Edward and Ruth Kelly - Page 5

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            payments that he received represented compensation for bringing                               
            business to his employer.                                                                     
                  Since 1979 Mr. Kelly has been registered with the Chicago                               
            Board of Options Exchange and the National Association of                                     
            Securities Dealers, Inc. (NASD), as an "options principal".  In                               
            this capacity he was authorized to approve customer accounts for                              
            options trading and oversee compliance with the rules of NASD and                             
            other rules concerning options transactions within the brokerage                              
            office.  Mr. Kelly did not need to be a registered options                                    
            principal in order to engage in any of his options trades; any                                
            Shearson Lehman customer satisfying certain financial and other                               
            criteria was qualified to trade options.                                                      
                  On their Forms 1040 for earlier taxable years not in issue,                             
            1983 through 1985, petitioners reported Mr. Kelly's occupation as                             
            "stockbroker-dlr".  The Schedule C filed with their return for                                
            1983 describes his main business activity as "dealer in options".                             
            Nevertheless, for each of these years petitioners treated                                     
            Mr. Kelly's net loss from options trading as a capital loss and                               
            reported it on Schedule D.                                                                    
                  In February 1987, before the preparation of his tax return                              
            for 1986, Mr. Kelly read newspaper articles discussing the then                               
            recent decision of the U.S. Supreme Court in Commissioner v.                                  
            Groetzinger, 480 U.S. 23 (1987).  On the basis of these articles,                             
            he understood the case to stand for the proposition that where a                              

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