COMMISSIONER OF INTERNAL REVENUE, PETITIONER, V. ROBERT P. GROETZINGER No. 85-1226 In the Supreme Court of the United States October Term, 1986 On Writ of Certiorari to the United States Court of Appeals for the Seventh Circuit Reply Brief for the Petitioner 1. In our opening brief, we argued that the court of appeals' definition of "trade or business" as any course of activity that "can fairly be characterized as a livelihood, occupation or means of earning a living" (Pet. App. 13a), while undoubtedly having some intuitive appeal, is at odds with the structure of the Internal Revenue Code and with this Court's decisions. The Code regularly distinguishes between "trade or business" activities and activities "entered into for profit, though not connected with a trade or business" (I.R.C. Section 165(c)(2)). Compare, e.g., I.R.C. Sections 162(a), 165(c)(1) and 167(a)(1) with Section 212, 165(c)(2) and 167(a)(2). And this Court held in Higgins v. Commissioner, 312 U.S. 212 (1941), that a person who devotes the bulk of his time and energy to managing his investments is not engaged in a "trade or business," even though his activities are extensive, regular, continuous, and undertaken with the intent to earn a profit. The Court in Higgins specifically rejected the argument that "business" should be defined as "a very comprehensive term (that) embraces everything about which a person can be employed," a definition rather similar to that propounded by the court of appeals below. Compare 312 U.S. at 217 with Pet. App. 13a. Respondent offers little rejoinder to our arguments. In positing a distinction between "active" and "passive" gamblers (Br. 10-11), respondent seems to agree that a person who gambles on an occasional or part-time basis -- the pattern presumably followed by most taxpayers who gamble -- is not engaged in a "trade or business" for tax purposes. Necessarily, therefore, respondent's argument is that a course of activity that typically is not a "trade or business" becomes a "trade or business" provided that the taxpayer spends an unusually large amount of time on it. But that argument flies in the face of this Court's opinion in Higgins, where it rejected the taxpayer's contention "that the 'elements of continuity, constant repetition, regularity and extent' differentiate his activities from the occasional like actions of the small investor" (312 U.S. at 215). Indeed, the Court suggested that personal portfolio management does not amount to a trade or business "(n)o matter how large the estate or how continuous or extended the work required may be" (id. at 218). Respondent offers no principled basis for distinguishing Higgins from this case, arguing in essence that Higgins should be confined to its facts. Amicus Touche Ross & Co. adopts a similarly agnostic stance, suggesting that a regular course of profit-seeking investment activity should be distinguished from a regular course of profit-seeking gambling activity because "one intuitively knows which of the above is business activity and which is not" (Amicus Br. 9). This approach, which amicus dubs the "I-know-it-when-I-see-it standard" (id. at 9 n.20), does not constitute legal argument. In our view, the reason that a full-time investor is not engaged in a "trade or business" is the reason put forth by Justice Frankfurter in Deputy v. du Pont, 308 U.S. 488, 499 (1940), namely, that "'carrying on any trade or business' * * * involves holding one's self out to others as engaged in the selling of goods or services," and an investor, however extensive his activities, is not so engaged. Justice Frankfurter's approach accords with the common-sense understanding of "trade or business." It also serves a useful analytical function, for it helps to mark the boundaries of "trade or business" as a subset of the somewhat larger universe of activities -- including investment and gambling activities -- that are regularly carried on with the intent to earn a profit. 2. In our opening brief, we argued that Justice Frankfurter's approach has been generally accepted by the lower courts and that the only departures from this consistent judicial pattern have occurred in cases in which application of that approach resulted in a (sometimes harsh) imposition of minimum tax on persons who gamble for their own account. Respondent contends (Br. 12-17) that the goods-or-services test has in fact not been widely recognized and that courts have often accorded trade-or-business status to activities in which taxpayers did not offer any goods or services. The cases on which respondent relies do not support this contention. In Maloney v. Spencer, 172 F.2d 638 (9th Cir. 1949) and Commissioner v. Stokes' Estate, 200 F.2d 637 (3d Cir. 1953) (cited in Resp. Br. 12), the taxpayers were plainly providing goods or services. The taxpayer in the former case owned and leased food-processing plants, and the taxpayer in the latter case sold and exploited patents. The self-employed golf or tennis pro (Resp. Br. 16) is paid for providing an entertainment service to the tournament promoter, the ticket-buying spectators, or both; a gambler like respondent does not provide an entertainment service and is not paid either by the racetrack operator or by the spectators. Cf. Rev. Rul. 70-543, 1970-2 C.B. 173 (professional golfer who wins prize money in tournaments is engaged in a "trade or business"). Respondent's reliance (Br. 15) on Diggs v. Commissioner, 715 F.2d 245 (6th Cir. 1983), is misplaced; as the court there noted (715 F.2d at 249), a Congressman is treated as carrying on a "trade or business" because Section 7701(a)(26) of the Code expressly provides: "The term 'trade or business' includes the performance of the functions of a public office." See Estate of Rockefeller v. Commissioner, 762 F.2d 264 (2d Cir. 1985), cert. denied, No. 85-307 (Dec. 16, 1985) that "(a) judge certainly is in business," but that statement is beside the point for the reason just given. Respondent errs in relying (Br. 14) on Kales v. Commissioner, 101 F.2d 35 (6th Cir. 1939), since that decision involved a full-time investor and was disapproved by this Court in Higgins. See 312 U.S. at 215 & n.5. And respondent's reliance (Br. 11) on Robida v. Commissioner, 460 F.2d 1172 (9th Cir. 1972), is also misplaced, because the question there was not whether the taxpayer was in a "trade or business," but whether he had "earned income" for purposes of certain foreign-tax rules. /1/ Respondent discusses several cases and hypothetical situations (Br. 8-9, 13, 16-17) in which a taxpayer is deemed to be in a "trade or business" even though he does not actually sell goods or services during the current tax year. These cases generally involve a course of activity -- such as writing and marketing a book, raising a herd of cattle, or operating a winery or nursery -- that may extend over several years without yielding an immediately salable product. The courts in such cases have correctly held that a taxpayer may be engaged in a "trade or business," notwithstanding his inability to sell anything currently, so long as he has embarked on the enterprise with the bona fide intention of making a profit from selling something eventually. These cases are not inconsistent with Justice Frankfurter's appraoch, for his test does not require that a taxpayer actually sell goods or services, but that he hold himself out to others as engaged in selling goods or services; the "holding out" may occur before the sales are consummated. And these cases provide no support for petitioner's argument that his gambling activities, in which he will never provide any goods or services, constitute a "trade or business." 3. Respondent understandably relies (Br. 2-3, 14-15) on a line of cases that hold stock market traders (as opposed to stock market investors) to be in a "trade or business." Respondent says that these cases at least implicitly reject the goods-or-services test, arguing that an "active trader does not buy or sell goods or services" but simply places orders with a broker (Br. 2). And respondent contends that there is no meaningful distinction between betting slips and securities, so that our position is tantamount to denying gamblers "the equal protection of the law' (id. at 2, 14). Although respondent has put his finger on what we regard as the most difficult aspect of this case, we do not view Justice Frankfurter's approach and the trader-versus-investor distinction as being irreconcilable. As the Second Circuit said in rejecting the contention that a "trader" does not satisfy the goods-or-services test, a trader "does offer goods to others in the sense that he buys and sells securities." Gajewski v. Commissioner, 723 F.2d 1062, 1067 n.8 (1983), cert. denied, 469 U.S. 818 (1984). Contrary to respondent's contention (Br. 2), the fact that a "trader" does not execute his trades himself, but rather instructs a broker to execute them on his behalf, does not make any difference; although a "trader" avails himself of a broker's services, the "goods" that are offered for sale are the securities, which (like a house), can be offered for sale only by their owner. Whereas a securities "trader" engages in the exchange of economic goods (albeit intangible ones) in the marketplace, the same cannot be said of a gambler like respondent, regardless of the frequency of his gambling. When respondent purchased a betting slip, he was not "trading" or "exchanging" anything with other market participants. He was simply entering into a contract with the racetrack that entitled him to a payment upon the occurrence of a specified condition. In holding that securities "traders" are engaged in a "trade or business," the courts have also emphasized the qualitative difference between "investing," in which securities are held primarily for income and long-term gains, and "trading," in which "securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements." Purvis v. Commissioner, 503 F.2d 1332, 1334 (9th Cir. 1976). The distinction between occasional and full-time gambling, by contrast, is not one of kind but merely one of degree. Respondent does not contend that there is any generic difference between what he does and what a weekend gambler does, only that he does it more often. A "trader," on the other hand, can point to a real distinction between his activities and those of an investor, and that distinction holds whether the investor invests on a full-time or a part-time basis. In concluding that securities "traders" are engaged in a "trade or business," finally, the courts have emphasized the Commissioner's "long administrative practice and interpretation of the (revenue laws) * * * to the effect that persons who buy and sell securities on their own account are engaged in a trade or business." Fuld v. Commissioner, 139 F.2d 465, 469 (2d Cir. 1943). This Court early adverted to the Commissioner's rulings that "a taxpayer who, for the purpose of making a livelihood, devotes a major portion of his time to speculating on the stock exchange may treat the losses thus incurred as having been sustained in the course of a trade or business." Snyder v. Commissioner, 295 U.S. 134, 139 (1935) (footnote omitted). There is, by contrast, no such longstanding administrative practice treating persons who gamble for their own account as engaged in a "trade or business." As we noted in our opening brief (at 32), the Internal Revenue Code provides special treatment for gambling transactions (I.R.C. Section 165(d)), and it is clear that securities trading, no matter how speculative, is not subject to this treatment. Although respondent complains that such distinctions unfairly discriminate against gamblers (Br. 2, 12), he cannot deny that our position, which differentiates between gambling and securities trading, finds precedent in the tax law, and in the law generally. 4. As an alternative to his contention that the goods-or-services test should not be applied here, respondent contends that he should be regarded as having satisfied that test. He notes that a "bookmaker or casino operator is in business because he offers services to others" (Br. 3). Reasoning that "(i)t takes two to gamble," respondent argues that he meets Justice Frankfurter's criteria because he in turn offers services, either "to the bookie or casino" (ibid.) or "to the other patron of the racetrack who is betting on the same race" (id. at 15). The short answer to respondent's argument is that both courts below found that he did not offer goods or services to anyone else. See Pet. App. 7a, 23a, 25a-26a. Were that not so, there would have been no need for those courts to reject the goods-or-services test in order to find respondent engaged in a "trade or business." But each court did explicitly reject that that test (id. at 18a-19a, 27a). In any event, respondent's argument turns the concept of "providing services" upside-down. A bookmaker or casino operator clearly holds himself out as providing the service of accepting wagers from customers. But the customers who place the bets do not provide goods or services; they consume them. A gambler who buys a betting slip is providing no more services than a fan who purchases a ticket to a baseball game. It is of course true that a betting market cannot exist without gamblers, just as a fish market cannot exist without consumers of fish. But that does not mean that the consumers who buy the product are "selling services" to the marketplace. 5. Amicus Touche Ross & Co. argues that the term "trade or business" should be given a meaning broad enough to encompass both respondent's gambling activities and "real estate construction and development" (Br. 3). Amicus never explains what its argument about real estate development ventures has to do with the issue presented here -- whether a taxpayer must provide goods or services to others in order to be engaged in a "trade or business." And amicus states (Br. 14) that "no circuit court has been asked to consider, in instances where property is to be constructed, leased, and eventually sold, whether the trade or business includes the construction of the property." This case presents no occasion for this Court to address a question that no court of appeals has addressed, especially where the question has nothing to do with this litigation. In order to appreciate the thrust of amicus's submission, it is necessary to have in mind the operation of a typical real estate tax shelter. One of the benefits that tax shelters traditionally aimed to offer investors was to accelerate deductions into the partnership's early years, with income to be deferred far into the future. In pursuit of this objective, real estate partnerships typically sought to deduct "upfront" expenses, such as management fees, loan commitment fees, and the like, as expenses of "carrying on (a) trade or business" under Section 162. The courts rejected these efforts with near unanimity, pointing out that the partnership did not purport to be in the construction business, but rather intended to be in the business of, for example, leasing rental apartments. And since the partnership during the construction phase was not yet "carrying on" its intended business, the partnership's start-up or "pre-opening" expenditures have generally been held not to be "trade or business" expenses that are currently deductible but rather have been held to be costs that must be capitalized. See, e.g., Goodwin v. Commissioner, 75 T.C. 424, 433 (1980). Amicus in essence seeks to make an end run around the "pre-opening expense" line of cases by arguing that a real estate tax shelter is "in business" from the moment of its inception, so that any expenses the partnership incurs are deductible "trade or business" expenses. See, e.g., Amicus Br. 5-6 & n.12. To advance this objective, amicus urges the Court (Br. 3, 6, 16) to revive the broad definition of "business" enunciated in Flint v. Stone Tracy Co., 220 U.S. 107 (1911). The Court there stated that "(b)usiness is a very comprehensive term (that) embraces everything about which a person can be employed," that is, anything "which occupies the time, attention, and labor of men for the purpose of a livelihood or profit" (220 U.S. at 171). Amicus concedes (Br. 8 n.17) that the relevance of this definition was "arguably weakened" by the Court's subsequent decision in Higgins, but that is a considerable understatement. The Court in Higgins explicitly rejected the definition set forth in Flint, reasoning that the meaning of "business" for purposes of a corporation excise tax enacted before the ratification of the Sixteenth Amendment had little relevance in defining that term for purposes of the modern income tax. See 312 U.S. at 217, quoting 220 U.S. at 171; see also United States v. Pyne, 313 U.S. 127, 131 (1941). As we have said, there is no reason for the Court here to consider the point at which a real estate tax shelter should be considered to have started its "trade or business." But amicus's brief does highlight rather starkly the extrapolative possiblities -- and serious consequences -- that could flow from the expansive concept of "trade or business" propounded by the court of appeals in this case. 6. Respondent urges that the decision below should be affirmed because it is unfair to impose a minimum tax on a gambler whose racetrack activities yielded him a net loss (Br. 19). We agree with the premise, but not with the conclusion. As we said in our opening brief (at 36-37), there is nothing inherently inequitable in holding that a person who gambles for his own account is not in a "trade or business." The inequity of which respondent complains stems, not from the goods-or-services test, but rather from the perhaps unfortuante draftsmanship of a minimum tax provision -- in effect from 1976 to 1982 -- that included gambling losses as tax preference items. Congress has solved that problem by amending the minimum tax. If this case concerned respondent's 1975 or 1983 tax year, he might well find it advantageous to reverse his position and argue that he is not in a "trade or business," for he might then avoid the self-employment tax that a ruling in his favor here could require him to pay. See I.R.C. Sections 1401, 1402(a). As the history of litigation on this question shows (compare Gentile v. Commissioner, 65 T.C. 1 (1975), with Ditunno v. Commissioner, 80 T.C. 362 (1983), predictions about the equities furnish an unsure guide to decision. For these reasons and those set forth in our opening brief, the judgment of the court of appeals should be reversed. Respectfully submitted. CHARLES FRIED Solicitor General DECEMBER 1986 /1/ We noted in our opening brief (at 19) that the goods-or-services test was first applied to deny trade-or-business status to a full-time gambler by Judge Tannenwald in Gentile v. Commissioner, 65 T.C. 1 (1975). Respondent errs in citing Gajewski v. Commissioner, 45 T.C.M. (CCH) 967 (1983), for the proposition that Judge Tannenwald has "changed (his) views" (Br. 7). That was a memorandum decision in which Judge Tannenwald was bound to follow the Tax Court's reviewed decision one month earlier in Ditunno v. Commissioner, 80 T.C. 362 (1983), which had overruled Gentile. Judge Tannenwald vigorously dissented in Ditunno. See 80 T.C. at 372-377).