                         T.C. Memo. 1996-133



                    UNITED STATES TAX COURT



    THEODORE A. ANDROS AND JOAN B. ANDROS, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 28208-89.                  Filed March 18, 1996.



    Stewart Allen Smith, for petitioners.

     Lawrence Davidow and Roland Barral, for respondent.



           MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS,   Judge:      Respondent     determined    deficiencies      in

petitioners'   Federal   income   taxes   for   1976   and   1980   in   the
                                      -2-

respective amounts of $983,966.13 and $2,338.90, and additional

interest for 1980 pursuant to section 6621(c).1

     Pursuant    to    an   amended   answer,        respondent    asserts   that

petitioners are liable for additional interest for 1976 pursuant to

section 6621(c), and additions to tax for 1976 and 1980 pursuant to

section 6653(a) in the respective amounts of $49,198 and $117.

     This case involves petitioner Theodore A. Andros' investment

in an options-spreads and futures-trading partnership, Tandrill

Associates (Tandrill).       It is part of the Arbitrage Management tax

litigation project.         The deficiencies result from respondent’s

disallowance of Theodore A. Andros’ allocable share of partnership

losses   from:   (1)    1979   option       spread    transactions     involving

Government securities, and (2) 1979 and 1980 futures transactions

involving commodities and Government securities.                  The deficiency

for 1976 results from respondent's reduction in petitioners' net

operating loss carryback to that year from 1979.

     The issues for decision are: (1) Whether respondent properly

disallowed petitioners’ allocable share of Tandrill’s losses for

1979 and 1980, pursuant to section 165(c)(2); the resolution of

this issue turns on whether the underlying partnership transactions


     1
           Pursuant to the Tax Reform Act of 1986, Pub. L. 99-514,
sec. 1151(c)(1), 100 Stat. 2744, former sec. 6621(d) was
redesignated as sec. 6621(c).
           Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the years in issue.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
                                           -3-

were entered into primarily for profit; (2) whether petitioners are

liable for additions to tax for negligence or intentional disregard

of    rules   or   regulations      for    1976     and   1980;    and       (3)    whether

petitioners are liable for additional interest for 1976 and 1980.

       We find that the underlying options-spreads and futures-

trading transactions by Tandrill were not entered into primarily

for    profit,     and    we   therefore     hold     that   respondent            properly

disallowed petitioners’ allocable share of Tandrill’s losses for

1979 and 1980.      We further hold that petitioners are not liable for

additions to tax for negligence or intentional disregard of rules

or regulations for 1976 and 1980, but that they are liable for

additional interest for 1976 and 1980.

                                 FINDINGS OF FACT

       Some   of    the    facts    have    been     stipulated        and    are    found

accordingly.       The stipulations of facts and the attached exhibits

are incorporated herein by this reference.

Background

       Petitioners,       husband   and     wife,    resided      in    Key    Biscayne,

Florida, at the time they filed their petition.                    They filed joint

Federal income tax returns for all relevant years. In April 1980,

petitioners filed a Form 1045, Application for Tentative Refund,

claiming that they were entitled to a net operating loss carryback

of $1,766,137 from 1979 to 1976.

       Joan B. Andros is involved in this case by virtue of having

filed joint Federal income tax returns with her husband, Theodore
                                -4-

A. Andros.   Unless otherwise specified, the term “petitioner”

refers to Theodore A. Andros.

     Petitioner received a B.A. in economics and psychology from

the University of Nebraska in 1950. He thereafter entered the U.S.

armed services and received the equivalent of an electronics

engineering degree.

     Petitioner is an experienced and sophisticated businessman. He

has a basic knowledge of tax law.      Petitioner understands the

beneficial treatment accorded to capital gains and knows that

excess losses in 1 year can be carried back to the 3 prior years.

Hy-Gain Electronics Corp.

     Petitioner was one of the founders of Hy-Gain Electronics

Corp. (Hy-Gain). Hy-Gain manufactured communications equipment.

From 1972 through 1976, petitioner was the executive vice president

as well as a director and shareholder of Hy-Gain.       His brother,

Andrew Andros, was Hy-Gain’s president.

     On March 19, 1976, petitioner sold his shares of Hy-Gain stock

for $3.6 million.   He realized a $3,492,989 long-term capital gain

from the sale.

Real Estate Transactions

     Upon leaving Hy-Gain, petitioner became involved in real

estate transactions, including condominium conversions.     By 1979,

he was involved in commercial real estate consulting.    He also had

investments in other business enterprises.
                                 -5-

Richard Illingworth

     Petitioner first met Richard Illingworth at a social gathering

in Miami in late 1977 or early 1978.        Petitioner informed Mr.

Illingworth that he was looking for investment opportunities. In

that regard, Mr. Illingworth explained to petitioner how he could

benefit from trading in commodity futures as well as option spreads

involving Government securities. They discussed the possibility of

forming a partnership that would engage in the trading of option

spreads and commodity futures.

     Mr. Illingworth was educated in England and in the late 1960's

entered the commodities business.      He first worked at the London

Metal Exchange for the Rudolf Wolff Co., a London metal broker and

commodity trader.   In 1971, he moved to the United States, where he

was employed by C. Tennant Sons & Co., a metals and futures trading

company. Two years later, Mr. Illingworth moved to ICC Metals (a

division of International Chemical Corp.) where he traded in copper

and other metals. Subsequently, he worked for Gill & Duffus under

a trader named Herbert Weiss.

     In 1977, Mr. Illingworth formed Manhattan Metals (Nonferrous)

Ltd. (Manhattan Metals), a New York corporation, involved in

physical commodities and futures trading.       He was the largest

Manhattan Metals shareholder and had a controlling interest.2    Mr.


     2
            The remaining stock was owned by Mr. Illingworth’s
                                                   (continued...)
                                  -6-

Illingworth’s goal was to build Manhattan Metals into a commission

merchant that would compete with Merrill Lynch.

     Initially,   Manhattan   Metals    brokered   relatively   small

transactions in metals, including copper. Manhattan Metals then

expanded its operations to include trading in the futures markets,

primarily in copper, gold, and silver.

     By 1980, Manhattan Metals had seven employees, including two

traders--Mr. Illingworth and Herbert Weiss. Mr. Weiss was the main

trader for Manhattan Metals.      He was authorized to make trades

without discussing them with Mr. Illingworth.      One of Mr. Weiss’

responsibilities was to evaluate the prices that were being paid by

Manhattan Metals for option spreads.

     Mr. Illingworth held seats on the New York Mercantile Exchange

and the New York Futures Exchange. Mr. Weiss was a member of the

Commodities Exchange, Inc. (COMEX).      Manhattan Metals was not a

member of any exchange.

     In addition to Manhattan Metals, Mr. Illingworth was a partner

in several partnerships that were involved in option spreads and

commodities trading activities.

Petitioner’s Investigation of Mr. Illingworth

     In considering the possibility of entering into an investment

relationship with Mr. Illingworth, petitioner engaged attorneys at


     2
      (...continued)
then wife and a third-party investor.
                                       -7-

the Miami law firm of Paul & Thomson, accountants at Peat Marwick,

and    a   private     investigator   to     investigate    Mr.    Illingworth’s

background.      The reports petitioner received confirmed what Mr.

Illingworth      had    stated   to   be   his     background     and    convinced

petitioner     that    Mr.   Illingworth     had   expertise      in   commodities

trading.

       Petitioner also consulted with accountants at Peat Marwick

regarding the tax ramifications of establishing and operating a

partnership with Mr. Illingworth.

Trading Terminology

       Trading in commodity futures contracts involves tremendous

leverage and thus the potential for large gains or losses.                         A

“futures” contract is a forward instrument (having a long side and

a short side) with respect to an underlying commodity.                           The

contract represents a commitment to deliver (sell) or receive (buy)

a specified quantity of a commodity at a specified price at a

specified date in the future.         At the expiration of the specified

time (which is referred to by the specified month), a trader

holding a short futures contract (a contract to sell the commodity)

must   deliver    the    underlying    commodity     to    the    holder    of   the

corresponding long contract at the specified price.                        A trader

holding a long futures contract (a contract to buy the commodity)

can compel the holder of the corresponding short contract to

deliver the underlying commodity.              Less than 5 percent of all
                                  -8-

futures contracts actually result in delivery of the underlying

commodity; most are offset.     Futures contracts involving sales and

purchases of commodities are regulated by the Commodity Futures

Trading Commission through the Commodity Exchange Act.

     A securities option is the right to buy or sell an underlying

security at a specific price (the “strike price”) and a specified

time (the expiration date). There are two types of options: “Call”

options and “put” options.       In a call option, the grantor (or

seller) of the option is required, if the buyer so desires, to sell

the underlying security to the buyer at the strike price on the

expiration date.   The buyer of a call option has the right to

“call” the security from the seller.      The buyer is “bullish” on the

underlying security; he is betting that the market price of the

underlying security will rise above the strike price.               If that

happens, the   option   buyer   will    purchase   the   security   on   the

expiration date at the strike price, which will be less than the

current market price.    With a put option, the grantor (or seller)

of the option is required, if the buyer so desires, to purchase at

the expiration date the underlying security put to him by the buyer

at the strike price.    In this latter case, the buyer is “bearish”

on the underlying security.     He is betting that the market price of

the underlying security will fall below the strike price by the

expiration date.   In that case, he will “put” the security to the

option writer, who must pay the higher strike price.
                                -9-

     The price of an option, or its “premium”, is composed of two

elements:   The option’s “intrinsic value” and its “time value”.

For a call option, the intrinsic value of the option is the amount,

if any, by which the price of the underlying security exceeds the

option’s strike price.    The balance of the premium is the time

value of the option.   For a put option, the intrinsic value of the

option is the amount, if any, by which the strike price exceeds the

price of the security.

     Generally, an option’s price in the marketplace will be

greater than its intrinsic value. The additional amount of premium

beyond the intrinsic value reflects that traders are willing to pay

the “time value” of money or the option’s “time premium”.   Market

participants are willing to pay this additional amount because of

the protective characteristics afforded by an option over an

outright long or short position in the underlying security.

     An option is “in the money” when the option’s strike price is

less than the current market price of the underlying instrument;

i.e., when it would be economically favorable for the option holder

to exercise the option. An option is “out of the money” when it

would be economically unfavorable to exercise the option. When the

option strike price equals the market price of the underlying

security, an option is “at the money”.

     In the futures market, a “spread” consists of the simultaneous

establishment of two opposite positions for delivery of the same
                                            -10-

commodity in different delivery months.                 Such a spread consists of

two “legs”: One is the purchase of a commodity for delivery at a

specific future date, while the other is the simultaneous sale of

the same commodity for delivery at a different specified future

date.        Although there are variations in spreads, all of them have

a simultaneous purchase and sale.

       In         the   options   market,    a   “spread”     (sometimes   called   a

“straddle”) is a position maintaining simultaneously both long and

short options of the same type (i.e., puts or calls) or of

different types in the same class. A “vertical spread” in the

options market consists of purchasing an option at one strike price

and simultaneously selling an option at another strike price, where

the options are identical in all other respects.3 “Vertical put

spreads” are positions in which a trader has both long (purchased)

puts        and    short   (sold)   puts    in   the   same   underlying   asset    at

different strike prices for the same maturity month.                  The spread is

a “credit spread” when the price paid for the long position is less

than the price received for the short position so that the trader’s

account shows a cash credit.               The trader is then considered to have

“sold” the spread.           A trader is said to have “purchased” the spread

(a “debit spread”) when the price paid for the long position is


        3
                   The following is a typical vertical spread:

                                    Buy 1 June 90 call
                                    Sell 1 June 95 call
                                      -11-

less than the price received for the short position so that the

trader’s account shows a debit.

      “Butterfly spreads” occur when a trader holds three positions

in   the   same   underlying   asset    in   puts    or     calls   in     the   same

expiration month at three different strike prices, with the highest

and lowest       strike   positions   one-half      the   size   of    the   middle

position.4

A General Description of Tandrill’s Trading Plan

      On August 22, 1979, petitioner and Mr. Illingworth formed

Tandrill,    a    general   partnership      under    the    laws     of   Florida.

Tandrill is a combination of the names of its two partners: T.

ANDROS and R. ILLINGWORTH. Petitioner contributed the major portion

of the funding for the partnership while Mr. Illingworth agreed to

conduct Tandrill’s trading activity.          As stated in the partnership

agreement, the purpose of Tandrill was to trade in:

             commodities   of    every    nature,   foreign
             currencies, U.S. Treasury Bills, U.S. Treasury
             Bonds,   GNMA    Certificates[5]   and   other


      4
          A “butterfly” spread is a balanced straddle position.
An example of a butterfly spread in gold would involve the
purchase of one contract of February gold, the short sale of two
contracts for April delivery, and the purchase of one contract of
June gold. If the price of gold goes up, the investor will profit
on his two long contracts in February and June and lose a
substantially like amount on his two short April contracts. The
“butterfly” spread gets its name because it has a heavy body in
the center (in this case the two April short contracts) and
lighter wings on the side (in this case the one long contract
each in February and June).
      5
          GNMA’s, sometimes referred to as “Ginnie Maes”, are
long-term coupon-bearing securities issued through the Government
                                                   (continued...)
                                   -12-

           government (foreign or domestic) financial
           instruments and futures contracts and options
           with respect to the foregoing, and in
           connection   therewith   to   use  arbitrage,
           spreading,   margin   and   other  leveraging
           devices, and such other techniques deemed
           appropriate.

Petitioner contributed $300,000 to Tandrill in exchange for a

93.75-percent partnership interest; Mr. Illingworth contributed

$20,000 in exchange for a 6.25-percent interest.

      On the same date Tandrill was formed (August 22, 1979),

Tandrill entered into a Management Agreement with Manhattan Metals,

whereby it was agreed that Manhattan Metals would “manage, buy,

sell, sell short, redeem and otherwise invest, reinvest and trade

in   commodities   of   every   nature”   on   Tandrill’s   behalf.   The

Management Agreement authorized Manhattan Metals to: (1) Perform

administrative functions for Tandrill; (2) employ Wilcap Advisors

(Wilcap)6 as an adviser in its trading activities; and (3) share in

commissions or fees that Tandrill paid.

      Tandrill paid Manhattan Metals a retainer and organization fee

of $10,000 upon execution of the Management Agreement. On an

ongoing basis, Tandrill was required to pay Manhattan Metals an


      5
      (...continued)
National Mortgage Association that represent undivided interests
in specific pools of Government-guaranteed mortgages. Such
certificates are backed by the full faith and credit of the
Federal Government.
      6
          Messrs. Paul Willensky and Mark Sherman were the
principals of Wilcap. Mr. Illingworth had known Messrs. Willensky
and Sherman less than a year, and had not previously dealt with
them, when he decided to use their company as an adviser to
Manhattan Metals.
                                     -13-

annual    management   fee   of    three-fourths      of    1    percent    of   the

aggregate value of Tandrill’s investments with Manhattan Metals

(including the value of commodities subject to futures contracts),

the value of premiums paid for options, and cash on hand.                  Such fee

was capped at a maximum of $50,000, or $12,500 per calendar

quarter, for the period ending September 30, 1980, and at a maximum

of $25,000 per year, or $6,250 per calendar quarter, thereafter.

       The Management Agreement had no fixed termination date; it

could be terminated on 30 days’ notice by either party. The

agreement provided that, if petitioner terminated the agreement

before September 30, 1980, Tandrill would pay Manhattan Metals the

difference between $50,000 and the sum of the quarterly fees that

had been paid to Manhattan Metals for that period.

       Manhattan   Metals    was   not     required    to       perform    services

exclusively for Tandrill.          Petitioner understood that although

Manhattan Metals would conduct Tandrill's trading activities and

that     Mr.   Illingworth   would    be    in   charge         of   deciding    the

partnership’s trading positions, Mr. Illingworth would be assisted

in doing so by others.        Petitioner had no interest in managing

Tandrill’s day-to-day trading activities; he merely wanted the

right to make suggestions and review documents.

       At the time that the trades were undertaken, petitioner did

not understand the exact nature of Tandrill's trading activities,

or the mechanics and theories of commodities trading. Although Mr.

Illingworth sent petitioner periodic updates regarding Tandrill’s
                                    -14-

trading activity, petitioner did not closely monitor the trades

Manhattan Metals performed for Tandrill.

      Tandrill's net asset value decreased each calendar quarter

during 1980.

Tandrill's Transactions

      Arbitrage        Management    Investment       Company     (Arbitrage

Management)7 and Pershing & Co. (Pershing) performed brokerage

services    for   Tandrill   with   respect   to   Treasury     bill   options

transactions; they also made the market in which such transactions

were executed.     Arbitrage Management or Pershing was on the "other

side" of each Treasury bill option transaction that Tandrill

entered.     A.C.L.I. International Commodity Services, Inc. (ACLI),

and Bache Halsey Stuart Shields, Inc. (Bache), performed brokerage

services for Tandrill with respect to its commodity futures trading

transactions.

      a.    Options Transactions

      The Treasury bill options transactions involved herein were

cleared through Pershing and Arbitrage Management.8 See appendices

A-D   for   a   list   of   Tandrill’s   put-option    positions.      Messrs.

Willensky and Sherman of Wilcap handled the trades on behalf of

Manhattan Metals. They made all the trading decisions with respect


      7
          Arbitrage Management Investment Company has been
involved in other cases in this Court. See, e.g., Fox v.
Commissioner, 82 T.C. 1001 (1984); Manko v. Commissioner, T.C.
Memo. 1995-10.
      8
          Pershing and Arbitrage Management "wrote" the options
comprising the spreads that Tandrill established.
                                  -15-

to the Treasury bill options transactions, after discussing with

Mr. Illingworth the "general parameters" of such trading.     Wilcap

decided which brokerage house would execute a particular options

transaction.

     The options transactions did not occur on a regulated exchange

but instead were conducted over the counter.9        Current trading

prices for the option spreads, or the constituent put options, were

not published daily.   There was no publicly available mechanism

through which a trader in Treasury bill options could ascertain the

current price of his positions.    No steps were taken to insure that

Tandrill paid or received fair prices for its positions in Treasury

bill options.

     All of the options transactions that Tandrill entered into

possessed the following characteristics: (1) They were part of

eight "vertical put" straddles or spreads; (2) all of the spreads

were opened and closed out in 1979; (3) the underlying commodities

were Treasury bills; (4) when the spreads were opened, all of the

puts were "in the money"; (5) all of the spreads were closed out

through "offset" before the date of issuance of the underlying

Treasury bills; (6) the options spreads were purchased as a unit

rather than as separate legs; and (7) the spread between exercise

prices varied from a minimum of .06 to a maximum of .125.    None of

the trade spreads was profitable.

     9
          In 1979 there were three or four dealers who made a
market in over-the-counter Treasury bill options.
                                 -16-

     Six of the options spreads were executed through Pershing.

These spreads were all credit spreads, so-called because Tandrill

received money or a credit to its account when it established the

spreads.10   These spreads involved the sale of put options having

a higher dollar exercise price and the purchase of puts with a

lower dollar exercise price.     The other two options spreads were

executed through Arbitrage Management.   Both of these spreads were

debit spreads, so-called because Tandrill paid money or suffered a

debit of its account when it established the spreads.         These

spreads involved the sale of put options having a lower dollar

exercise price and the purchase of put options having a higher

dollar exercise price.

     b.   Futures Transactions

     Tandrill's futures transactions generally had the following

characteristics: (1) Most took the form of straddles or spreads;

(2) Tandrill's British pound and Swiss franc futures trading took

place on the International Monetary Market; (3) the Treasury bill

futures trading took place on the Chicago Mercantile Exchange; (4)

the Treasury bond and GNMA futures trading took place on the

Chicago Board of Trade; (5) the sugar futures trading took place on

the Coffee, Cocoa and Sugar Exchange; (6) the gold, silver, and

copper futures trading took place on the COMEX; (7) the trading in




     10
          Vertical spreads, like individual options, can either
be purchased or sold. These spreads were sold by Tandrill.
                               -17-

"physical" copper took place through Manhattan Metals;11 and (8) all

of the futures positions were closed out through "offset".

     In 1979 and 1980, Tandrill entered into futures transactions

in gold, silver,12 copper, and Treasury bills through Bache.   With

respect to these transactions: (1) The gold and silver trading

began on November 1, 1979, and the copper trading began on November

14, 1979; (2) all the gold, silver, and copper futures transactions


     11
          Tandrill's trading in "physical" copper had the
following characteristics: (1) Delivery or receipt of the
commodity was never intended and never took place; (2) all gains
and losses were cleared through a "difference account"; (3)
Manhattan Metals was on the other side of each transaction that
Tandrill entered into; Manhattan Metals was the source of any
profits and losses Tandrill realized; and (4) the "physical"
copper trades did not occur on an exchange. Respondent could not
determine how the “physical copper” transactions affected
petitioners’ or Tandrill’s tax returns, and the tax consequences
of these transactions are not in dispute here.
     12
          The price of silver fluctuated substantially on Nov.
21, 23, and 27, 1979. The following chart (taken from the COMEX
Statistical Yearbook for 1979) indicates the price movement and
number of contracts of September 1980 silver traded each day
between Nov. 15 and 27, 1979:
                          Price           Contracts
           Date          Movement          Traded

          Nov.   15       down 7.8            605
          Nov.   16       up 7                235
          Nov.   19       up 2                126
          Nov.   20       up 3                 80
          Nov.   21       down 21           4,463
          Nov.   23       up 31.5             817
          Nov.   26       up 7                173
          Nov.   27       up 40             4,240

     Of the 721 silver contracts that Tandrill closed out in
1979, 718 were closed out on either Nov. 21 or 27, 1979. On Nov.
21, 1979, Tandrill closed out 359 silver contracts by
repurchasing 119 May 1980 silver contracts and 240 December 1980
silver contracts. On Nov. 27, 1979, Tandrill closed out 359
silver contracts by repurchasing 108 March 1981 silver contracts,
75 March 1980 silver contracts, and 176 September 1980 silver
contracts.
                                        -18-

involved balanced straddles; some were butterfly spreads;13 (3) in

1979, Tandrill,        in   its    account     with     Bache,   entered       into    160

contracts of copper futures straddles, 330 contracts of                               gold

futures straddles, and 1,110 contracts of silver futures straddles;

(4) in 1979, Tandrill closed out by offset 100 of the copper

futures contracts, 164 of the gold futures contracts, and 697 of

the     silver   futures       contracts,        realizing       a       net   loss        of

$1,772,139.10, including commissions; (5) every futures spread

Tandrill closed out in 1979 involved the realization of a loss,

with the exception of an aggregate gain of $612 realized on 20 July

1980 copper      contracts;       and   (6)    on   a   weighted         average   basis,

Tandrill's 1979 silver, gold, and copper spreads were kept open an

average 12.10 days.14


      13
          For example, on Nov. 26, 1979, Tandrill purchased 20
May 1980 copper contracts, sold 40 July 1980 copper contracts,
and purchased 20 September 1980 copper contracts.
      14
                            HOLDING PERIODS, 1979 TRADES

 DATE        DATE                                                NUMBER             DAYS X
 SOLD        BOUGHT         QUANTITY          DESCRIPTION        OF DAYS           QUANTITY

11/01/79    11/21/79          18          Apr. 81 Gold           20                  360
11/06/79    11/21/79         146          Apr. 81 Gold           15                2,190
11/15/79    11/21/79         119          May 80 Silver           6                  714

11/01/79    11/21/79          73          Dec. 80 Silver         20                1,460
11/02/79    11/21/79          79          Dec. 80 Silver         19                1,501
11/05/79    11/21/79          88          Dec. 80 Silver         16                1,408

11/15/79    11/27/79         108          Mar. 81 Silver         12                1,296
11/21/79    11/27/79          75          Mar. 80 Silver          6                  450
11/21/79    11/27/79         132          Sept. 80 Silver         6                  792

11/21/79    11/27/79          44          Sept. 80 Silver            6              264
                                                                         (continued...)
                                      -19-

        Tandrill realized gains and losses in 1979 and 1980 from

commodity futures transactions, with respect to which Bache was the

broker, in the following amounts:

                           Net Gain/Loss                  Net Gain/Loss
 Commodity                     1979                            1980

Silver                     ($1,402,729.30)                 $738,631.30
Gold                        ( 264,033.00)                   207,874.60
T-Bill futures                 199,502.00                   (44,448.80)
Copper                      ( 105,440.00)                   (35,821.10)
Other                             ---                       (16,940.90)
Total                       (1,572,700.30)                  849,295.10

        In 1980, Tandrill entered into futures transactions in copper,

gold, sugar, Treasury bills, Treasury bonds, and GNMA's through

ACLI.        Tandrill realized $749,143.50 in net losses with respect to

the commodity futures transactions.                For example, on June 26-27,

1980, Tandrill entered into a "spread of a spread" involving GNMA

and Treasury bond contracts: (a) It purchased 30 March 1981 GNMA

contracts and sold 30 September 1981 GNMA contracts; and (b) it

purchased 30 September 1981 Treasury bond contracts and sold 30



        14
             (...continued)
11/27/79        12/26/79        3        Dec. 80 Silver      29             87
11/14/79        11/21/79       10        Mar. 80 Copper       7             70

11/14/79        11/23/79       10        Mar. 80 Copper       9             90
11/21/79        12/03/79       10        July 80 Copper      12            120
11/23/79        12/03/79       10        July 80 Copper      10            100

11/26/79        12/13/79       20        July 80 Copper      17            340
11/26/79        12/19/79       20        July 80 Copper      23            460
11/26/79        12/07/79       20        Sept. 80 Copper     11            220

TOTALS                        985                                         11,922

Average days per transaction               13.56
Average days per contract (11,922/985)     12.10
                                       -20-

March 1981 Treasury bond contracts.            On October 28, 1980, Tandrill

entered into another "spread of a spread" involving GNMA and

Treasury bond       contracts:   (a)    It    purchased     30    June   1981    GNMA

contracts and sold 30 March 1981 GNMA contracts; and (b) it

purchased   30     June   1981   Treasury      bond   contracts     and    sold    30

September    1981     Treasury    bond       contracts.     The    October      1980

transactions resulted in a $327,030 loss on the GNMA contracts and

a $368,280 loss on the Treasury bond contracts. This left Tandrill

with unrealized profits of $691,406.25 in its open positions.

Tandrill's open positions were liquidated in 1981.

Tandrill’s Liquidation

     Tandrill ceased operations in 1981; at this time, its capital

had dwindled to approximately $10,000. Petitioner received only one

distribution     from     Tandrill,    in    the   amount    of    $9,782,      which

represented his proportionate share of Tandrill's net assets on the

1981 liquidation date.

Tandrill's Forms 1065

            Peat    Marwick’s    New    York    office    prepared       Tandrill’s

partnership returns (Forms 1065) for 1979 and 1980.15

     a.   1979

     On its 1979 partnership return, Tandrill reported an ordinary

loss of $1,858,743 on Treasury bill options and claimed deductions



     15
          Petitioners introduced into the record Tandrill’s 1979
and 1980 yearend financial statements. However, they failed to
present evidence proving the reliability of such documents. We
have therefore not utilized these statements in making our
determination.
                                       -21-

for a management fee and accounting fee of $22,500 and $270,

respectively.        These ordinary losses arose from purchased put

options on Treasury bills.             Each of Tandrill's purchased put

options was closed out at a loss in 1979.

       Tandrill also reported short-term capital gains of $163,666 on

this   return,      computed    as   the   excess    of       short-term    gains   of

$1,736,366 over short-term losses of $1,572,700. The $1,736,366 in

short-term capital gains arose from the sale of put options on

Treasury bills. The $1,572,700 in short-term capital losses arose

from futures transactions in gold, silver, copper, and Treasury

bills.

       b.    1980

       On its 1980 partnership return, Tandrill reported an ordinary

loss of $19,428 on Treasury bill futures transactions, interest

income      of   $36,065,   and   deductions    for       a    management    fee    and

accounting fee of $43,750 and $9,700, respectively. Tandrill also

reported     short-term     capital    losses   of    $918,244      and     long-term

capital gains of $1,509,077.           Both the short-term capital losses

and    long-term      capital     gains    arose     from       commodity     futures

transactions.

Petitioners' 1979 and 1980 Federal Income Tax Returns

       Peat Marwick’s Miami office prepared petitioners’ returns for

both years in issue. Petitioner provided Peat Marwick with his tax

information and copies of his 1979 and 1980 Schedules K-1 from

Tandrill for use in Peat Marwick’s preparation of petitioners’ 1979

and 1980 returns.
                                       -22-

      Petitioners reported the following amounts of income and loss

on   their   1979    and   1980    returns    with   respect   to   petitioner's

investment in Tandrill:

               Income                Short-Term                 Long-Term
 Year          (Loss)             Capital Gain (Loss)          Capital Gain

 1979        ($1,758,908)             $153,437                      ---

 1980              (34,512)           (860,854)                 $1,414,760

      In April 1980, petitioners filed a Form 1045, Application for

Tentative Refund, claiming entitlement to a net operating loss

carryback of $1,766,137 from 1979 to 1976.

Notice of Deficiency

      In     the    notice    of     deficiency,      respondent     disallowed

petitioners’ allocable share of losses arising from Tandrill’s

transactions on the premise that no profit motive existed with

respect to the transactions.16 Respondent determined the following

corrected amounts of income and loss petitioner realized through

his investment in Tandrill:

                    Income              Short-Term              Long-Term
  Year              (Loss)             Capital Gain            Capital Gain

  1979               $5,010                   ---                   ---

  1980               33,811                   ---                   ---




      16
          Respondent also determined that “the transactions at
issue were either shams or devoid of the substance necessary for
recognition for federal income tax purposes.” Respondent’s
amended answer reiterated this position. However, at trial,
respondent’s counsel informed the Court that the only issue for
decision in this regard is whether Tandrill entered into the
transactions at issue primarily for profit. We therefore will
assume that Tandrill’s transactions were not shams.
                                    -23-

Accordingly, the adjustments respondent made in the notice of

deficiency increased (decreased) petitioners' income and loss items

as follows:

                    Income           Short-Term                 Long-Term
  Year              (Loss)          Capital Gain               Capital Gain

  1979            $1,763,918         ($153,437)                      ---

  1980                68,323             860,854               ($1,414,760)

The adjustment to petitioners' 1979 income results in a reduction

of   petitioners'    net     operating    loss     carryback    to   1976   from

$1,766,137 to $146,279, and an increase of $1,619,858 in taxable

income for 1976.     The disallowed deductions arose from Tandrill's

transactions involving Treasury bill option spreads and commodity

futures.17

                                   OPINION

Issue 1.     Tandrill Losses

     The first issue for decision is whether respondent properly

disallowed petitioners’ allocable share of Tandrill’s 1979 and 1980

losses pursuant to section 165(c)(2).            This issue turns on whether

the underlying partnership transactions were entered into primarily

for profit.    Petitioners have the burden of proof in this regard.

Rule 142(a).

     17
          We note that prior to the trial in this case, the
Internal Revenue Service (IRS) audited Mr. Illingworth’s 1978-80
tax years, disallowing loss deductions that he had claimed
relating both to Tandrill’s transactions at issue herein and to
other transactions involving other partnerships. The IRS
determined that Tandrill’s transactions had not been entered into
for profit. Mr. Illingworth ultimately accepted an IRS
settlement offer based on this determination.
                                      -24-

      Respondent   contends     that     the   purpose      of   the    options

transactions was to generate corresponding amounts of ordinary

losses and short-term capital gains in 1979, while the purpose of

the commodity futures transactions was to generate short-term

capital losses     in   1979   and   long-term   capital     gains     in   1980.

Respondent posits that at the time the transactions were entered

into, Tandrill’s general partners (petitioner and Mr. Illingworth)

expected to realize economic losses rather than economic profits.

According to respondent, petitioner was aware that the economic

consequences of the transactions entered into by Tandrill were de

minimis as compared to their potential tax benefits.             On the other

hand, petitioners argue that the transactions at issue were entered

into with both a profit motive and profit potential.             We agree with

respondent.

      Respondent and petitioners each rely on reports and testimony

of their respective experts.         As the trier of fact, we must weigh

the   evidence   presented     by    these   experts   in   light      of   their

demonstrated qualifications as well as all other credible evidence.

Estate of Christ v. Commissioner, 480 F.2d 171, 174 (9th Cir.

1973), affg. 54 T.C. 493 (1970). We are not bound by the opinion of

any expert witness when that opinion is contrary to our own

judgment.   Chiu v. Commissioner, 84 T.C. 722, 734 (1985).
                              -25-

                      The Parties’ Experts

Mr. Natenberg

     Respondent’s first expert witness, Sheldon Henry Natenberg,

received a B.A. in mathematics from the University of Illinois.

After working in unrelated fields for 10 years, he became an

independent option trader in 1982.   Mr. Natenberg is an options

consultant and conducts educational seminars for traders all over

the world. He has written a book, Option Volatility and Pricing

Strategies, which was published in 1988 and revised in 1994.     Mr.

Natenberg is a member of the Chicago Board of Trade.

     Mr. Natenberg's report, rebuttal report, and testimony solely

addressed Tandrill's 1979 options spreads. Mr. Natenberg testified

that Tandrill’s options trades consisted of vertical put spreads,

with all the puts being in the money. Grouping the trades by

opening date and exercise price, he further testified that the

trades consisted of eight different put vertical spreads. Six

spreads were initially sold and later bought back, and two spreads

were initially purchased and later sold out.   Mr. Natenberg opined

that in every one of the six spread positions initiated with the

sale of a vertical put spread, the spread was sold at a price so

low that a profit could be considered at best highly unlikely.    He

further stated that when the spread positions were closed, they

then were bought back at a price greater than the maximum possible

spread value. Thus, according to Mr. Natenberg, profit was not the

motivation for the trades.
                                   -26-

     Mr.   Natenberg   testified   that   in   closing   out   the   spread

transactions, Tandrill experienced a cash outflow.        By paying more

than the theoretical maximum value to close out the spreads,

Tandrill reduced its overall profits (if any) or increased its

overall losses.   Mr. Natenberg explained that over the life of an

option, the option’s value will vary depending on current market

conditions and the likelihood of changing conditions in the future.

He referred to the Black-Scholes Model.18       The Black-Scholes Model

is a mathematical refinement of the premise that changes in value

of an underlying asset are random.        The Black-Scholes Model uses

the laws of probability to determine the price at which an option

would have to trade so that neither the buyer nor the seller of the

option would show a profit in the long run.19

     Mr. Natenberg opined that at the moment of expiration, an

option can take only one of two values:        Zero if it is out of the

money, and intrinsic value if it is in the money. Thus, at

expiration of the option it is always possible to calculate the

maximum potential profit or loss resulting from any individual

option trade as well as from a trade consisting of multiple

options.   Further, the maximum value of a put option spread is the


     18
           The Black-Scholes Model was developed by Fisher Black
and Myron Scholes in 1973. It is a tool for analyzing an
option’s value.
     19
          The Black-Scholes Model requires five inputs in order
to generate a theoretical value: Exercise price, expiration date,
price of the underyling instrument, prevailing interest rate, and
volatility.
                                     -27-

difference between the exercise prices of the purchased and sold

puts, and the minimum value is zero.

      According to Mr. Natenberg, the amount of money or credit that

Tandrill received upon the establishment of all six of its credit

spreads was always substantially outside (less than) the range of

values indicated by the Black-Scholes Model. In addition, the

amount of money or credit that Tandrill received upon closing out

the two debit spreads through Arbitrage Management was always

substantially outside (less than) the range of values indicated by

the Black-Scholes Model.

      Mr. Natenberg analyzed Tandrill’s trades based on a comparison

of the trade prices with two numbers:            The maximum possible value

of   each   vertical   spread   if   held   to   expiration,    and   a   price

evaluation of each spread using the Black-Scholes Model. See

appendix E for Mr. Natenberg’s Trade Analysis.                 Mr. Natenberg

concluded that Tandrill’s options trades were done at prices that

“practically ensured that they would result in a loss.”20


      20
          Mr. Natenberg gave as an example Tandrill’s first
trade, on Sept. 20, 1979, where the partnership sold the
97.50/97.625 put spread 47 times. He stated that if the price of
the underlying Treasury bill were at or below 97.50 at
expiration, the spread would have a maximum value of $58,750. If
the price of the underlying Treasury bill were at or above 97.625
at expiration, the spread would be worthless. At the time the
trade was made the Treasury bill price was 97.45. Because this
price was below 97.50, there was, in Mr. Natenberg’s opinion, a
far greater chance for the spread to be worth at expiration its
maximum value of $58,750 than its minimum value of zero. Thus,
according to Mr. Natenberg, the value of the spread should be
closer to $58,750 than to zero. Mr. Natenberg confirmed this by
                                                   (continued...)
                                      -28-

Mr. Maduff

     Respondent’s other expert, Michael L. Maduff, received a B.A.

in economics from the University of Iowa.           Between 1965 and 1984,

he was chief executive officer of Maduff & Sons, Inc., a licensed

futures commission merchant and clearing member of the Chicago

Mercantile Exchange.      After 20 years in business, he went to law

school at Northwestern University and received a J.D. in 1988.

Since 1988 he has been a practicing attorney, as well as a

consultant and expert witness regarding the futures industry.

     Mr. Maduff's report and testimony concern Tandrill's 1979-81

commodity and futures transactions.            Mr. Maduff testified that a

spread    in   gold,   silver,   or   copper   futures   is   principally   a

speculation on interest rates rather than a speculation on the

value of the metal itself.21




     20
      (...continued)
using the Black-Scholes Model to evaluate the spread. From this
analysis he determined that a reasonable value for this spread
would have been somewhere between $32,638 and $50,553. But
Tandrill actually sold the spread for $25,004. Even allowing for
subjective judgments among different market participants, Mr.
Natenberg opined that this was well below the price any
knowledgeable trader would have placed on the spread.
     21
          Mr. Maduff explained that in 1979 and 1980, precious
metals and long-term interest rates made historic highs and
experienced great volatility. While absolute prices of the
metals may be volatile, the relative price for different delivery
months of the same metal remained fairly constant, reflecting the
cost of maintaining an inventory of the metal over time, so-
called carrying costs, with interest being the major component of
these carrying costs.
                                -29-

     Mr. Maduff stated that the documentation petitioners provided

concerning Tandrill’s futures trading, while not complete, was

sufficient for him to conclude that Tandrill in fact made trades on

the futures exchanges and that those trades generally were “tax

straddles with no economic objective or effect other than to move

income from one year to the next with minimal market exposure and

no hope of profit.”   He testified that while the commissions Bache

and ACLI charged Tandrill do not appear on the documents provided,

he was able to extrapolate the sum of commissions and fees charged

from the information supplied, namely $52.70 per contract charged

by Bache, and $41.50 for gold and $26.50 for copper charged by

ACLI.22




     22
          The charges connected with the execution of Tandrill’s
futures trading took two distinct forms: Broker’s commissions
(and associated fees) and market slippage, or the bid/ask price
spread. (The bid/ask price is the difference between the prices
at which floor traders are willing to buy and prices at which
they are willing to sell.) After studying the Bache and ACLI
monthly statements, Mr. Maduff concluded that Bache and ACLI
charged commissions and associates fees on a per-contract, round-
turn basis. (A per-contract basis means that the commissions and
fees are the same for each contract of a particular commodity
traded, without regard to the price. A round-turn basis means
that no commission is charged when a position is established
(whether long or short), but rather the broker waits until the
position is closed out with an offsetting sale or purchase and
then charges a single fee for the entire round-turn transaction.)
Tandrill also paid execution costs, meaning the markup the
investor pays to the floor trader every time he buys and the
markdown he suffers every time he sells. Thus, commissions are
paid only when a position is closed out while execution costs are
encountered when an investor enters his position and again when
he closes it out. The total marginal costs of a single contract
include two execution costs and one commission cost.
                                  -30-

The Bache Trades

     Mr. Maduff was able to draw conclusions only with respect to

Tandrill’s 1979 trading through Bache because the documents that

were presented regarding Tandrill’s 1980 trades through Bache were

incomplete.

     a.    Treasury Bills

     The   Treasury   bill   trading    began   in   September      1979   and

continued through the end of the year.           Mr. Maduff stated that

taken in isolation, the Treasury bill trading would appear to have

been undertaken with a profit motive.           But, he went on to say,

because Tandrill failed to provide records of other interest rate

transactions it may have engaged in during the period, it is

possible that, when viewed in conjunction with transactions in

other brokerage accounts, the Treasury bill positions through Bache

would prove to be mere hedges against these other positions and

thus not    reasonably   likely   to   have   resulted   in   net   profits.

     b.    Gold, Silver, and Copper Transactions

     Mr. Maduff concluded that Tandrill’s 1979 gold, silver, and

copper transactions were not motivated by the desire to achieve an

economic profit and were taken solely for tax purposes. The gold

and silver trading began on November 1, 1979, and the copper

trading began on November 14, 1979.             Every transaction was a

perfectly balanced straddle with an equal number of purchases and
                               -31-

sales on each day.    A few of these transactions were butterfly

spreads.23

     At times, Tandrill established positions that appeared to be

regular, nonbutterfly spreads but which, on closer examination, had

little risk involved.    For instance, in early November 1979,

Tandrill purchased February 1981 gold contracts and sold April 1981

gold contracts, a “forward spread” which apparently anticipated

that interest rates would decline.     However, at the same time

Tandrill purchased January 1981 silver contracts, it sold December

1980 silver contracts, resulting in a “back spread” which sought to

profit from an increase in interest rates.

     In 1979, Tandrill bought and sold 160 contracts of copper

futures straddles, 330 contracts of gold futures straddles, and

1,110 contracts of silver futures straddles through Bache.24    Of

these transactions, 164 contracts of gold futures, 721 contracts of

silver futures, and 100 contracts of copper futures were all




     23
          The butterfly effect offsets forward spreads (which are
profitable if interest rates decline) with back spreads (which
are profitable if interest rates increase). Mr. Maduff believes
that this sort of strategy is "economically schizophrenic".
     24
          Mr. Maduff believed that because Tandrill engaged in
more transactions than necessary to achieve a given economic
purpose, its transactional costs were greater. Moreover, because
Tandrill held positions for short periods of time, it was less
likely the positions would move.
                                         -32-

offset, resulting in losses of approximately $1,772,000, including

commissions for 1979.25

       Mr. Maduff posited that in every case, when these positions

were        first      established,     Tandrill       made   contrary   straddle

transactions in the same quantity in a different delivery month of

the same futures contract.             When these positions were closed out,

Tandrill replaced them with a like quantity of contracts in the

same futures contract but in a different delivery month, at the

same time retaining into a subsequent year the profitable positions

that had been established at the same time as these loss positions




       25
               The closed-out losing trades were as follows:

Source No.      Date        Quantity     Description          Loss

330011         11/23/79       164       Apr. 81 gold      $264,032.80
330010         11/21/79        75       May 80 silver      183,837.50
330012         11/23/79        44       May 80 silver      104,933.80
330013         11/23/79       240       Dec. 80 silver     352,253.00
330014         11/27/79       108       Mar. 81 silver     183,026.60
330015         11/28/79        75       Mar. 80 silver     127,317.50
330016         11/28/79       176       Sept. 80 silver    313,250.20
330029         12/16/79         3       Dec. 80 silver     138,110.70
330019         11/21/79        10       Mar. 80 copper      10,819.00
330020         11/23/79        10       Mar. 80 copper      13,569.00
330028         12/3/79         20       July 80 copper      49,388.00
330028         12/7/79         20       Sept. 80 copper     28,138.00
330029         12/18/79        20       July 80 copper        (612.00)
330029         12/19/79        20       July 80 copper       4,138.00
                                       -33-

had been established.26 In sum, Mr. Maduff concluded that these

trades clearly were not motivated by the desire to make a profit.

The ACLI Trades

       Tandrill did not enter into any transactions through ACLI

during 1979. Tandrill’s 1980 transactions established through ACLI




       26
          The following are Tandrill’s 1979 positions established
or offset, and contrary positions:
Date        Position Established or Offset     Contrary Position

11/1/79 Sold short 18 Apr. ‘81 gold            Bought 18 Feb. ‘81 gold
11/6/79 Sold short 146 Apr. ‘81 gold           Bought 146 Feb.‘81 gold
11/21/79 Repurchased 164 Apr. ‘81              Sold short 117 Dec.‘80 gold
                                               Sold short 27 June ‘81 gold
11/15/79 Sold short 119 May ‘80 silver         Bought 119 July ‘80 silver
11/21/79 Repurchased 119 May ‘80 silver        Sold Short 75 Mar. ‘80 silver
                                               Sold short 44 Sept. ‘80 silver
11/1/79     Sold short 73 Dec. ‘80 silver      Bought 73 Jan. ‘81 silver
11/2/79     Sold short 79 Dec. ‘80 silver      Bought 79 Jan. ‘81 silver
11/5/79     Sold short 88 Dec. ‘80 silver      Bought 88 Jan. ‘81 silver
11/21/79    Repurchased 240 Dec. ‘80 silver    Sold short 108 Mar. ‘81 silver
                                               Sold short 132 Sept. ‘80 silver
11/15/79    Sold short 108 Mar. ‘81 silver     Bought 108 Dec. ‘80 silver
11/27/79    Repurchased 108 Mar. ‘81 silver    Sold short 108 Dec. ‘80 silver
11/21/79    Sold short 75 Mar. ‘80 silver      Bought 75 May ‘80 silver
11/27/79    Repurchased 75 Mar. ‘80 silver     Sold short 75 May ‘80 silver
11/21/79    Sold short 132 Sept. ‘80 silver    Bought 132 Dec. ‘80 silver
11/21/79    Sold short 44 Sept. ‘80 silver     Bought 44 May ‘80 silver
11/27/79    Repurchased 176 Sept. ‘80 silver   Sold short 132 Dec. ‘80 silver
                                               Sold short 44 May ‘80 silver
11/27/79    Sold short 3 Dec. ‘80 silver       Bought 3 Sept. ‘80 silver
12/26/79    Repurchased 3 Dec. ‘80 silver      Sold short 3 Mar. ‘81 silver
11/14/79    Sold short 20 Mar. ‘80 copper      Bought 20 May ‘80 copper
11/21/79    Repurchased 10 Mar. ‘80 copper     Sold short 10 July ‘80 copper
11/23/79    Repurchased 10 Mar. ‘80 copper     Sold short 10 July ‘80 copper
11/21/79    Sold short 10 July ‘80 copper      Sold 10 Mar. ‘80 copper
11/23/79    Sold short 10 July ‘80 copper      Sold 10 Mar. ‘80 copper
11/26/79    Sold short 40 July ‘80 copper      Bought 20 May ‘80 copper
                                               Bought 20 Sept. ‘80 copper
12/3/79 Repurchased 20 July ‘80 copper         Sold short 20 Dec. ‘80 copper
12/13/79 Repurchased 20 July ‘80 copper        Sold short 20 Mar. ‘80 copper

12/19/79 Repurchased 20 July ‘80 copper        Sold short 20 Mar. ‘80 copper
11/26/79 Bought 20 Sept. ‘80 copper            Sold short 20 July ‘80 copper
12/7/79 Sold 20 Sept. ‘80 copper               Bought 20 May ‘80 copper
                                  -34-

involved futures contracts in copper, gold, 90-day Treasury bills,

sugar, GNMA’s, and 30-year U.S. Treasury bonds.27

      Mr. Maduff focused on the GNMA’s and bond trades.        He opined

that the GNMA and bond28 trades appear to have been intended to roll

gains from 1980 into 1981, and in fact succeeded in rolling

$695,156.25 of gains into 1981.       In addition, because these trades

involved contracts not maturing until 1982, they had the potential

of   generating   long-term   gains   and   short-term   losses.   After

examining these transactions, Mr. Maduff concluded that these

trades did not have any profit motive or potential.

      The GNMA and Treasury bond transactions were established on

June 26 and 27, 1980, with the purchase on each day of: 15 March

      27
          With the exception of the GNMA’s and bonds, all of the
transactions were initiated by July 1, 1980, and closed out by
Dec. 31, 1980. Thus, Mr. Maduff did not perform a detailed study
of the copper, gold, 90-day Treasury bill, or sugar transactions
because it was clear that they were not used to postpone income
recognition from one year to the next. Also, they did not have
the potential for long-term capital gains because all were closed
out in less than 6 months.
      28
          Treasury bond futures contracts and GNMA futures
contracts are similar instruments. Both consist of 30-year debt
instruments with a $100,000 face value and a nominal 8-percent
“coupon”. Bonds are obligations of the U.S. Government; GNMA’s
are mortgage-backed debt instruments guaranteed by an agency of
the U.S. Government. The primary difference is that, in periods
of falling interest rates, GNMA’s are subject to prepayment while
bonds are not.
          In addition, these debt instruments, which on their
face provide a constant income flow for approximately 30 years,
will fluctuate in value with interest rates. However, a 3-month
spread in either bonds or GNMA’s will tend to be stable because
that spread represents only the difference between 90-day
interest rates and 30-year interest rates for a 90-day period
rather than 30-year interest rates themselves.
                                 -35-

1981 GNMA contracts and the simultaneous sale of 15 September 1981

GNMA contracts; and the purchase on each day of 15 September 1981

Treasury bond contracts and the simultaneous sale of 15 March 1981

Treasury bond contracts.   These transactions taken as a whole have

the appearance, and effect, of incurring minimum market exposure to

risk of loss and no possibility of net gain (after transaction

costs) notwithstanding the fact that the transactions, viewed

separately, each had the possibility of making or losing thousands

of dollars per contract.      This was accomplished by establishing

“straddles of straddles”.29

     While Tandrill’s GNMA trades consisted of long March and short

September (a 6-month forward spread), the bond trades were the

opposite, short March and long September (a 6-month back spread).

Consequently, while either the GNMA straddle or bond straddle taken

     29
          For example, Tandrill’s bond trades of June 26 and 27,
1980, occurred as follows: In that period the price of March
GNMA’s dropped $1,062.50 per contract and the price of March
bonds dropped $1,250 per contract. At the same time the
March/September GNMA spread moved $93.75 per contract, and the
March/September bond spread moved $62.50 per contract. Finally,
the entire position taken as a whole moved the minimum possible
increment that day, $31.25 per contract.
          On Oct. 28, 1980, Tandrill executed a straddle of a
straddle involving GNMA’s and bonds, buying 30 June GNMA’s and
simultaneously selling 30 March GNMA’s, and buying 30 June bonds
and simultaneously selling 30 September bonds. These
transactions resulted in recognition of a $327,030 loss on the
GNMA’s and a $368,280 loss on the bonds and still left Tandrill
with offsetting 3-month straddles, June/September GNMA’s vs.
June/March bonds. On Oct. 30, 1980, after recognizing a net loss
of $693,750 (plus commissions of $1,560), Tandrill still had
profits of $691,406.25 in its open GNMA/bond position, for a net
loss of $2,343.75 (or 2-1/2 points per contract). This loss is
primarily attributable to transaction costs.
                                     -36-

in isolation would allow the investor to profit or lose based on

the relative fluctuation of long and short-term interest rates, the

two   positions    taken    together      would    result     in     virtually   no

fluctuation at all.

Mr. Maduff’s Conclusions

      1.    Taken in isolation, Tandrill’s 1979 Treasury bill trading

established through Bache appears to have been taken with a profit

motive.30

      2.    Tandrill’s     1979   gold,     silver,     and    copper     straddle

transactions     established      through      Bache   were    “tax    straddles”,

entered into without an objective of earning an economic profit.

      3.    Tandrill’s   1980     GNMA   and    Treasury      bond    transactions

established through ACLI were “tax straddles”, entered into without

an objective of earning an economic profit.

Mr. Borst

      Petitioners’ expert, Thomas J. Borst, received a B.S. in

business administration from Miami University (in Oxford, Ohio) in

1962, and an M.B.A. from the Wharton School of Commerce and Finance

at the University of Pennsylvania in 1964. After working for Inland

Steel Company and International Business Machines Corp., Mr. Borst

became an institutional and retail securities broker with several

securities firms between 1968 and 1974. Later, he began trading on

the Chicago Board Options Exchange as an independent market maker

      30
          Mr. Maduff asserted that he cannot “be certain” of this
conclusion because of “inadequate documentation”.
                                     -37-

and then on the Chicago Board of Trade as an independent floor

trader.    He also was a principal of Frontier Limited, a commodity

trading advisory firm, and a vice president of Hedged Portfolio

Advisors, Inc., a firm that provided sophisticated tactical trading

data and advice to institutions.         Since 1991, he has traded solely

on the Chicago Board of Trade.

     Mr.    Borst’s   report   and     testimony    dealt   with    Tandrill’s

Treasury bill futures contracts and Treasury bill options contracts

during the last 4 months of 1979.31 His primary conclusion was that

Tandrill’s transactions “had the potential to earn a profit”.

Treasury Bill Futures Contracts

     For the period beginning September 29, 1979, Tandrill shorted

90-day Treasury bill futures contracts.              This initial strategy

reflected     Tandrill’s    expectation     that    interest    rates    would

increase.32

Treasury Bill Options Contracts

     For    the   period   beginning    September    29,    1979,   Tandrill’s

Treasury bill options trading consisted of “selling” vertical put




     31
          In addition to his expert report, Mr. Borst prepared a
rebuttal report which briefly discussed gold and silver commodity
futures, commodity trading, and the Black-Scholes Model.
     32
          Short Treasury bill futures positions increase in value
as the price of Treasury bills decrease in value (when interest
rates increase). Conversely, short Treasury bill futures
positions decrease in value as the price of Treasury bills
increases (when interest rates decrease).
                               -38-

spreads and thereafter closing these positions by “buying” vertical

put spreads.33

Credit Option Spreads

     Part of Tandrill’s trading strategy was to purchase Treasury

bill put options at one strike price and sell the same amount of

Treasury bill put options at a higher strike price for the same

maturity month.34

     Mr. Borst provided an example of the type of credit spreads in

which Tandrill engaged. On September 20, 1979, 6 December 1979

Treasury bill futures contracts were “sold” by the trader at 90.25

and 90.26, and 11 March 1980 Treasury Bill futures contracts were

“sold” by the trader at 90.89.    Also, a total of 47 March 97.50

puts were “bought” for a total price of $1,153,991, and 47 March

97.625 puts were “sold” for $1,178,995.   The credit on the options

positions was $25,004.



     33
          Each option was on $1 million face value Treasury
bills; the minimum price movement was $.01 ($100). The
underlying Treasury bills’ maturity date depended upon the
expiration date of the option. The usual maturity date of the
Treasury bills was about 3 months after the expiration date of
the option.
     34
          The year 1979 was an extremely volatile period for
interest rates in the United States. Rates were increasing
rapidly into September 1979 and during that month. Tandrill’s
strategy in this regard provided some risk control in the event
that Treasury bill interest rates that had been increasing began
to decline. If interest rates fell, the price of the short
Treasury bill futures positions would increase, thereby creating
losses for Tandrill.
                                      -39-

     Because Tandrill’s options trades in the aggregate generated

a credit, its put positions could suffer an unfavorable price

movement   and   still   provide   Tandrill      with    an    overall   profit.

Further, Tandrill’s put positions provide it with the ability to

absorb some of the risk in its futures positions.              That is, the put

positions could, in the aggregate, move unfavorably by $25,004

before Tandrill suffered a net loss.          Thus, $25,004 could be used

as a cushion to absorb losses in the short futures positions (if

the price of the short futures positions increased rather than

decreased).

Tandrill’s Portfolio Trading Strategy

     Tandrill’s initial trading strategy was to build a portfolio

of Treasury bill put option credit spreads and short futures

positions in Treasury bills.       During this period, Tandrill closed

some of its short commodity futures positions at a profit.                   For

example, on October 3, 1979, it closed two of its short futures

contracts (December) at 88.80 and two more on October 8 at 89.90--a

profit before    commissions     of    $9,000.     Mr.    Borst    stated    that

interest rates were rising at the time Tandrill closed out its

short position, as evidenced by the fact that the closing price of

the short futures contracts in October was lower than the price of

the contracts    when    they   were   entered    into    in    September.    But

Tandrill did not simultaneously close its put positions obtained on

September 20.     Mr. Borst believed that this was understandable
                                        -40-

because it was probable that the credit spread put positions would

have suffered losses in the aggregate.35

Tandrill’s Positions at September 30, 1979

     At the end of September, Tandrill was short 56 Treasury bill

futures,    a    position     worth   millions    of   dollars.   Tandrill   had

partially reduced the risk of this position by selling 144 put

spreads, each       on   $1   million    worth    of   Treasury   bill   futures.

Although Tandrill received $78,000 in premiums from selling the

higher strike puts over the lower, it stood to lose $180,000 if

both ends of the spreads expired in the money, and thus could have

incurred an overall net loss of $102,000.

     Despite      this   potential      loss,    Tandrill   covered   the   short

futures in early October, while actually increasing the short put

exposure.       Tandrill realized an $82,500 profit from covering its

short Decembers.

      The trade also locked in an additional $100,000 to $125,000

profit on the new March-December Treasury bill futures spread. Mr.

Borst believed that Tandrill made a very bold and risky move,

switching from a very bearish position to a very bullish one.

Tandrill’s Positions at October 31, 1979

     Tandrill was long December 1979 Treasury bill futures against

an equal number of the March 1980 Treasury bill futures.                 The long


     35
          Mr. Natenberg disagreed with this analysis. He opined
that if one enters a position as a true hedge, once the primary
asset has been disposed of, the hedge is no longer required.
According to Mr. Natenberg, a true hedger would liquidate the
hedge at the time of disposition of the primary asset.
                                       -41-

position was rapidly moving toward the price of the 1-year bills

whereas the       March   future    had   a    substantially     longer   time    to

expiration, so Tandrill had an opportunity to profit further on

this spread if short rates stabilized or fell.                 According to Mr.

Borst, Tandrill was also well positioned with its options spreads.

Tandrill’s Trading October 31-November 15, 1979

        As of November 15, 1979, Tandrill had completed the unwinding

of its credit spreads.         As short-term interest rates continued to

rise, the results were worse than anticipated.             Tandrill, however,

had approximately 150 basis points locked into its futures spread.

Thus, Tandrill “took off” some of these points by covering a part

of its short position and realized a $13,000 profit.

Tandrill’s Final Trades: November 19-December 7, 1979

        Tandrill closed out its last options spread over a 5-day

period in late November.           It did not adjust its futures position

until about a week later, effectively switching its position from

bearish to bullish, as it held one extra December Treasury bill

future.     On November 28, 1979, it sold 26 December Treasury bill

futures and bought only 21 March, shifting again to an aggressively

bearish stance, as it was now short ($1 million worth) of Treasury

bill futures and held that position until December 7, 1979.

        Tandrill was unable to buy the rest of its Treasury bill

futures spreads at 50 basis points, but rather, it had to pay 90

basis    points    for    21   spreads    on    November   28.      Through      its
                                      -42-

speculative “legs”, however, Mr. Borst believed that Tandrill “made

the best of a deteriorating situation”. The last three spreads

Tandrill bought on December 7 resulted in its reducing its profit

further, but it was short two extra March Treasury bill futures,

which it also covered at this point at the lowest price of any

March transaction.

Conclusion

       Mr. Borst opined that the aforementioned trading transactions

were    “very    sophisticated”.       Tandrill’s     trader    managed   huge

positions       very   “adroitly”   in    extremely    volatile     financial

instruments and a volatile financial market.            Mr. Borst concluded

that because Tandrill earned approximately $78,000 during a 2-1/2

month period, such fact demonstrated the high quality of Tandrill’s

trading ability, as well as the fact that Tandrill’s strategies had

the economic potential to earn a profit.

Mr. Natenberg’s Rebuttal of Mr. Borst’s Report

       Mr.   Natenberg    disagreed      with   Mr.   Borst’s    conclusions.

According to Mr. Natenberg, while a trader may hedge, the fact that

he does so is not necessarily a sign of experience.             A new trader

may choose a poor hedge, either one where the trader misjudges the

amount of protection offered by the hedge, or one where the cost of

the hedge is too great relative to the protection.              Nor does the

fact that a hedge is constructed necessarily show that it was done

with the intention of earning a profit, either in the hedge or in
                                     -43-

the primary asset.    In fact, Mr. Natenburg believes Tandrill paid

more for some of the option hedges than they could ever be worth.

The Relevant Law

     Section 165(c)(2) provides that, in the case of an individual,

the deduction for losses set forth in section 165(a) is limited to

“losses incurred in any transaction entered into for profit, though

not connected with a trade or business”. Accordingly, in order for

Tandrill’s losses to be deductible, petitioners must establish that

the transactions     giving   rise    to    them   were   “entered    into   for

profit”.   Fox v. Commissioner, 82 T.C. 1001, 1018 (1984); Smith v.

Commissioner, 78 T.C. 350, 390 (1982).         For this purpose, “profit”

means economic profit, independent of tax savings.                   Surloff v.

Commissioner, 81 T.C. 210, 233 (1983).

     Section 108 of the Deficit Reduction Act of 1984, Pub. L. 98-

369, 98 Stat. 494, 630, as amended by section 1808(d) of the Tax

Reform Act of 1986, Pub. L. 99-514,           100 Stat. 2817, provides as

follows:


     SEC. 108. TREATMENT OF CERTAIN LOSSES ON STRADDLES ENTERED
INTO BEFORE EFFECTIVE DATE OF ECONOMIC RECOVERY TAX ACT OF 1981.

         (a) General Rule.--For purposes of the Internal
    Revenue Code of 1954, in the case of any disposition of
    1 or more positions--

           (1) which were entered into before 1982 and form
           part of a straddle, and

           (2) to which the amendments made by title V of the
           Economic Recovery Tax Act of 1981 do not apply,
                                    -44-


      any loss from such disposition shall be allowed for the
      taxable year of the disposition if such loss is incurred
      in a trade or business, or if such loss is incurred in a
      transaction entered into for profit though not connected
      with a trade or business.

           (b) Loss Incurred in a Trade or Business.--For
      purposes of subsection (a), any loss incurred by a
      commodities dealer in the trading of commodities shall be
      treated as a loss incurred in a trade or business.

      Accordingly, a taxpayer, other than a commodities dealer,36 is

not eligible to deduct a loss on the disposition of a leg in a

straddle, unless the taxpayer proves that the loss was incurred “in

a transaction entered into for profit”.        DEFRA sec. 108 as amended.

To meet this requirement the taxpayer must establish that he entered

into the straddle transaction primarily for profit.               Ewing v.

Commissioner, 91 T.C. 396, 416-417 (1988), affd. without published

opinion 940 F.2d 1534 (9th Cir. 1991); Boswell v. Commissioner, 91

T.C. 151, 158-159 (1988).       To meet the primarily-for-profit test,

the investor need not be unaware of the tax consequences that might

ensue from his transactions.          However, where an investor has a

profit motive as well as a tax motive for entering into the

investment, the profit motive must be of first importance.

      Because petitioner’s investments were made through Tandrill,

the   existence   of   a   profit   motive   must   be   determined   at   the


      36
          Neither respondent nor petitioners contend that
petitioner or Tandrill was a commodities dealer for purposes of
the profit motive presumption of DEFRA sec. 108(b) as amended.
See Kovner v. Commissioner, 94 T.C. 893 (1990).
                                -45-

partnership level.   Rosenfeld v. Commissioner, 82 T.C. 105, 112

(1984); Brannen v. Commissioner, 78 T.C. 471, 505 (1982), affd. 722

F.2d 695 (11th Cir. 1984); Hager v. Commissioner, 76 T.C. 759, 784

(1981).   A   partnership’s   profit   motivation   is   determined   by

reference to the actions of the general partners who manage the

affairs of the partnership.   See Resnik v. Commissioner, 66 T.C. 74

(1976), affd. per curiam 555 F.2d 634 (7th Cir. 1977).

     In Ewing v. Commissioner, supra at 417-418, it was established

that profit must be the taxpayer’s primary motive in order for a

loss from a particular straddle transaction to be deductible.         In

Ewing we also set forth the following additional guidelines, taken

from Fox v. Commissioner, 82 T.C. 1001 (1984):

          (1) The ultimate issue is profit motive and not
     profit potential.    However, profit potential is a
     relevant factor to be considered in determining profit
     motive. 82 T.C. at 1021.

          (2) Profit motive refers to economic             profit
     independent of tax savings. 82 T.C. at 1022.

          (3) The determination of profit motive must be made
     with reference to the spread positions of the straddle
     and not merely to the losing legs, since it is the
     overall scheme which determines the deductibility or
     nondeductibility of the loss. 82 T.C. at 1018, citing
     Smith v. Commissioner, 78 T.C. at 390-391.

          (4) If there are two or more motives, it must be
     determined which is primary, or of first importance. The
     determination is essentially factual, and greater weight
     is to be given to objective facts than to self-serving
     statements characterizing intent. 82 T.C. at 1022.

          (5) Because the statute speaks of motive in
     “entering” a transaction, the main focus must be at the
                               -46-

     time the transactions were initiated. However, all
     circumstances surrounding the transactions are material
     to the question of intent. 82 T.C. at 1022. [Ewing v.
     Commissioner, supra at 417-418]


     Petitioners contend that Tandrill’s primary purpose in entering

into the transactions at issue was to further its profit-making

objectives. Respondent, on the other hand, argues that Tandrill did

not enter into these transactions primarily for profit.   Respondent

further contends that the most important factor determining profit

is the trading pattern involved.   Each party relies on its expert’s

analysis of Tandrill’s trading.

Tandrill’s Trading Activities Were Not Profit Motivated

     We have considered the qualifications and experience of the

parties’ experts and their particular knowledge and experience in

options and futures transactions, as well as the substance and

reasoning of their reports.   We found respondent’s expert witness

reports and testimony more useful and persuasive than that of

petitioner’s. Messrs. Natenberg’s and Maduff’s reports support our

conclusion that tax considerations primarily motivated Tandrill’s

trading.37




      37
          Mr. Maduff concluded that Tandrill’s 1979 Treasury bill
trading established through Bache appears to have been taken with
a profit motive. We therefore assume that respondent concedes
that these trades were taken with a profit motive. Thus, the
following discussion does not address Tandrill’s 1979 Treasury
bill trading established through Bache.
                                     -47-

     a. Tandrill Paid More than Fair Value When Purchasing Option
     Spreads and Received Less than Fair Value When Selling Option
     Spreads

     Tandrill’s    put   option   spreads   resulted   in    losses   solely

because: (1) With regard to the credit spreads, Tandrill received

less than fair value when it initiated the spreads and paid more

than fair value when it closed out such spreads; and (2) with regard

to the debit spreads, Tandrill received less than fair value when

it closed out the spreads.

     The option spreads (unlike the futures transactions) were not

executed on a regulated exchange.           They were over-the-counter

transactions executed through Pershing and Arbitrage Management.

Thus, there was no active trading market to assure a fair price to

all traders.      Further, there was no institutional safeguard to

prevent Pershing or Arbitrage Management from charging Tandrill more

(or paying Tandrill less) than some other trader for an identical

position.

     There is no evidence in the record that Tandrill bargained with

Pershing    or   Arbitrage   Management,    or   engaged    in   “comparison

shopping”, to insure that it received fair prices, even though there

were three or four dealers that made a market in over-the-counter

Treasury bill options.       Mr. Illingworth did not instruct Messrs.

Willensky and Sherman of Wilcap (who placed the actual trades) to

attempt to get the best price they could for the option spreads, nor
                                        -48-

did he otherwise discuss with them the prices they were getting for

the spreads.

        Moreover, even though in 1979 options traders generally relied

upon the Black-Scholes theoretical pricing model, Mr. Illingworth

was unaware of the model.        Even in the absence of Mr. Illingworth’s

usage        of   the   Black-Scholes    theoretical   pricing   model,   Mr.

Illingworth should have known that Tandrill was systematically

receiving far less than fair value for the spreads it was selling.38

Such transactions result from a systematic disregard of economic

values in executing option spread transactions.39

        38
          For example, when Tandrill closed out its credit
spreads, in each case it paid more for the closing spread than
its maximum theoretical value.
        39
          Respondent claims that Fox v. Commissioner, 82 T.C.
1001 (1984), is factually similar to this case. Respondent
posits that Tandrill’s option spreads were similar to the 1977
series of transactions in Fox in that both were initiated and
closed out in the same year and over a relatively short period of
time.
          In Fox all the transactions were executed through
Arbitrage Management. Like Tandrill’s two option spread
transactions executed through Arbitrage Management (but unlike
the six such transactions executed through Pershing), the spreads
in Fox were debit and bearish spreads. Id. at 1003. Also, the
taxpayers in Fox and Tandrill each sustained economic losses.
Id. at 1004.
          Further, the tax strategy used by the taxpayer in Fox
was very similar to the strategy Tandrill followed. The taxpayer
in Fox reported ordinary losses and short-term capital gains for
the years in issue, treating the dispositions of individual legs
of the spreads as separate taxable events. Because Treasury
bills were at that time specifically excluded from the definition
of a capital asset by sec. 1221(5), the taxpayer reported the
losses as ordinary losses. This Court upheld the deficiency,
holding that the taxpayer did not enter into the transactions
                                                   (continued...)
                                 -49-

     b.     Tandrill’s Futures Transactions Were Not Profit Motivated

     Tandrill’s 1979 gold, silver, and copper futures transactions

and the 1980 Treasury bond and GNMA futures transactions were

entered into for the purpose of deferring income from one tax year

to the next, and generating approximately equal amounts of short-

term capital loss and long-term capital gain. The futures straddles

were designed to minimize the volatility of the straddle as a whole,

yet produce substantial losses in one leg of the straddle (and

offsetting gain in the other leg).      The loss was then realized, and

the gain deferred.     In Tandrill’s straddles, the opportunity for

profit and risk of loss was minimized by keeping the spreads in

effect for short periods of time, putting on spreads with short

intervals between delivery dates, and maximizing the butterfly

effect.40

     39
      (...continued)
primarily for profit and that the transactions were not a type of
tax-motivated transaction that Congress intended to encourage.
          Petitioners attempt to distinguish Fox on the grounds
that the taxpayer in Fox: (1) Did not engage in any Treasury bill
futures trading; (2) conducted all the trading in “isolated year-
end transactions” that were “unquestionably tax motivated”; and
(3) had entered into the options transactions only after both he
and his accountant had “thoroughly investigated their potential
tax benefits.”
          We agree with respondent that the two options spreads
Tandrill initiated through Arbitrage Management were similar to
the spreads in Fox.
      40
          More specifically, Tandrill’s commodity futures trading
was used to defer income from 1979 into 1980 in the case of the
gold, silver, and copper straddles cleared through Bache, and
from 1980 into 1981 in the case of the Treasury bond and GNMA
                                                   (continued...)
                                    -50-

     This strategy reduced Tandrill’s overall potential for economic

profit or loss, but substantially increased its transactional costs.

We are convinced that Tandrill’s primary aim was to generate tax

benefits.

     The tax-motivated nature of Tandrill’s futures straddles is

reflected in the timing of the transactions that closed out its

losses.    For example, in 1979 the loss legs of the precious metals

straddles were closed out on dates of large price movements in the

underlying metals.41      The record indicates that in November 1979,

traders closed out their short silver positions and simultaneously

replaced    them   with   other   short    silver   positions.   The   sole

motivation of this strategy was to lock in a tax loss for 1979 and

to push the corresponding gain into 1980.           This is precisely what

Tandrill did.      Of the 721 silver contracts that it closed out in

1979, 718 were closed out either on November 21, 1979, or November

27, 1979, landmark dates for large price movements.



     40
      (...continued)
futures straddles cleared through ACLI.
      41
           For instance, in November 1979, the price of silver
futures fluctuated far more than normal. This meant that for
traders holding silver spreads, both long and short legs
increased sharply in value, placing the long leg in a position
with a substantial profit and the short leg in a position with a
substantial loss. For tax-motivated individuals, this was the
optimal occasion to close out the loss leg, realizing the loss
for tax purposes, and to replace that position with another short
position comprising the same number of silver contracts
(typically with a delivery date late in 1980).
                                       -51-

        c.    Tandrill’s Overall Tax Strategy

        The purpose of Tandrill’s investment strategy was to generate

losses from the loss legs of its Treasury bill option spreads that

would be deductible by petitioners as ordinary losses in 1979 and

to generate a corresponding (though somewhat smaller) amount of gain

from the profit legs of the option spreads that would be taxable as

short-term capital gains.         From its futures straddles, Tandrill’s

purpose was to generate short-term capital losses in 1979 that would

offset the short-term capital gains generated by the Treasury bill

options transactions, and to defer the recognition of gain from the

profit legs of such commodity futures straddles until a subsequent

year.    The gain was carried forward into 1980 and realized as long-

term capital gain.        A similar approach was used to defer capital-

gain income from 1980 into 1981.              Such strategy was employed to

produce in substance an economic loss on a long-term basis.

     We agree with respondent that Tandrill’s options transactions

employed a character-mismatching strategy similar to the 1977

options spreads in Fox v. Commissioner, 82 T.C. 1001 (1984).                 The

loss on the loss leg of each option spread would be an ordinary

loss; the profit on the gain leg would be a short-term capital gain.

     The ordinary losses Tandrill reported on its Form 1065 for 1979

arose from Treasury bill options transactions (and, to a minor

extent, from deductions for management and accounting fees).                 The

losses       from   Treasury   bill   transactions   for   1979   amounted    to

$1,858,743 and arose from purchased put options that were closed out
                                          -52-

at a loss in 1979.         Because the losses were on purchased puts, they

purportedly qualified for ordinary loss treatment under section

1234.42

     The $163,666 in net short-term capital gain Tandrill reported

for 1979 represents the excess of its short-term capital gains of

$1,736,366       over    its   short-term    capital   losses     of   $1,572,700.

Tandrill realized its short-term capital gains on put options on

Treasury bills and the short-term capital losses from the loss legs

of futures straddles on gold, silver, copper, and Treasury bills.43

Tandrill’s $1,509,077 of long-term capital gain for 1980 resulted

from the closing out of Tandrill’s commodity futures straddles.

        We are convinced that Tandrill’s overall trading strategy was

geared toward the assurance of tax savings for its partners rather

than a real profit motive.          See, e.g., Leslie v. Commissioner, T.C.

Memo.        1996-86    (dealing   with    profit   motive   in    gold   futures

transactions).          And profit motive is the crucial test.          See, e.g.,

Fox v. Commissioner, supra at 1021.




        42
          Sec. 1234(a)(1) provides that the character of the gain
or loss on the sale or exchange of a purchased option is the same
as the character of the gain or loss on the sale of the property
to which the option relates. Because Treasury bills were at that
time specifically excluded from the definition of a capital asset
by sec. 1221(5), Tandrill reported the losses as ordinary losses.
        43
          Under sec. 1234(b), the character of the gain or loss
recognized on the closing out of granted options is short-term
capital gain or loss.
                                     -53-

Petitioner and Mr. Illingworth

     Both petitioner and Mr. Illingworth testified that they did not

discuss the tax ramifications of creating and operating Tandrill.

Under the circumstances herein, we are not required to, and we do

not, accept the self-serving testimonial evidence presented by

petitioners   to   sustain   their    burden   of   establishing   error   in

respondent’s determination.44 See Geiger v. Commissioner, 440 F.2d

688, 689-690 (9th Cir. 1971), affg. per curiam T.C. Memo. 1969-159.

     Based upon the entire record, we conclude that petitioner

became a partner in Tandrill in order to reap tax benefits; i.e.,

to offset the $3,492,989 gain he realized in 1976 from the sale of

his Hy-Gain stock with losses from Tandrill.           The record makes it

clear that petitioner, Mr. Illingworth, and Tandrill all had the

same primary objective: to create tax losses.            The absence of a

primary for-profit objective is “so obvious that it must be the same

for all of the individual partners or their [partnership].” Donahue

v. Commissioner, T.C. Memo. 1991-181, affd. without published

opinion 959 F.2d 234 (6th Cir. 1992).          Thus, it makes no practical

difference whether the relevant motive belongs to petitioner, Mr.

Illingworth, or Tandrill itself.

     Petitioner willingly accepted the Partnership and Management

Agreements.   He contributed $300,000 for a 93.75-percent interest;

Mr. Illingworth contributed $20,000 for a 6.25-percent interest.


     44
          Petitioner’s testimony was marked by frequent failures
of recall, and he failed to provide answers to simple questions.
                                     -54-

However, Tandrill paid Mr. Illingworth’s company, Manhattan Metals,

$10,000 (denominated as a retainer and organization fee) upon the

signing   of    the     Management   Agreement.      Thus,   in   essence,   Mr.

Illingworth’s net contribution was approximately $10,000.

     In addition, in 1980 Manhattan Metals received a $50,000

management fee (and $25,000 annually thereafter), plus an incentive

payment that would be triggered if the net assets of Tandrill

increased      beyond    a   stipulated     annual    percentage     threshold.

Manhattan Metals also had the right to share in the brokerage

commissions and other fees Tandrill paid.

     Petitioner’s $300,000 investment was a fraction of the tax

benefits that Tandrill’s transactions were expected to provide.

Petitioners’ total deficiencies of $986,305 for 1976 and 1980

(arising from the disallowance of Tandrill’s losses) represent a

claimed tax benefit of more than three times his investment in

Tandrill. We believe that petitioner agreed to the arrangement with

Mr. Illingworth and Manhattan Metals because tax savings, rather

than Tandrill’s economic performance, was petitioner’s primary

objective.

     Petitioner was a prototypical “passive investor”.               He did not

have a meaningful role in Tandrill’s management.                  Tandrill only

engaged in trading activities, and these activities were delegated

to Manhattan Metals (and hence effectively to Mr. Illingworth) by

means of the Management Agreement. Petitioner testified that he did

not understand Tandrill’s trading activities. Although he claims to
                                  -55-

have invested in Tandrill in order to earn a profit, we believe that

petitioner chose to invest in an area in which he had little

background in order to realize tax benefits.

     Petitioner was financially sophisticated.          His tax advisers at

Peak Marwick gave him “an education” on the anticipated tax benefits

of Tandrill’s trading.     They informed him that the tax consequences

of his investment in Tandrill “could be advantageous.”          It is clear

that petitioner expected the tax losses that Tandrill generated.

     Moreover,    petitioner   expected    to   carry   back   losses   from

Tandrill 3 years. See sec. 172(b)(1)(A). Tandrill began operations

in 1979, and that year petitioner carried his Tandrill losses back

to 1976, the year in which he reported a gain of almost $3.5 million

from the sale of Hy-Gain stock and an adjusted gross income of

$2,047,797.     Petitioners’ tax liability for 1976 was $1,355,566.

     Thus, as a result of investing in Tandrill, petitioners were

expecting to carry back a net operating loss into 1976.                 This

carryback would reduce their tax liability by $1,053,742. This

reduction, more than any supposed profit potential, was petitioner’s

real motive.

     Mr. Illingworth was the “brains” behind Tandrill’s trading

activities.     While he clearly understood the nature of Tandrill’s

options   and    futures   transactions,   he    delegated     at   least   a

considerable portion of the decision making.45           Concurrently, Mr.


     45
           Mr. Illingworth’s precise role in Tandrill’s trading
                                                    (continued...)
                                   -56-

Illingworth was involved with other partnerships that realized tax

losses in all years for which their results are in evidence.            The

partnerships had similar trading patterns to Tandrill.            This is

another indication that Mr. Illingworth’s “expertise” as a trader

lay in his ability to produce tax losses for his partners.

Conclusion

     We conclude that Tandrill did not enter into the options and

futures transactions with a primary profit motive. Thus, respondent

properly disallowed petitioners’ allocable share of Tandrill’s 1979

and 1980 losses under section 165(c)(2).

Issue 2.   Section 6653(a) Additions to Tax

     The   second   issue   is   whether   petitioners   are   liable   for

additions to tax for negligence or intentional disregard of rules

or regulations for 1976 and 1980.      For these years, respondent has

the burden of proving petitioners’ negligence or disregard of rules

and regulations because it is a new matter raised in respondent’s

amended answer.     Rule 142(a).




     45
      (...continued)
activities is unclear. As president of Manhattan Metals, he had
ultimate responsibility for Tandrill’s trading. However, the
extent to which Mr. Illingworth personally determined which
trades Tandrill should make, what trading strategies Tandrill
should adopt, or the degree of his oversight is uncertain. For
example, he apparently delegated all responsibility for the
options trading to Messrs. Willensky and Sherman of Wilcap
Advisors, and for the futures trading to Mr. Weiss, a Manhattan
Metals employee. And Mr. Illingworth testified that Mr. Weiss
did not discuss his trades with Mr. Illingworth.
                                    -57-

     Section 6653(a) for 1976 and 1980 imposes an addition to tax

if any part of an underpayment of tax is due to negligence or

intentional disregard of rules or regulations.           Negligence is the

lack of due care or failure to do what a reasonable and ordinarily

prudent    person   would   do   under   the   circumstances.     Neely    v.

Commissioner, 85 T.C. 934, 947 (1985).

     Based upon the record before us, we conclude that respondent

has not satisfied her burden of proof on this issue.                 Thus,

petitioners are not liable for the section 6653(a) additions to tax

for 1976 and 1980.

Issue 3.    Section 6621(c) Additional Interest

     The    third   issue   is   whether   petitioners    are   liable    for

additional interest for 1976 and 1980.         Respondent determined that

petitioners are liable for the increased rate of interest provided

in section 6621(c) (formerly section 6621(d)).           Respondent has the

burden of proof on this issue with regard to 1976 (because it is a

new matter raised in respondent’s amended answer) and petitioners

have the burden of proof with regard to 1980.

     Section 6621(c) provides for an interest rate on substantial

underpayments attributable to tax-motivated transactions that is

120 percent of the underpayment rate provided in section 6601. See

Stanley Works & Subs. v. Commissioner, 87 T.C. 389, 413-415 (1986).

Section 6621(c) applies to interest accrued after December 31, 1984,

even though the transaction was entered into prior to the date of

enactment of section 6621(c). Solowiejczyk v. Commissioner, 85 T.C.
                                  -58-

552, 555-557 (1985), affd. without published opinion 795 F.2d 1005

(2d Cir. 1986).    An underpayment is substantial if it exceeds

$1,000.   Sec. 6621(c)(2).    The phrase “tax-motivated transactions”

includes straddles and transactions lacking a profit motive.       See

Ewing v. Commissioner, 91 T.C. at 422-423.

     We have concluded that petitioner and Mr. Illingworth formed

Tandrill for the purpose of generating tax benefits.    Moreover, the

$1,000 statutory threshold is surpassed in this case for both

taxable years in issue.      Consequently, petitioners’ underpayments

based on the losses attributable to tax-motivated transactions are

subject to the additional interest provided by section 6621(c).      We

hold that petitioners are liable for the increased rate of interest

under section 6621(c) on the entire underpayments for 1976 and 1980.

     To reflect the foregoing,

                                                Decision will be

                                           entered under Rule 155.
                                   -59-

                                APPENDIX A

        TANDRILL'S 1979 PURCHASES OF PUT OPTION POSITIONS THROUGH

        PERSHING AND BY THE CORRESPONDING SALES OF SUCH POSITIONS

        In all of the transactions below, the expiration date for the

option was December 5, 1979, and the expiration date of the

underlying Treasury bill was March 4, 1980.


Purchases                                 Sales



Date      No.   Yield       Cost          Date    No.       Proceeds


9/20       47    97.50    $1,153,991      11/7    33       $ 544,731
                                          11/8    14         225,498
11/7       33   97.625      586,905
11/8       14   97.625      243,404       9/20    47       1,178,995
9/24       41   97.53       941,196       11/12   20         280,600
                                          11/13    6          82,044
                                          11/14    7          92,785
                                          11/15    8          99,640
11/12      20   97.65       305,220
11/13       6   97.65        89,436
11/14       7   97.65       101,402
11/15       8   97.65       109,496       9/24    41         962,721
9/25       40   97.53       902,320       11/9    40         610,640
11/9       40   97.65       659,840       9/25    40         924,280
9/26       16   97.50       354,128       11/9     8         119,752
                                          11/12    4          54,928
                                          11/13    4          53,508
11/9        8   97.625      129,984
11/12       4   97.625       60,052
11/13       4   97.625       58,628       9/26    16         363,968
10/2       26   97.45       516,282       11/9    11         159,203
                                          11/12   10         132,360
                                          11/15    5          58,300
11/9       11   97.51       166,188
11/12      10   97.51       138,720
11/15       5   97.51        61,480       10/2    26         523,120
10/3        8   97.45       158,344       11/14    8          99,680
11/14       8   97.51       104,768       10/3     8         160,520
                                    -60-

                               APPENDIX B

       TANDRILL'S 1979 PURCHASES OF PUT OPTION POSITIONS THROUGH

        ARBITRAGE MANAGEMENT AND THE CORRESPONDING SALES OF SUCH

                                POSITIONS

         In all of the transactions below, the expiration date for the

option was March 26, 1980, and the expiration date of the underlying

Treasury bill was June 24, 1980.

Purchases                                  Sales

Date      No.   Yield        Cost          Date    No.     Proceeds

10/30      25   97.16      $1,464,975      11/20   13      $632,476
                                           11/21   10       488,170
                                           11/23    2        96,562
11/20      13   97.08         629,408
11/21      10   97.08         485,470
11/23       2   97.08          96,162      10/30   25      1,454,325
10/31      24   97.16       1,389,744      11/19   24      1,191,360
11/19      24   97.08       1,185,192      10/31   24      1,380,192
                                 -61-

                              APPENDIX C

 TANDRILL'S 1979 PUT OPTION SPREAD TRANSACTIONS THROUGH PERSHING

                       AND ARBITRAGE MANAGEMENT


        In all of the transactions below, the expiration date for the

option was December 5, 1979, and the issuance date of the underlying

Treasury bill was March 4, 1980.

Trade
Date       Type       No.     Trade     Commission    Cash Flow

Opening Trade:

9/20        Bought     47     97.50        $940      $(1,153,991)
            Sold       47     97.625        940        1,178,995
                                                          25,004

Closing Trades:

11/7        Sold       33     97.50         660         544,731
            Bought     33     97.625        660        (586,905)

                                                        (42,174)

11/8        Sold       14     97.50         280         225,498
            Bought     14     97.625        280        (243,404)

                                                        (17,906)


Opening Trade:

9/24        Bought     41     97.53         820        (941,196)
            Sold       41     97.65         820         962,721
                                                         21,525

Closing Trades:

11/12       Sold       20     97.53          400        280,600
            Bought     20     97.65          400       (305,220)
                                                       ( 24,620)

11/13       Sold        6     97.53          120         82,044
            Bought      6     97.65          120        (89,436)
                                                        ( 7,392)

11/14       Sold        7     97.53          140         92,785
            Bought      7     97.65          140       (101,402)
                                                       ( 8,617)
                                    -62-
11/15      Sold          8       97.53            160             99,640
           Bought        8       97.65            160           (109,469)
                                                                ( 9,856)




Opening Trade:

9/25       Bought       40       97.53            800           (902,320)
           Sold         40       97.65            800            924,280
                                                                  21,960

Closing Trade:

11/9       Sold         40       97.53            800            610,640
           Bought       40       97.65            800           (659,840)
                                                                ( 49,200)



Opening Trade:

9/26       Bought       16       97.50            320           (354,128)
           Sold         16       97.625           320            363,968
                                                                   9,840

Closing Trades:

11/9       Sold          8       97.50            160            119,752
           Bought        8       97.625           160           (129,984)
                                                                ( 10,232)

11/12      Sold          4       97.50             80            54,928
           Bought        4       97.625            80           (60,052)
                                                                ( 5,124)

11/13      Sold          4       97.50             80            53,508
           Bought        4       97.625            80           (58,628)
                                                                ( 5,120)


_____________________________________________________________

Opening Trade:

10/2       Bought       26       97.45            520           (516,282)
           Sold         26       97.51            520            523,129
                                                                   6,838

Closing Trades:

11/9       Sold          8       97.50            160            159,203
           Bought        8       97.625           160           (166,188)
                                                                ( 6,985)

11/12      Sold          4       97.50             80            132,360
           Bought        4       97.625            80           (138,720)
                           -63-
                                        (   6,360)

11/13      Sold     4   97.50     80     58,300
           Bought   4   97.625    80    (61,480)
                                        ( 3,180)



Opening Trade:

10/3       Bought   8   97.45     160   (158,344)
           Sold     8   97.51     160    160,520
                                           2,176

Closing Trade:

11/4       Sold     8   97.45     160     99,680
           Bought   8   97.51     160   (104,768)
                                        ( 5,088)
                                  -64-


                               APPENDIX D

            TANDRILL'S 1979 PUT OPTION SPREAD TRANSACTIONS
                     THROUGH ARBITRAGE MANAGEMENT

        In all of the transactions below, the expiration date for the

option was March 26, 1980, and the issuance date of the underlying

Treasury bill was June 24, 1980.

Trade
Date        Type       No.    Trade         Commission     Cash Flow

Opening Trade:

10/30        Bought    25      97.16           500       $(1,464,975)
             Sold      25      97.08           500         1,454,325
                                                          (   10,650)

Closing Trades:

11/20        Sold      13      97.16           260          632,736
             Bought    13      97.08           260         (629,148)
                                                              3,588

11/21        Sold      10      97.16           200          488,370
             Bought    10      97.08           200         (485,270)
                                                              3,100

11/23        Sold       2      97.16            40           96,602
             Bought     2      97.08            40          (96,122)
                                                                480




Opening Trade:

10/31        Bought    24      97.16           480       (1,389,744)
             Sold      24      97.08           480        1,380,192
                                                         (    9,552)

Closing Trade:

11/19        Sold      24      97.16           480        1,191,840
             Bought    24      97.08           480       (1,184,712)
                                                              7,128
                                                     -65-

                                                APPENDIX E

                                              TRADE ANALYSIS

           TRADE                  DAYS TO     UNDERLYING   INTEREST   SPREAD     MAXIMUM         SPREAD
DATE        TYPE     TRADE       EXPIRATION      PRICE       RATE      PRICE   SPREAD VALUE   VALUE RANGE

9/20/79     Spread +47 97.50P       76           97.45      10.21     25,004      58,750       32,638-50,553
            Sale   -47 97.625P

9/24/79     Spread +41 97.53P       72           97.50      10.02     21,525      49,200       26,786-41,143
            Sale   -41 97.65P

9/25/79     Spread +40 97.53P       71           97.48      10.08     21,960      49,200       26,744-41,508
            Sale-4097.65P

9/26/79     Spread +16 97.50P       70           97.45      10.21      9,840      20,000       11,184-17,399
            Sale   -16 97.625P

10/2/79     Spread +26 97.45P       64           97.41      10.38      6,838      15,600        8,357-12,246
            Sale   -26 97.51P

10/3/79     Spread + 8 97.45P       63           97.40      10.40      2,176       4,800         2,605-3,928
            Sale   - 8 97.51P

11/7/79      Spread -33 97.50P      28           96.88      12.50     42,174      41,250       38,976-40,856
          Purchase +33 97.625P

11/8/79      Spread -14 97.50P      27           96.89      12.45     17,906      17,500       16,551-17,340
          Purchase +14 97.625P

11/9/79      Spread -40 97.53P      26           97.01      11.98     49,200      48,000       44,316-47,592
          Purchase +40 97.65P

11/9/79      Spread - 8 97.50P      26           97.01      11.98     10,232      10,000         9,135-9,915
          Purchase + 8 97.625P

11/9/79      Spread -11 97.45P      26           97.01      11.98      6,985      6,600          5,800-6,544
          Purchase +11 97.51P

11/12/79 Spread -20 97.53P          23           97.00      12.00     24,620      24,000       22,526-23,819
       Purchase +20 97.65P

11/12/79 Spread - 4 97.50P          23           97.00      12.00      5,120       5,000         4,649-4,962
       Purchase + 4 97.625P

11/12/79 Spread -10 97.45P          23           97.00      12.00      6,360      6,000          5,389-5,955
       Purchase +10 97.51P

11/13/79 Spread - 6 97.53P          22           97.00      12.00      7,392       7,200         6,787-7,148
       Purchase + 6 97.65P

11/13/79 Spread - 4 97.50P          22           97.00      12.00      5,120       5,000         4,671-4,964
       Purchase + 4 97.625P

11/14/79 Spread - 7 97.53P          21           96.95      12.20      8,617       8,400         8,055-8,341
       Purchase + 7 97.65P

11/14/79 Spread - 8 97.45P          21           96.95      12.20      5,088       4,800         4,457-4,766
       Purchase + 8 97.51P

11/15/79 Spread - 8 97.53P          20           97.08      11.70      9,856       9,600         8,884-9,539
       Purchase + 8 97.65P

11/15/79 Spread - 5 97.45P          20           97.00      12.00      3,180       3,000         2,710-2,978
       Purchase + 5 97.51P

10/30/79 Spread +25 97.16P          148          96.99      12.06     10,650      20,000       10,603-16,178
       Purchase -25 97.08P

10/31/79 Spread +24 97.16P          147          96.96      12.15      9,552      19,200       10,422-16,439
       Purchase -24 97.08P
                                                   -66-

                                              APPENDIX E
                                             (Continued)

                                            TRADE ANALYSIS

           TRADE                DAYS TO     UNDERLYING   INTEREST   SPREAD    MAXIMUM         SPREAD
DATE        TYPE   TRADE       EXPIRATION      PRICE        RATE     PRICE   SPREAD VALUE   VALUE RANGE

11/19/79   Spread -24 97.16P      128          97.02      11.93     6,168       19,200       10,066-14,791
           Sale   +24 97.08P

11/20/79   Spread -13 97.16P      127          97.01      11.95     3,068       10,400        5,503-8,249
           Sale   +13 97.08P

11/21/79   Spread -10 97.16P      126          97.08      11.68     2,700       8,000          3,980-4,873
           Sale   +10 97.08P

11/23/79   Spread - 2 97.16P      124          97.16      11.35       400        1,600          747-562
           Sale   + 2 97.08P
