Co. and Land of Milk & Honey

Farms, Inc. (the corporations).    Petitioners retained ownership

of their farmland and leased it to the corporations for use in

the corporations’ farming operations.    Petitioners also received

a modest salary from the corporations.

     During the years at issue, each of the corporations

maintained its own books and records, had its own bank account,

and filed Federal income tax returns.    One of the corporations,

Land of Milk & Honey Farms, Inc., is listed as the “producer”

and the “operator” on Government forms relating to Federal

agricultural subsidy programs for each of those years.

     Prior to the incorporation of petitioners’ farming

operations, petitioner Herman Welter (Mr. Welter) engaged in

commodities trading activities through several brokerage

accounts.   Mr. Welter continued to engage in such activities
                                 - 4 -

through those accounts after the incorporation, without

transferring the accounts to the corporations.     Petitioners

represented to respondent that they continued to maintain the

brokerage accounts in Mr. Welter’s name after the incorporation

as a matter of convenience and to avoid additional filing and

account maintenance fees and expenses.     During the years at

issue, Mr. Welter’s commodities trading activity consisted

primarily of futures transactions in soybeans, oats, and corn.

      On their Federal income tax returns for the years at issue,

petitioners reported the following amounts as gain or loss from

Mr. Welter’s commodities trading activity:

                      Year          Gain (Loss)

                      1994       ($189,164.00)
                      1995          33,248.07
                      1996        (142,345.30)

In each instance, petitioners treated the gain or loss as

ordinary income or loss.     In the notice of deficiency, respondent

recharacterized such amounts as capital gain or loss, as

applicable.

                                OPINION

I.   Commodities Trading Activity

      A.   Arguments of the Parties

      Petitioners claim ordinary income and loss treatment with

respect to Mr. Welter’s commodities trading activity on the

ground that such activity consisted of hedging transactions
                               - 5 -

within the meaning of 26 C.F.R. section 1.1221-2 (1996) (former

section 1.1221-2).   Respondent contends, among other things, that

Mr. Welter’s commodities trading activity is not described in

former section 1.1221-2.

     B.   Law

     The term “capital asset” includes all classes of property

not specifically excluded by section 1221.   Sec. 1.1221-1(a),

Income Tax Regs.   Section 1221, as in effect during the years at

issue, did not contain a specific exclusion relating to hedging

transactions.   However, former section 1.1221-2(a)(1) provided

that, notwithstanding section 1.1221-1(a), Income Tax Regs., the

term “capital asset” does not include property that is part of a

hedging transaction.2   Former section 1.1221-2(b) defined the

term “hedging transaction” as follows:3

          (b) Hedging transaction defined. A hedging
     transaction is a transaction that a taxpayer enters
     into in the normal course of the taxpayer’s trade or
     business primarily –

                (1) To reduce risk of price changes or
           currency fluctuations with respect to ordinary



     2
        That regulatory exclusion was codified in 1999. See sec.
1221(a)(7) and (b)(2), added by the Ticket to Work and Work
Incentives Improvement Act of 1999, Pub. L. 106-170, sec.
532(a)(3), 113 Stat. 1928.
     3
        Former sec. 1.1221-2(g)(2)(i) provided that, in the case
of transactions entered into prior to Oct. 1, 1994, taxpayers
could rely on the rules of sec. 1.1221-2T, Temporary Income Tax
Regs., 58 Fed. Reg. 54037 (Oct. 20, 1993) (former sec. 1.1221-
2T). The definitions of “hedging transaction” in former sec.
1.1221-2(b) and former sec. 1.1221-2T(b)(1), respectively, are
substantially identical.
                               - 6 -

           property * * * that is held or to be held by the
           taxpayer; or

                (2) To reduce risk of interest rate or price
           changes or currency fluctuations with respect to
           borrowings made or to be made, or ordinary
           obligations incurred or to be incurred, by the
           taxpayer.

     C.   Discussion

     At trial, Mr. Welter testified that he engaged in

commodities trading primarily “to reduce the risk from the grain

that we have to buy.”   However, petitioners stipulated that they

did not produce any commodities during the years at issue and the

corporations conducted all of the farming operations in question.

Essentially, petitioners contend that they and the corporations

should be treated as a single economic unit for purposes of

applying former section 1.1221-2(b).

     Unfortunately for petitioners, their position is undercut

both by the language of former section 1.1221-2(b) and by long-

standing principles of Federal income taxation.   Former section

1.1221-2(b) clearly contemplates that, in order for a transaction

to qualify as a hedging transaction, the taxpayer entering into

the transaction and the taxpayer whose risk is thereby hedged

must be one and the same.   Furthermore, it is axiomatic that:

(1) Absent extraordinary circumstances, a corporation’s business

is not attributable to its shareholders for tax purposes, see

Burnet v. Clark, 287 U.S. 410 (1932), and (2) a person who

chooses the corporate form to conduct his business activities may
                               - 7 -

not subsequently disregard that form in order to gain a tax

advantage, see Moline Props., Inc. v. Commissioner, 319 U.S. 436

(1943).

     We recently decided a case presenting a question similar to

the question in this case.   In Pine Creek Farms, Ltd. v.

Commissioner, T.C. Memo. 2001-176, the taxpayer-corporation

raised corn, soybeans, and cattle.     It also engaged in

commodities trading activities involving corn, soybeans, cattle,

and hogs, treating the losses therefrom as ordinary losses.      The

Commissioner recharacterized the portion of the overall loss

attributable to hog futures as a capital loss, notwithstanding

that the taxpayer’s majority shareholder was a major shareholder

of two other closely held corporations that conducted hog

farrowing and hog finishing operations, respectively.       In

upholding respondent’s determination, we stated:

     Therefore, the business transactions of * * * [the
     corporations engaged in the hog business] cannot be
     attributed to * * * [the common shareholder] and from *
     * * [the common shareholder] to petitioner. We find no
     exceptional circumstances which would cause us to
     ignore the corporate entities and attribute the
     production of hogs to petitioner. While it may have
     been easier for * * * [the common shareholder] to
     maintain all the hedging transactions in one account
     under petitioner’s name, the hog futures transactions
     cannot be treated as hedging transactions of
     petitioner. * * *

     Under the reasoning of Pine Creek Farms, Ltd. v.

Commissioner, supra, the business activities of the corporations

cannot be attributed to Mr. Welter.     Petitioners do not argue
                                - 8 -

that the corporations were devoid of substance or were merely Mr.

Welter’s alter egos; indeed, the evidence points to the contrary.

Thus, while it may have been more convenient for Mr. Welter to

maintain the existing brokerage accounts in his own name

following the incorporation of petitioners’ farming operations,

the commodities transactions he engaged in through those accounts

during the years at issue do not qualify as hedging transactions

within the meaning of former section 1.1221-2(b).     It follows

that gains and losses attributable to such transactions are

capital in nature.   We therefore sustain respondent’s adjustments

with respect to Mr. Welter’s commodities trading activity.

II.   Penalties

      Section 6662 imposes a penalty equal to 20 percent of the

portion of any underpayment which is attributable to, among other

things, a substantial understatement of income tax.      Sec. 6662(a)

and (b)(2).   An understatement of income tax is deemed

substantial if it exceeds the greater of:      (1) 10 percent of the

tax required to be shown on the return for the year, or (2)

$5,000.   Sec. 6662(d)(1)(A).   For these purposes, the amount of

an understatement is reduced to the extent it is attributable to

a position (1) for which there is substantial authority, or (2)

which the taxpayer adequately disclosed on his return and for

which there is a reasonable basis.      Sec. 6662(d)(2)(B). In

addition, the section 6662 penalty does not apply to the extent
                                 - 9 -

the taxpayer can show that there was a reasonable cause for the

underpayment and that he acted in good faith with respect

thereto.   Sec. 6664(c)(1).

     Giving effect to respondent’s adjustments in the notice of

deficiency, petitioners’ tax liabilities for 1994 and 1996 were

$26,258 and $20,785, respectively.4       Petitioners reported tax of

$948 and $1,377 for those years.    Since each of the resulting

understatements of $25,310 and $19,408 is greater than $5,000,

those understatements are substantial within the meaning of

section 6662(d)(1)(A).5   Petitioners do not contend that any

mitigating factors apply (e.g., substantial authority or adequate

disclosure), and petitioners’ counsel conceded at trial that the

issue is purely computational.    Accordingly, petitioners are

liable for penalties under section 6662 as determined by

respondent.

     To reflect the foregoing,


                                              Decision will be entered

                                         for respondent.


     4
        Because their commodities trading losses were capital in
nature, petitioners are entitled to deduct only $3,000 of such
losses for each of the years at issue. See sec. 1211(b).
Regarding respondent’s other adjustments, see supra note 1.
     5
        Ten percent of the tax required to be shown on
petitioners’ 1994 return is $2,626, and 10 percent of the tax
required to be shown on petitioners’ 1996 return is $2,079.
Since $5,000 is greater than each of those amounts, that figure
controls for purposes of determining the existence of substantial
understatements in this case. See sec. 6662(d)(1)(A).
