*2484 1. A partnership engaged in the business of buying and selling securities purchased the land and building partly occupied by it for office purposes and organized a corporation to hold the title to such property. It organized another corporation to which it assigned on its books of account certain slow-moving securities. The partnership held all the stock of both of these corporations and had large loan accounts with them. Each corporation in 1918 issued additional shares of stock to the partnership and the partnership wrote down each loan account in one case for the full amount of such loan account in excess of par of stock received, and in the other case for a portion of the loan account in excess of par of stock received. Held that the partnership sustained no deductible losses as a result of these transactions. Held, further, that the shares of stock of both corporations are not a part of the body of securities carried by the partnership as its stock in trade and may not be included in inventory of stocks for income-tax purposes.
2. A partnership, carrying on business as a recognized dealer and broker in securities, having organized a corporation of which all*2485 the stock is owned by the partnership and to which the partnership assigns from time to time slow-moving securities and likewise from time to time causes a reassignment of the same, may not, for income-tax purposes, inventory at their market value and so reflect in the accounts and inventories of the partnership the securities thus carried in the name of the corporation.
3. A partnership which rents from a corporation, all of whose stock it owns, land and buildings at a stipulated annual rental, and pays such rental and in addition loans to the corporation an amount to meet its operating expenses is not entitled to deduct from gross income as an operating expense the amount of the loan.
*965 Docket No. 3364 is the joint appeal of Franklin Q. Brown and Otto J. Thomen from the determination of deficiencies in income tax for the year 1918 of $17,586.86 and $2,934.16, respectively. These taxpayers were, during the year 1918, partners in the firm of Redmond & Co., and the deficiencies resulted from an increase in partnership income by the disallowance*2486 of deductions claimed by the partnership on account of certain alleged losses and the exclusion from inventory of the stock of the two corporations organized and owned by the partnership.
Docket No. 3110 is the appeal of Franklin Q. Brown, involving deficiencies in income tax for the year 1919 in the amount of $9,778.35, and for 1921 of $128.52. Counsel agreed that these two appeals should be submitted upon the same evidence, but that the final *966 redetermination of deficiencies for the years 1919 and 1921 should be held under advisement pending the redetermination of the deficiencies for the year 1918.
FINDINGS OF FACT.
During the year 1918 the petitioners were members of a partnership doing business under the firm name of Redmond & Co., with offices at 31-33 Pine Street, New York City. Franklin Q. Brown owned a 40.625 per cent interest in the partnership and Otto J. Thomen 15.10417 per cent.
The building occupied by Redmond & Co. at the above address was located in the financial district of New York City. It was a four-story-and-basement, fireproof office building, constructed of brick, steel, and marble. It had a frontage of 50 feet on Pine Street and was*2487 approximately 100 feet deep. Redemond & Co. occupied part of the basement, the first floor, mezzanine, and part of the fourth floor. The remainder of the building was occupied by other tenants. The lot on which the building stood had previously belonged to H. S. Redmond, senior member of Redmond & Co., who constructed the building thereon in 1905 and 1906. Redmond & Co. first occupied the building in 1906.
H. S. Redmond died in 1910 and in 1912 the Equitable Trust Co., trustee under his will, entered into a contract with the partnership whereby the partnership agreed to purchase the property. The contract provided among other things:
(1) That Redmond & Co. should pay the Redmond Estate $900,000, payable as follows:
One hundred dollars ( $100) on the signing of this contract, receipt of which is hereby acknowledged, six hundred and fifty thousand dollars ($650,000) by accepting a conveyance of the said premises subject to a certain mortgage thereon for that amount, which is now past due, and bearing interest at the rate of four and one-half per centum per annum, and the balance or sum of two hundred and forty-nine thousand nine hundred dollars ($249,900), with interest thereon*2488 at the rate of six per centum per annum to be computed from the first day of January, 1912, in cash on the delivery of the deed hereinafter mentioned.
(2) That the trustee should give a deed in fee simple conveying the premises free from all encumbrances except the mortgage and the then existing leases including a "lease made to Hebden and Greata, agent for the Bank of Montreal," dated July 20, 1905, expiring May 1, 1920; and the tenancy of Messrs. Post and Flag, expiring May 1, 1912.
(3) The date for delivery of the deed was to be "the fifteenth day after the entry of a final decree of distribution upon the accounting of the Executors of said will."
*967 (4) In the meantime Redmond & Co. was to be entitled to the use of the premises with the right to make leases valid as against the seller for terms extending to the date fixed for the delivery of the deed, and Redmond & Co. was not only obligated to pay all taxes, assessments, water rate charges, etc., which became a lien subsequent to January 1, 1912, and a proportionate part of the mortgage interest and insurance premiums and other charges which accrued subsequent to that date, but was also obligated to keep the premises*2489 in repair and to comply with building laws.
(5) The last paragraph of the contract provided:
The purchaser [Redmond & Co.] shall not, without the seller's consent, assign this contract or rights accruing hereunder save to successors carrying on the business of the purchaser, or to a corporation formed for the purpose of taking title to the said property, and all of whose stock, less qualifying shares, shall be held by the purchaser or shall be held by successors carrying on the business of the purchaser; but such assignment shall not release the purchaser from the obligations incurred hereby. The restrictions contained in this paragraph are applicable only up to the delivery of the deed hereunder.
In May, 1916, Redmond & Co. organized the New Pine Street Real Estate Corporation, hereinafter referred to as the Pine Street Corporation, for the purpose of taking over the Pine Street property. The capital stock of the corporation had a par value of $1,000, all of which was subscribed and paid for in cash by the partnership. The above mentioned contract was assigned to the corporation and on May 18, 1916, a deed to the property was delivered in accordance with its provisions. *2490 The mortgage had previously been reduced to $600,000, thereby increasing the cash payment to $300,000. Redmond & Co. advanced the money to pay this amount and the interest thereon.
On or about May 18, 1916, Redmond & Co. entered into an agreement with the Pine Street Corporation, whereby Redmond & Co. was to pay the corporation as rental "such sum as would represent any deficiency in its operations."
From May 18, 1916, to December 31, 1916, the net earnings from operations of the building were $29,811.33 (including $30,000 rental paid by Redmond & Co.), but the Pine Street Corporation was obligated to pay interest on the mortgage amounting to $18,931.40 and interest on the loan from Redmond & Co. amounting to $10,886.83, making the net loss $26.90.
The results of operation in 1917 were less favorable to the Pine Street Corporation than in 1916. The operating deficit for that year amounted to $24,782.89. It appearing to the partnership that it was advancing to the Pine Street Corporation an amount in excess of the fair rental of the building, the board of directors of the corporation *968 on December 12, 1917, adopted a resolution fixing the annual rental of Redmond*2491 & Co. at $30,000 and further providing that in the event Redmond & Co. should expend more than that amount for the benefit of the Pine Street Corporation such excess should be "considered and treated" as a loan. In accordance with this resolution Redmond & Co. was during the year 1918 charged with rent upon the books of the Pine Street Corporation in the amount of $30,000. Redmond & Co., however, continued throughout the year 1918 to pay all the expenses of management, upkeep and care of the Pine Street property in the same manner as was done during the years from 1912 to 1917, inclusive. The operating deficit of the Pine Street Corporation for 1918 was $21,318.32. Redmond & Co. paid this amount from time to time during the year, as the items of expense of the corporation were incurred or fell due and claimed the deduction of this amount in the return made by the partnership for 1918.
The balance sheets of the Pine Street Corporation as at the close of the calendar years 1916, 1917, and 1918, show as follows:
| BALANCE SHEET | ||
| As at December 31, 1916. | ||
| Assets | ||
| Cash | $1,000.00 | |
| Redmond & Co. (operating account) | 17,108.10 | |
| Real estate and buildings | 903,399.83 | |
| 921,507.93 | ||
| Liabilities | ||
| Accrued liabilities: | ||
| Interest | $12,604.17 | |
| Taxes | 2,635.00 | |
| 15,239.17 | ||
| Redmond & Co. (loan account) | 353,399.83 | |
| Mortgage payable | 550,000.00 | |
| Deferred credit - prepaid rent | 1,895.83 | |
| Equity of shareholders: | ||
| Capital stock issued | $1,000.00 | |
| Net loss on operations from May 18 to Dec. 31, 1916 | 26.90 | |
| 973.10 | ||
| 921,507.93 |
| BALANCE SHEET | ||
| As at December 31, 1917. | ||
| Assets | ||
| Cash | $1,000.00 | |
| Real estate and buildings | $903,399.83 | |
| Less depreciation | 6,000.00 | |
| 897,399.83 | ||
| 898,399.83 | ||
| Liabilities | ||
| Accrued liabilities: | ||
| Interest | $10,312.50 | |
| Taxes | 2,525.00 | |
| Sundries | 715.25 | |
| Redmond & Co.: | ||
| Loan account | $453,399.83 | |
| Operation account | 3,682.10 | |
| 457,081.93 | ||
| Mortgage payable | 450,000.00 | |
| Deferred credit - prepaid rent | 1,895.83 | |
| 922,530.51 | ||
| Equity of shareholders: | ||
| Capital stock issued | $1,000.00 | |
| Deficit account, per Exhibit E | 25,130.68 | |
| 24,130.68 | ||
| 898,399.83 |
| BALANCE SHEET | |||
| As at December 31, 1918. | |||
| Assets | |||
| Cash | $1,000.00 | ||
| Real estate and buildings | 768,190.70 | ||
| Prepaid insurance | 362.97 | ||
| 769,553.67 | |||
| Liabilities | |||
| Accrued liabilities: | |||
| Interest | $10,312.50 | ||
| Taxes | 2,950.00 | ||
| Sundries | 425.82 | ||
| 13,688.32 | |||
| Redmond & Co.: | |||
| Loan account | $125,220.70 | ||
| Operating account | 25,197.82 | ||
| 150,418.52 | |||
| Mortgage payable | 450,000.00 | ||
| Deferred credit - prepaid rent | 1,895.83 | ||
| Equity of shareholders: | |||
| Capital stock issued | $200,000.00 | ||
| Deficit account - | |||
| Balance as at Dec. 31, 1917 | $25,130.68 | ||
| Net loss for the year ended Dec. 31, 1918 | 21,318.32 | ||
| 46,499.00 | |||
| 153,551.00 | |||
| 769,553.67 |
*2493 *969 In the opinion of Redmond & Co. and of the officers of the Pine Street Corporation, the real estate owned by it in 1918 was worth less than it was in 1912 when the partnership agreed to purchase the real estate, at a price of $900,000. At or about the close of 1918 these parties caused an appraisal to be made of the real estate, which *970 showed a then market value of approximately $750,000 for the real estate and building. The real estate and building were set up on the books of the Pine Street Corporation as at December 31, 1918, at a value of $768,190.70. During all of the years 1916 to 1918, inclusive, Redmond & Co. owned all of the shares of capital stock of the Pine Street Corporation. On December 30, 1918, the Pine Street Corporation issued to Redmond & Co. additional capital stock of a par value of $199,000, and Redmond & Co. in return canceled the indebtedness of the corporation to the partnership, in the amount of $328,179.13. In writing this transaction on its books the Pine Street Corporation charged the difference between the indebtedness canceled and the par value of the stock issued against the real estate and building account, reducing the*2494 book value of the land and building to $190.70 as at December 31, 1918.
The partnership, in its income-tax return for 1918, deducted from gross income as a "loss from the exchange of a claim against the Pine Street Real Estate Corporation for its stock $130,000.00." It also deducted from gross income the operating loss of the Pine Street Corporation for 1918 in the amount of $21,318.32. Both of these deductions were disallowed by the respondent in the determination of deficiencies for 1918.
The R. C. Securities Corporation, hereinafter referred to as the Securities Corporation, was organized in 1916 with capital stock of $20,000 par value, all of which was issued to Redmond & Co. For this stock Redmond & Co. paid $1,000 in cash and accepted the remainder in exchange for securities transferred from the partnership. The securities so transferred were of a slow-moving character and for various reasons were difficult to sell at the time.
The journal of the Securities Corporation shows that from time to time following the date of its incorporation and through the taxable years here involved, the partnership transferred securities to the Securities Corporation, and the corporation*2495 transferred securities back to the partnership. The Securities Corporation did no business with any person other than the partnership of Redmond & Co.
The indebtedness of the Securities Corporation on December 31, 1918, was $110,768.93, of which amount $110,000 resulted from loans from Redmond & Co., the remainder being the total of bills payable. On that date the Securities Corporation issued to Redmond & Co. additional stock of $80,000 par value, and Redmond & Co. canceled the indebtedness of $110,000. The assets of the corporation consisted of securities valued at $99,284.20 and accrued interest receivable in the amount of $1,577. The value attributed to the securities was arrived at after a careful survey by the members of Redmond & Co. In determining this value, market quotations, real assets *971 back of the securities, and credit and financial status of the various corporations were considered.
The partnership, in its income-tax return for 1918, deducted from gross income "loss from exchange of a credit against the R.C. Securities Corporation for its stock, $30,000.00." This deduction was disallowed by the respondent in determining deficiencies.
The balance*2496 sheet of the Securities Corporation as at December 31, 1918, as taken from its books, follows:
| BALANCE SHEET. | ||
| As at December 31, 1918. | ||
| Assets | ||
| Accrued interest receivable | $1,577.00 | |
| Investments | 99,284.20 | |
| 100,861.20 | ||
| Liabilities | ||
| Bills payable | $768.93 | |
| Capital stock | $100,000.00 | |
| Surplus | 92.27 | |
| 100,092.27 | ||
| 100,861.20 |
The principal business of Redmond & Co. was that of buying and selling securities on its own account and on commission. The company also served on reorganization committees, prepared financial plans and formed new companies. A seat on the New York Stock Exchange was held in the name of W. S. Jarvis. The "securities" dealt in included bonds, stocks (preferred and common), mortgage bonds, debentures and short-term notes. The company accepted deposits but did not discount commercial paper. Neither did it make loans except against collateral in connection with its stock exchange business.
As a dealer in securities it was entitled to inventory securities held by it, the subject of sale in its ordinary business, at the beginning and close of each year. In taking its inventory Redmond & Co. included the*2497 stock of the Pine Street Corporation and of the Securities Corporation. In the inventory for December 31, 1918, the stock of the Pine Street Corporation was included at a value of $153,551, and the stock of the Securities Corporation was included at a value of $100,000. The value of the stock placed upon the Pine Street Corporation was attributed by the partnership to the building and land, less liabilities. The value attributed to the stock of the Securities Corporation was the value placed by the partnership on the securities, *972 plus accrued interest and less the liabilities. Redmond & Co. sometimes advertised in the newspaper some of the securities held for sale and at times circularized their customers, but in the case of the stocks of these two corporations, of which it held all the stock, no advertising was done. The stock of neither corporation was ever listed on the Stock Exchange.
During the year 1919, Otto J. Thomen withdrew from the partnership of Redmond & Co. and the partnership was reorganized.
OPINION.
SMITH: The issues in these appeals are (1) whether the cancellation by Redmond & Co. of indebtedness of the Pine Street Corporation and of the*2498 Securities Corporation, and the issue to Redmond & Co. by these corporations of additional capital stock were transactions from which gain or loss was realized and, if so, the amount of such gain or loss to Redmond & Co.; (2) whether the stock of the corporations mentioned was properly included in its inventory by Redmond & Co.; and (3) whether Redmond & Co. should be allowed to deduct as rent, the amount of the deficit shown on the books of the Pine Street Corporation for the year 1918.
We are of the opinion under the circumstances and on the facts in these cases that the issues of stock by the corporations mentioned in consideration for the cancellation by Redmond & Co. of indebtedness against them were not such transactions as resulted in gain or loss. The Revenue Act of 1918 permits an individual, and likewise a partnership, under section 214(a), to deduct from gross income in computing net income:
(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in trade or business;
(5) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in any transaction entered into for profit, *2499 though not connected with the trade or business; but in the case of a nonresident alien individual only as to such transactions within the United States;
(6) Losses sustained during the taxable year of property not connected with the trade or business (but in the case of a nonresident alien individual only property within the United States) if arising from fires, storms, shipwreck, or other casualty, or from theft, and if not compensated for by insurance or otherwise.
It further provides under section 202(b) as follows:
When property is exchanged for other property, the property received in exchange shall for the purpose of determining gain or loss be treated as the equivalent of cash to the amount of its fair market value, if any; * * *
The transactions by Redmond & Co. with the two corporations of which it owned all the stock of each were not arm's-length transactions. No actual loss was sustained by the partnership, regardless of *973 how the transactions might be treated on the partnership books of account. From the standpoint of the corporations, we could not hold that the release of the corporations from the indebtedness resulted in any income to the corporations. *2500 This clearly follows from the decision of the Circuit Court of Appeals, Second Circuit, in United States v. Oregon-Washington R. & Nav. Co.,250 Fed. 211, in which it was held:
Under Corporation Excise Tax Act Aug. 5, 1909, § 38, the term "income" must be accepted as those more or less periodic earnings, as distinguished from permanent sources of wealth; hence, where the sole stockholder of a corporation which furnished the capital released a debt in favor of the corporation, such sum should be treated as capital rather than income, though such a release cannot be treated as a mere matter of bookkeeping, but as adding to the corporate assets.
See also Kerbaugh-Empire Co. v. Bowers,271 U.S. 170">271 U.S. 170; Appeal of Independent Brewing Co.,4 B.T.A. 870">4 B.T.A. 870. Although the transaction before us is the converse of that considered in the above cited cases, we think the same ruling must follow, namely, that no loss was sustained by Redmond & Co., but that the transactions simply amounted to contributions of capital to corporations by the sole stockholder.
Exception is taken by the petitioners to the action of the Commissioner in excluding*2501 from inventory the stock of the Pine Street Corporation and of the Securities Corporation. The method of determining income by use of inventories is controlled by section 203 of the Revenue Act of 1918, which reads as follows:
That whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
Article 1585 of Regulations 45, as amended by Treasury Decision 3296, promulgated by the Commissioner under the authority given in section 203, quoted above, reads as follows:
Inventories by dealers in securities. - A dealer in securities, who in his books of account regularly inventories unsold securities on hand, either (a) at cost or (b) at cost or market, whichever is lower, or (c) at market value, may make his return upon the basis upon which his accounts are kept; provided that a description of the method employed shall be included*2502 in or attached to the return, that all the securities must be inventoried by the same method, and that such method must be adhered to in subsequent years, unless another be authorized by the Commissioner. For the purpose of this rule, a dealer in securities is a merchant of securities, whether an individual, partnership, or corporation, with an established place of business, regularly engaged in the purchase of securities and their resale to customers; that is, one who as a merchant buys securities and sells them to customers with a view to the gains *974 and profits that may be derived therefrom. If such business is simply a branch of the activities carried on by such person, the securities inventoried as here provided may include only those held for purposes of resale and not for investment. Taxpayers who buy and sell or hold securities for investment or speculation, and not in the course of an established business, and officers of corporations and members of partnerships, who in their individual capacities buy and sell securities, are not dealers in securities within the meaning of this rule. A dealer in securities is not entitled to the benefits of section 206 with reference*2503 to the gain from the sale of securities.
Commissioner's counsel has taken the position that the right of the partnership to inventory the stock in question turns on the fact as to whether or not the stock was held as an investment or as a part of its stock in trade, and further, that the circumstances indicate that the stock was not held for sale. The taxpayers contend, however, that the stock of the Pine Street Corporation and of the Securities Corporation was held by Redmond & Co. only because no buyer could be found; and that even if the stock was held as an investment and not for sale it was properly included in inventory under article 1585, Redmond & Co. being a dealer in securities within the meaning of that article.
We are of the opinion that the position of the Commissioner with respect to the inventorying of the shares of stock of the Securities Corporation and of the Pine Street Corporation owned by Redmond & Co. is correct. The partnership was a dealer in securities. There is no evidence, however, that the partnership at any time offered the shares of stock of the two corporations above mentioned for sale. The contention of the petitioners that the company might*2504 or would have sold them if they could have gotten their price for them does not make them securities for sale in the ordinary course of business. The evidence does not warrant a finding that they constituted a part of the body of securities of the partnership held for sale. The circumstances under which the assets of both corporations were acquired and the corporations were organized all lead to the conclusion that the shares of stock of the corporations were not a part of the securities held for sale. They simply constituted an investment of Redmond & Co.
We are further of the opinion that the slow-moving securities that had been transferred or sold to the Securities Corporation were like-wise not a part of the inventoriable securities of the partnership. Legal title to the securities transferred was in the Securities Corporation. If the business of that corporation was the purchase and sale of securities, the corporation itself would undoubtedly be entitled to inventory them. But the partnership which owned the shares of stock of the Securities Corporation, not having legal title to the securities held by such corporation, could not inventory them.
*975 There remains*2505 for determination the question whether Redmond & Co. is entitled to deduct from its gross income of 1918 the amount of the deficit in the operation of the Pine Street Corporation which it advanced to that corporation during that year. The evidence indicates that it was the intention of both Redmond & Co. and the Pine Street Corporation to treat this transaction as a loan from the partnership to the corporation. The evidence does not indicate that it was paid as a part of an agreed rental. The petitioners claim that in effect it was in the nature of a rental. We are of the opinion, however, that there is no sound basis for such contention. Upon the record as made, the action of the respondent in disallowing the deduction from the gross income of the partnership is sustained.
No action will be taken concerning the deficiencies for 1919 and 1921 until after the final determination of the deficiencies for 1918 have been settled in accordance with this opinion.
Reviewed by the Board.
Judgment will be entered on 15 days' notice, under Rule 50.
GREEN did not participate.
TRUSSELL, PHILLIPS, and MILLIKEN dissent.