Commodities Dealer's Trades Through Floor Broker Were Subject to SE Tax

Prior to 1994, R was a member of the Chicago Board of Trade (CBOT), and actively traded futures contracts for U.S. Treasury bonds for his own account on the CBOT trading floor. In 1994, the Commodity Futures Trading Commission (CFTC) initiated an investigation of R, alleging improper trading conduct. R remained a member of the CBOT. However, because of the ongoing CFTC investigation, in 1994 (while the investigation was pending), he chose to conduct his trades through a floor broker rather than directly on the CBOT trading floor.

In 1994, R realized a total of $1,541,926 in net gains from trading commodities futures contracts through the broker. He paid more than $89,000 in commissions to the floor broker. On Nov. 21, 1994, as a result of the settlement with the CFTC, R was allowed to trade directly on the floor of the CBOT under the supervision of another trader.

On his timely filed 1994 Federal income tax return, R treated the total $1,541,926 in net gains as capital gains and reported it on Schedule D. On his Schedule C, R claimed $160,446 as ordinary and necessary business expenses from his commodities trading activity, and indicated that he was in the trade or business of a commodities dealer. The record does not indicate that the $89,000 in commission expenses paid to the floor broker were not included in the ordinary and necessary expenses R claimed on his 1994 return.

In a deficiency notice mailed to R, the IRS determined that R's earnings from trading in futures contracts were subject to self-employment (SE) tax.

Sec. 1401 imposes a tax on SE income from a taxpayer's trade or business. Generally, capital gains are excluded from SE income. In 1984, however, Congress enacted Sec. 1402(i), which provided that gains realized by commodities dealers in the ordinary course of trading in futures contracts are subject to SE tax.

Sec. 1402(i)(1) specifically states:

In determining the net earnings from self-employment of any options dealer or commodities dealer, there shall not be excluded any gain or loss (in the normal course of the taxpayer's activity of dealing in or trading section 1256 contracts) from section 1256 contracts or property related to such contracts. (Emphasis added.)

A commodities dealer is defined in Sec. 1402(i)(2)(B) as "a person who is actively engaged in trading section 1256 contracts and is registered with a domestic board of trade which is designated as a contract market by the Commodities Futures Trading Commission." The term "Sec. 1256 contract" means any regulated futures contract—such as the U.S. Treasury bond futures contracts in which R traded.

R argues that his trading activity in 1994 through a broker did not occur in the normal course of his commodities- trading activity and therefore that Sec. 1402(i) does not apply. R argues that his regular trading activity in prior years (which involved his personally making trades on the CBOT floor) is distinguishable from the trades in 1994 which R, because of the CFTC investigation, conducted through a floor broker. R notes particularly that he incurred $89,000 in broker's fees for the latter transactions.

The Service contends that throughout 1994, R was a commodities dealer and that the $1,541,926 in earnings he realized from his commodities-futures trades are subject to SE tax.

R's earnings in 1994 from his commodities-trading transactions do not qualify for an exception from SE tax. R has not established that his trading activity in commodities futures contracts in 1994 was outside the scope of his normal trading activity, nor has he established that the trades on his behalf in 1994 were less frequent or regular than the trades in prior years. Other than the use of a broker on the CBOT floor (in lieu of R himself being on the floor), the evidence in this case does not establish any significant factual differences in his trading activity.

R remained a member of the CBOT. On his 1994 return, R indicated that he was in the trade or business of trading commodities futures contracts, and claimed his related expenses as ordinary and necessary trade or business expenses. However, R's use of a floor broker does not substantially alter the normal course of his commodities-trading activity and the earnings he realized therefrom in 1994 are subject to SE tax.

Keith M. Rudman, 118 TC No. 21