Wall Street and Chicago commodities brokers are lobbying hard for legislation that would overturn a 1977 Internal Revenue Service ruling that sought to outlaw one of the most popular new tax shelters: the commodity straddle.
Treasury officials conservatively estimate that high-income taxpayers are able to save $100 million a year using straddles. Other sources guess the figures are much higher -- in the range of $150 million to $250 million.
The tax straddle is a sophisticated technique in which a taxpayer can convert a short-term capital gain, which is taxed at high rates by the government, into a long-term capital gain, which is taxed at substantially lower rates. At the very least, the taxpayer can shift the short-term capital gain from one year to another.
As devised by Wall Street brokers, the tax straddles were virtually riskless. Most of them were done in silver futures contracts on the Commodities Exchange in New York. Because the 1977 IRS ruling referred specifically to silver straddles. New York sources say much of the tax straddle business has moved into other commodities such as gold, copper and some government agency securities.
According to an internal memo at Merrill Lynch, Pierce, Fenner & Smith, Inc., written last August, while tax straddles are controversial, the "commodity straddle business continues to be done. (It appears that during 1978 business was a good or better than ever.)"
But most brokers, including Merrill Lynch, have shied away from the particular commodity transactions frowned on by the IRS: the so-called butterfly straddle in silver futures.
What the IRS found in 1977 was that because the primary reason a taxpayer enters into a straddle is to create an artificial short-term capital loss "while insuring that no real economic effect resulted from such transactions," the taxpayer could not deduct the loss on his tax return.
The tax laws permit deduction of losses when there is an element of economic risk.
The futures markets are supposed to exist for users of a commodity to hedge against future price increases.
For example, a miller might want to insure the price he will pay for grain six month from now. He would enter into a futures contract in which he promises to pay, say, $2 a bushel next June. A speculator, betting that the price a grain will go down, will take the other half of the contract promising to deliver the grain at that price. If the price of grain goes down, the speculator makes money. If it goes up, he loses (he might have to pay $2.10 for grain he will deliver at $2.)
But in the tax straddle, the taxpayer is not interested in speculating of hedging, but rather wants to enter into an even-sided transaction (simultaneously entering in both "buy" and "sell" contracts for different months in the same commodity) to generate a loss in one year and a gain in the following year.
Although the tax laws require a citizen to own nearly all assets for a full year before any profits on their sale can be taxed at lower, long-term capital gains rates, profits on a commodity contract become "long term" if the contract is owned for six months and a day.
Supposed a taxpayer earned a $10,000 short-term gain on the sale of stock and is in the 70 percent (top) tax bracket: he would pay $7,000 in taxes.
However, if he is able to generate a $10,000 loss, it will cancel the $10,000 gain. Then, during the next year, if he takes a similarily sized profit on the other half of his straddle, it will be taxed at a 28 percent rate because of the way the laws work. On a long-term gain, 60 percent of the profit is not taxed. The remaining 40 percent would be taxed at 70 percent -- so the taxpayer would owe the government $2800 rather than $7000.
Even if he is not able to realize a full $10,000 gain, the tax differential is so great that the small risks he took in the straddle make it well worth his time and money, sources say.
Commodities brokers organized themselves into a group called the Futures Industry Association to lobby against the 1977 IRS ruling -- which last year was extended to include Treasury bill futures as well as silver futures.
Sen. Bob Dole (R-Kan) brought up the tax straddle situation before the Senate Finance Committee last week, but an aide to Dole said today that the Republican is not sure exactly what, if anything, should be done.
Although some New York and Senate sources thought a bill might be brought up at Thursday's Finance Committee hearing, sources said late tonight that it now appears unlikely.
Senate sources said the commodities industry has proposed to outlaw certain types of tax straddles -- including some variations on the butterfly straddle that drew the IRS' ire.
But Senate sources say the issue is so complex that it is unlikely anything will be done this session, if ever.
The Futures Industry Association, congressional sources say, has been lobbying hard in both the House and the Senate.
Wall Street sources say that despite the 1977 ruling, commodities straddles are still a large part of the commodities business, and therefore, an important source of commissions.
The IRS has issued many deficiency notices to taxpayers who have done tax straddles and have about a dozen cases pending in tax courts on the issue.
If the industry can get a bill out of Congress, it would end the worries a taxpayer has about entering into a straddle to reduce his or her taxes.