*1192 1. A specialist in stocks listed on the New York Stock Exchange, whose operations consist of matching buy and sell orders given to him by other brokers and of buying and selling his specialties on margin as a speculation, is not a dealer in such stocks and may not inventory them under article 105 of Regulations 74. Other securities acquired for investment and used as collateral for a margin account were not acquired for resale and as to such securities petitioners were not dealers.
2. Assessments levied by the exchange on members for operating expenses are deductible as ordinary and necessary expenses.
3. Contributions to a fund from which payments were made to families of deceased members of the exchange are not shown to be ordinary and necessary expenses.
*1297 The respondent determined deficiencies in income tax for the year 1929 as follows: James B. Lowell, Docket No. 68048, $12,138.14; James Russell Lowell, Docket No. 68049, $737.85.
In each case the respondent has refused to allow petitioners to inventory securities for the*1193 purpose of computing income. The propriety of respondent's action in this respect is the principal issue. A part of the expense deductions claimed by James B. Lowell and the partnership of which he was a member during a portion of the year were disallowed by the respondent and this, too, is in issue.
Some of the facts were stipulated and the others were established by testimony.
FINDINGS OF FACT.
The petitioners, James B. Lowell and James Russell Lowell, are members of the partnership of Lowell & Son, formed March 7, 1929, and during the remainder of the year 1929 were engaged in the business of buying and selling securities as members of the New York Stock Exchange. James B. Lowell became a member of the New York Stock Exchange in 1903 and after that time and until the formation of the partnership on March 7, 1929, was engaged in the business of buying and selling securities as an individual.
*1298 In his income tax return for the year 1929 James B. Lowell computed a profit from transactions in securities as follows:
| Sales | $6,346,696.97 | |
| Cost of Sales: | ||
| Inventory 1/1/29 | $507,993.65 | |
| Purchases | 5,973,488.75 | |
| Commissions | 1,867.50 | |
| Interest | 5,695.03 | |
| Expense | 10.38 | |
| $6,489,055.31 | ||
| Inventory 12/31/29 | 152,462.54 | |
| $6,336,592.77 | ||
| Profit | $10,104.20 |
*1194 In this computation inventories of securities on hand at beginning and end of the year were valued at cost or market, whichever is lower.
The respondent has recomputed the profit from transactions in securities to be $58,117.70, by reason of denying the petitioner James B. Lowell the right to use the inventory method of reporting income, though the full cost of the securities sold during the year 1929 has been allowed in computing said profit.
If it is held that petitioner James B. Lowell had the right to inventory securities on hand at the beginning and end of the year, taxable income as determined in the 60-day letter should be reduced on this account in the sum of $48,013.50. Otherwise, the respondent's computation in that regard is correct.
The partnership return of Lowell & Son for the year 1929 showed a net income of $160,774.35, which was divided equally between the two petitioners herein. The $160,774.35 included profit of $106,317.84 from the sale of securities, computed as follows:
| Sales | $20,920,744.57 | |
| Cost of Sales: | ||
| Purchases | $20,952,592.75 | |
| Commissions | 8,230.25 | |
| Interest | 20,087.23 | |
| $20,980,910.23 | ||
| Inventory 12/31/29 | 166,483.50 | |
| 20,814,426.73 | ||
| Profit | $106,317.84 |
*1195 The respondent increased the profit from the sale of securities from $106,317.84 to $111,464.78 by reason of denying the partnership of Lowell & Son the right to use the inventory method of reporting income, though the full cost of the securities sold during *1299 the year 1929 has been allowed in computing said profit, and increased taxable income of each of the petitioners by one half of the difference of $5,146.94.
If it is held that the partnership of Lowell & Son was entitled to inventory its securities on hand December 31, 1929, on the basis of cost or market, whichever is lower, taxable income of each of the petitioners as determined in the 60-day letter should be reduced in the sum of $2,573.47, otherwise the respondent's computation in that regard is correct.
Petitioner James B. Lowell was a specialist on the floor of the New York Stock Exchange. His specialties were United States Steel Corporation preferred, Stewart-Warner Corporation, and Pan American Petroleum. As a specialist he was assigned a trading post on the floor of the exchange, at which post the latest prices in his stocks were displayed, and all transactions in those stocks, in which exchange*1196 members participated, took place at that post, but not all of them through the petitioner. That is, exchange members before the post could and did deal either with each other or with the petitioner. Petitioner's dealings were entirely with other members of the exchange; neither he nor the partnership had any outside customers.
At his post on the exchange floor petitioner kept a book for each of his specialties, on one side of which he recorded the "buy" orders and on the other the "sell" orders given to him by other brokers. When the buy and sell orders matched petitioner executed them for the brokers without knowledge as to the identity of the purchaser or vendor. For this service petitioner received a commission from the brokers on the orders executed, which was paid him monthly.
When the orders on his books did not match, petitioner was permitted to and did buy and sell his specialities for his own account. He made such purchases and sales based on his judgment as to the possible action of the market. At times he was in a long position, that is, had some of his specialities on hand, and at other times he sold short. He engaged in such transactions for two purposes. *1197 One was to maintain a market for the shares, so that those who desired to buy or sell could always do so. The other purpose was the purely speculative one of hope of profit on a change in the market. The rules of the exchange did not permit him to receive a commission on such purchases and sales for his own account. The transactions for his own account were on a marginal account carried at Wrenn Brothers, members of the exchange. In order for that firm to carry his account, it was necessary for petitioner to deposit collateral. This consisted of various stocks and bonds which petitioner had acquired *1300 over a period of years. The total cost of those securities and their market value at January 1 and also December 31, 1929, was as follows:
| Cost | Market value | |
| January 1, 1929 | $566,700.28 | $507,993.65 |
| December 31, 1929 | 259,182.67 | 152,462.54 |
The partnership had no opening inventory. At the close of the year 1929 it had on hand only Pan American Petroleum stock and Stewart-Warner Corporation stock, which had cost $171,630.44 and had a then market value of $166,483.50. During the year the partnership had purchased and sold stock of several other*1198 corporations.
Petitioner James B. Lowell used the inventory method of determining and reporting income for a number of years prior to 1929.
In 1929 petitioner James B. Lowell, as an individual, and the partnership of Lowell & Son paid to the New York Stock Exchange the respective sums of $203.30 and $1,393.23 as dues and assessments, which payments were required by the rules of the exchange. These dues and assessments are imposed on members to meet the operating expenses of the exchange, such as telephone service, messenger service, and clerk hire, and also include assessments for what is known as the gratuity fund. Upon the death of a member of the exchange a certain sum is paid to his widow or children from the gratuity fund. Subsequent to the formation of the partnership James R. Lowell paid $45.33 to the gratuity fund and James B. Lowell paid $90 thereto. The amounts of $203.30 and $1,393.23 have been denied as deductions by the respondent on the ground that they were capital expenditures.
OPINION.
ARUNDELL: Briefly restating the facts in the case of James B. Lowell, it appears that he was a specialist in three stocks on the New York Stock Exchange. He owned other*1199 securities, which were hypothecated as collateral for his marginal account. He inventoried both groups of securities at cost or market, whichever was lower. He entered a partnership in March of 1929 with the other petitioner and continued specializing in the same stocks as theretofore. The partnership had no opening inventory and its closing inventory consisted entirely of two of the stocks specialized in, which it inventoried at market in determining income for 1929. The respondent has denied to both the individual and the partnership the right to inventory their securities for the purpose of determining income.
Petitioners claim the right to inventory securities on the ground that they were dealers therein within the meaning of article 105 of *1301 Regulations 74. That article, in so far as material here, provides as follows:
* * * 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*1200 to the gains and profits that may be derived therefrom. * * *
In , we approved the above article as being "reasonable, and designed to carry out fairly the terms and intent of the statute."
The securities here involved should, we think, be divided into two groups. First, those used by petitioner James B. Lowell as collateral for his margin account, and, second, those in which the petitioner was a specialist. In the first group, according to the schedules in evidence, were about forty different securities at the beginning and also at the close of the year. There were some changes during the year, but in the main petitioner had the same securities at the beginning and at the end of the year. These, petitioner James B. Lowell testified he had accumulated over a period of years and were "all stocks that were bought for investment." An investor in securities is not a merchant and does not come within the definition of the regulations above quoted. See ; *1201 ;; . In view of petitioner's testimony as to the purpose for which he purchased the securities under consideration, it seems beyond serious question that as to them he cannot be classified as a dealer. Those securities constituted his capital, and capital may not be inventoried for purposes of determining income from sales.
The other group consists of those stocks dealt in as specialties. Some of the transactions in these stocks consisted of matching purchase orders against sales orders, the orders on both sides of the book being received from brokers, and for this service a commission was paid by the brokers. It is obvious that in such transactions no securities would need be carried in stock if the buy and sell orders matched up evenly each day. To what extent they were even is not shown, but the testimony of petitioner James B. Lowell is that he endeavored to come out as nearly even as possible. Transactions of this kind in our opinion cannot be classified as the "purchase of securities and their resale to customers." Art. 105, Regulations*1202 74. The petitioner in such cases was not selling securities previously purchased, but was rather acting as a broker on a commission basis. *1302 A dealer or merchant gains or loses directly in proportion to fluctuations in the market price of the commodity in which he deals; not so with petitioners in their matching operations, for no matter how much the spread in prices their commission was the same on each 100-share lot cleared on their books.
The other transactions in the specialty stocks were not such as to come within the generally accepted understanding of the terms of merchant or dealer. They were purchases or sales, sometimes short sales, made when there were no matching orders on the books. These transactions, according to the testimony, were for the purpose of creating or maintaining a market; they were speculative, as explained by the witness, in that he was betting on a rise or fall in the market according to whether he was long or short of the stock. An effort was made to even up on each transaction within the day though this was not always accomplished. These transactions were engaged in to maintain the market only for the day; they were engaged in on*1203 margin with Wrenn Brothers; no certificates were issued in the names of petitioners or the partnership; and neither the petitioners nor their partnership could deal directly with the public. These matters demonstrate the width of the gap between the petitioners and a dealer or merchant, who is generally understood to be one who carries a stock of his wares and stands ready to deal directly with all who wish to trade in that commodity. We are accordingly of the opinion, and so hold, that petitioners were not dealers in the stock in which they were specialists.
These cases are distinguishable from that of . In that case the petitioner's decedent was a member of a partnership which had an established place of business at which it dealt in securities. The partnership specialized in the stock of one corporation, the New York Dock Co., and we found as a fact that the stock of that corporation was not purchased either for investment or speculation, but for future resale at a profit. The purchasers of the stock were mostly, but not entirely, members of the New York Stock Exchange, and on resales to them the partnership dealt*1204 with them as principals and customers. At the close of each year involved in that case the partnership had on hand substantial amounts of the stock. In the opinion in that case we distinguished it from Donander Co. and , in the following language, which also aptly points out some of the distinctions between it and the present case:
In each of the cited cases we found that the petitioner was not a dealer, but was engaged primarily in investing or speculating as opposed to merchandizing securities. An entirely different situation is presented in the *1303 case at bar. The partnership with which we are concerned here is clearly shown by the evidence to have dealt in the stocks involved primarily as a merchant. While it purchased through brokers who were members of the stock exchange and sold to brokers as principals or customers, it held itself out as a merchant of securities and the transactions were cleared through its own office, not those of the brokers. It also purchased from and sold to others than brokers. We know of no good reason why a broker, even though acting for an undisclosed client, should not properly*1205 be regarded as a customer in the making of repeated purchases of securities and held for resale by the partnership.
The remaining question is that of deductions claimed as expenses and disallowed by the respondent on the ground that they were capital expenditures. The evidence is uncontradicted that the amounts paid were levied by the exchange on its members and they were obligated to pay as a condition to doing business on the floor of the exchange. The assessments for the most part were for the purpose of meeting operating expenses and as such are clearly allowable as expense deductions. Respondent's only serious objection to the claim is that part of the amount paid went to a gratuity fund out of which a certain sum was paid to the widow or children of deceased members. Payments going to this fund, the respondent argues, were in the nature of insurance premiums. The evidence as to the method of operation of the gratuity fund is rather unsatisfactory. We have nothing on this except the testimony of one of the petitioners who described the fund and the method of administration in general terms. Whether assessments were levied on living members and the whole sum paid*1206 out to the family of a deceased member, or whether a fund was accumulated so that the family of a deceased member benefited from payments made during his life, is not shown. It may be that the rules of the exchange describe the method of operation, but they were not placed in evidence. We accordingly hold that the amounts paid into the gratuity fund cannot be allowed as deductions on the showing made. The evidence is not entirely clear as to who claimed deductions for the payments made to the gratuity fund aggregating $135.33, but, as the payments were made by petitioners after formation of the partnership, we assume that the total was included in the deductions claimed by the partnership, and we hold that the respondent properly disallowed that much of the partnership deduction.
Decision will be entered under Rule 50.