*72 Decision will be entered under Rule 50.
1. During the taxable year petitioner, the operator of a cotton warehouse, illegally removed and sold as his own 812 bales of cotton which had been stored by others with him. From such sales, he received $ 137,642.12, which he deposited as his own in his personal bank account. There is no showing of any recognition, consensual or otherwise, of any obligation to the owners of the cotton for the sales proceeds until after the taking of the cotton was discovered by State warehouse inspectors in 1958. Held, that respondent did not err in failing to exclude the sales proceeds from gross income in his determination of deficiency herein.
2. Held, that petitioner has not shown that his losses from the purchase and sale of cotton futures contracts were ordinary losses, rather than capital losses, as respondent has determined.
*907 The respondent determined a deficiency in income tax against the petitioners for 1955 in the amount of $ 117,386.81. The questions presented for determination are: (1) Whether the proceeds from the sale of cotton which petitioner illegally removed from his cotton warehouse are includible in his taxable income, and (2) whether a loss of $ 169,871.78 which petitioner sustained on trading in cotton futures contracts is a capital loss or an ordinary business loss. Several other issues have been settled by stipulation.
FINDINGS OF FACT.
Some of the facts have been stipulated and are found as stipulated.
The petitioners are husband and *74 wife, residing in Jasper, Alabama. They filed a joint income tax return for 1955 with the district director of internal revenue for Alabama. The return was prepared on an accrual basis. L. M. Muldrow will be referred to as petitioner. Helen B. Muldrow is a party to the proceeding only by having filed a joint return with him.
In 1955 and for several years prior thereto, petitioner owned and operated a licensed cotton warehouse in Jasper. He operated the warehouse as an individual proprietorship under the name of Jasper Bonded Warehouse. The business consisted of receiving and storing cotton for which he issued negotiable warehouse receipts, under the provisions of Ala. Code tit. 2, art. 34, secs. 504, et seq. (1940). Also, in the course of his operations, he made purchases of cotton for others on a commission basis.
During 1955 petitioner operated four separate warehouses. Most of his routine warehouse business, such as receiving, weighing, sampling, *908 and storing cotton, was handled by his employees. Petitioner's only office employee was a secretary, who handled office records and assisted petitioner generally.
Much, if not most or all, of the cotton stored in *75 petitioner's warehouses was owned by or pledged to Commodity Credit Corporation, or pledged to others, such as the Cotton Producers Association, as security for promissory notes which the Commodity Credit Corporation was committed to purchase. With respect to the Cotton Producers Association, which provided cooperative loans to its producers, a producer would deliver his cotton to the warehouse, at which time he would receive a check from petitioner covering the cotton so delivered. The amount of the check would be based on the grade, staple, loan value, and weight of the individual bale, less $ 2.10 to cover various charges, consisting of 75 cents for the Cotton Producers Association; 25 cents as exchange paid to the bank; 25 cents as a classing fee to the United States Government; 5 cents for postage; 50 cents to the warehouse as receiving fee; and 30 cents as clerk's fee. Petitioner would then draw a draft on the Cotton Producers Association covering the settlement which had been made with the producer, which draft would be in a net amount after allowing for the 75 cents allowed to the Cotton Producers Association. The $ 1.35 per bale thus received by petitioner over and above*76 the amount already paid to the producer would be applied in satisfaction of the remaining charges as indicated.
During the taxable year most, if not all, of the cotton purchased on a commission basis was purchased for the Duncan Cotton Company. In making purchases for the Duncan Cotton Company, petitioner would arrange a purchase from a ginner or other cotton merchant and would draw a draft on Duncan Cotton Company to cover the purchase price. At a subsequent date, Duncan Cotton Company would issue a check to petitioner, compensating him to the extent of 75 cents per bale for making the purchase.
In the course of the operations outlined, petitioner in 1955 handled 4,790 bales of cotton, of which 3,202 bales were for the Cotton Producers Association, 1,015 bales consisted of cotton purchased for others on a commission basis, and 573 bales were "Purchased For Loan Repayment." 1*77 Also in 1955 petitioner "paid for" the purchase of 267 bales of cotton "to cover" a sale of cotton to Duncan Cotton Company in 1953. 2
*909 In 1955, petitioner issued duplicate or fictitious receipts for 812 bales of cotton stored in his warehouse. He substituted these receipts on the bales of stored cotton for the actual receipts, the tag numbers of which he removed from the bales. After retagging the bales with fictitious receipts, he shipped and sold the cotton as his own property. For the 812 bales so retagged, sold, and shipped, he received $ 137,642.12, which he deposited in his personal bank account at the First National Bank in Jasper and used the money as his own. The cotton so sold by petitioner was not owned by him, but by other parties. He never purchased or paid *78 for it. Neither did he make the matter known to the holders of the valid warehouse receipts nor to anyone.
The 812 bales of cotton converted and sold by petitioner in 1955 were either owned by or pledged to the Commodity Credit Corporation, or pledged to others, such as the Cotton Producers Association, as security for promissory notes which the Commodity Credit Corporation was committed to purchase.
In his 1955 income tax return, petitioner reported cotton sales of $ 323,609.85. The amount so reported as cotton sales purported to cover 1,827 bales, of which 812 bales was the cotton belonging to others taken by petitioner from his warehouse and sold as his own, and 1,015 bales was the cotton purchased for others on a commission basis. Of the said 1,827 bales, 1,142 were acquired by Duncan Cotton Company. The only cotton sold by petitioner during 1955 as his own and for his own account was the 812 bales of embezzled cotton.
The action of Muldrow in taking and selling as his own the cotton of others from his warehouse was not discovered until June 1958, when State warehouse inspectors discovered a shortage of 3,024 bales, of which 812 bales represented the cotton so taken and sold*79 in 1955. Muldrow was indicted in the United States District Court for the Northern District of Alabama, on 11 counts charging that "he did knowingly, willfully, unlawfully, feloniously steal, conceal, remove, dispose of and convert to his own use" the cotton in question. He entered a plea of guilty and "was convicted under Section 714, Title 15, U.S.C." In January 1959, he received a 5-year probationary sentence. He was also indicted by the grand jury of Walker County, Alabama, and 15 cases charging embezzlement are still pending against him in the Circuit Court of Walker County, many of the cases containing 5 separate counts.
Following the above discovery, the United States District Court ordered Muldrow to convey all of his property to a trustee for the benefit of his creditors, including firms and agencies holding the valid uncanceled warehouse receipts. The holders of these receipts have filed claims against the trustee. None of them have condoned or excused the conversions and each has filed a claim with the trustee for the amount of "their" loss.
*910 In 1955 and in years prior thereto Muldrow engaged in buying and selling commodity futures contracts for his own account. *80 In a small room adjoining his office, he had a ticker tape installed on which he received the results of trading on the New York and New Orleans Cotton Exchanges and the New York Produce Exchange. He also had a ticker tape connection with Atlanta, Georgia. He spent more than half of his working time watching the ticker tape and handling his futures transactions. He personally made all buy and sell decisions, although the orders were sometimes placed by his secretary.
He became a member of the New Orleans Cotton Exchange in July 1954, a member of the New York Cotton Exchange in March of 1955, and a member of the New York Produce Exchange in 1956.
Each of the firms through which petitioner bought and sold futures contracts was a registered commission merchant under the United States Department of Agriculture, Commodity Exchange Authority, and throughout 1955, and prior and subsequent thereto, was engaged as a carrying futures broker. Petitioner's orders to buy or sell futures contracts were placed with such a registered broker. Following their receipt they were executed by the broker on the floor of the exchange and confirmation slips were promptly transmitted to Muldrow. All*81 of the futures transactions required delivery of cotton unless there was a contra purchase or sale "before the month of the commodity involved went off the board." When a transaction was closed out, Muldrow's account was credited or debited with the resulting profit or loss. All of these transactions were executed in strict accord with the rules and regulations of the exchange through which the purchases and sales were consummated.
Prior to the time any of the transactions were executed petitioner transmitted form letters to the various brokers certifying that all transactions in cotton futures in which he requested "exemption from the original margin requirements" of a specified rule of the particular cotton exchange would consist exclusively of hedges. In his letter to Steiner, Rouse & Company of New York, under date of May 2, 1952, he stated that his transactions in cotton futures would consist of hedges bought or sold against an approximate quantity of "spot cotton or commitments in actual cotton on which the price has been fixed" or "futures contracts in the same or other cotton markets, in accordance with accepted interpretations of transactions for trade accounts." In his*82 letter to Courts & Co. of Atlanta, under date of December 21, 1955, he described his business as that of merchant, but did not designate any one of the described hedge transactions as representing the transactions in which he would engage. 3
*911 At the inception of all futures transactions listed in a schedule attached to his 1955 return, the transactions were designated by petitioner, and in turn carried by each carrying futures broker, as hedging transactions. Each such transaction was carried as a hedging transaction on all the books and records of the carrying futures broker through and by whom the transactions were executed.
During years prior to 1955, *83 petitioner's transactions in spot cotton, 4 in terms of bales handled, were as follows:
| Year | Own account | Commission | Equities | Total bales |
| account | of cotton | |||
| 1951 | 704 | 2,703 | 0 | 3,407 |
| 1952 | 864 | 3,741 | 374 | 4,979 |
| 1953 | 158 | 1,327 | 0 | 1,485 |
| 1954 | 621 | 2,551 | 333 | 3,505 |
Petitioner had no inventory of spot cotton of his own at the beginning or at the end of 1955, and the only purchases of spot cotton which could have been purchases for his own account during 1955 would have to have been the 267 bales paid for in 1955 "to cover" that number of bales of cotton sold to Duncan Cotton Company in 1953.
At the beginning of 1955, petitioner did have an inventory of 707 bales of Linters 5 and Kapok, valued at $ 18,333.08, and at December 31, 1955, an inventory valued at $ 3,650. In his income tax return for 1955, he reported sales of Linters and Kapok at $ 20,275.38 and purchases during the year of $ 6,097.03.
*84 Petitioner's cotton futures transactions averaged over 50 a month during 1955. For the entire year his purchases amounted to $ 12,227,292.43, sales to $ 12,071,725.98, and expenses to $ 14,305.33. His net loss for the year was $ 169,871.78.
OPINION.
It is the position of petitioner that to the extent of the proceeds from the sale of the 812 bales of cotton illegally taken and sold from his warehouse his cotton sales as reported in his 1955 return were overstated and should be adjusted to eliminate the $ 137,642.12 received therefor. In short, it is his contention that the said sales proceeds should be excluded in arriving at his gross income. As the basis for the claim, it is said that petitioner never held the funds under any claim of right but has forthrightly admitted his indebtedness to the legitimate holders of uncanceled warehouse receipts, that he in fact conveyed all of his assets to a trustee for the benefit of the "admitted and recognized claim holders" and having filed his return *912 on an accrual basis and the sales proceeds thus not being his, sales should be reduced in the amount stated by its elimination.
The difficulty with the contention is that certain *85 of the material facts are not shown of record as counsel states them and the argument advanced is strongly reminiscent of the reasoning in Commissioner v. Wilcox, 327 U.S. 404, overruled in James v. United States, 366 U.S. 313. In the James case, Chief Justice Warren in his opinion said:
When a taxpayer acquired earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, "he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent." North American Oil v. Burnet, supra, at p. 424. In such case, the taxpayer has "actual command over the property taxed -- the actual benefit for which the tax is paid," Corliss v. Bowers, supra. * * *
During the taxable year petitioner sold for his own account 812 bales of embezzled cotton, for which he received likewise as his own $ 137,642.12. He deposited these funds in his personal bank account and had unrestricted*86 use of them throughout the taxable year and, to the extent not previously lost or dissipated, during 1956 and 1957 and in 1958 at least until the time his defalcations were discovered. There is no showing of any recognition, consensual or otherwise, of an obligation to pay over any of the funds to the rightful owners of the cotton or of any holding of the funds for them until after his misdeeds caught up with him in 1958. And, under the James case, any such belated acknowledgment of liability may not be related back to the year of conversion, and that regardless of whether the taxpayer used an accrual or cash method of accounting in reporting his income.
The respondent did not err in failing to exclude from gross income the proceeds from the sale in 1955 of the 812 bales of converted cotton.
With respect to the losses sustained by petitioner in his buying and selling of cotton futures contracts, the parties are in apparent agreement that if petitioner's futures transactions were bona fide hedging transactions, his losses thereon in 1955 were deductible in full and are not subject to the statutory limitations on the deduction of capital losses. The petitioner makes a further*87 claim, however, that even if his transactions in cotton futures were not "true" hedges, they were an integral part of his regular business and under the decision of the Supreme Court of the United States in Corn Products Refining Co. v. Commissioner, 350 U.S. 46, the losses thereon were ordinary losses and deductible in full.
Noting that the Supreme Court in United States v. New York Coffee & Sugar Exchange, 263 U.S. 611, had pointed out that there were three general classifications of dealings in commodity futures, namely, speculation, legitimate capital transactions, and hedging, the United States Court of Appeals for the Second Circuit, in its opinion *913 in Corn Products Refining Co. v. Commissioner, 215 F. 2d 513, affirmed by the Supreme Court at 350 U.S. 46, stated: "These classifications have since been adopted as convenient nominal guides by the courts to determine the proper tax consequences of futures transactions. Where futures are dealt with for the purposes of speculation or what is called legitimate capital transactions, they obviously*88 fall outside the possibly relevant exclusions of Section 117(a)."
A hedge, on the other hand, is not a transaction looking to a favorable fluctuation in price for the realization of profit on the particular futures contract itself, as in the case of a speculative or capital transaction, but is a form of insurance against unfavorable fluctuations in the price of a commodity in which a position has already become fixed or, as in the case of a producer such as a cotton grower, will become fixed in normal course and the sale, liquidation, or use of the commodity is to occur at some time in the future. See Fulton Bag & Cotton Mills, 22 T.C. 1044, where the taxpayer was a manufacturer of cotton bags and by transactions in cotton futures sought to protect its inventory of raw cotton against a possible decline in the market price; Stewart Silk Corporation, 9 T.C. 174, where a silk manufacturer, which was meeting increased sales resistance to its manufactured products from manufacturers of synthetic fabrics, sold futures in raw silk for the purpose of protecting its raw silk inventory from unfavorable fluctuations in price; Kenneth S. Battelle, 47 B.T.A. 117,*89 where cotton futures were sold by a cotton farmer to offset production risks on cotton he was producing and would have on hand for sale at a later date; Ben Grote, 41 B.T.A. 247, a wheat farmer who sold wheat futures to protect against the possibility of an unfavorable price at the time his wheat crop would be ready for market; and Sicanoff Vegetable Oil Corporation, 27 T.C. 1056, reversed on other grounds 251 F. 2d 764, wherein, at page 1067, we described hedging transactions as follows:
Generally, where a hedge is made, a position is taken in the futures market to offset a risk with respect to actuals. The purchase or sale of a futures contract to offset the risk of holding another futures contract does not ordinarily qualify as a bona fide hedge -- for such risk is a speculative one, and is not attached to the holding of a commodity expected to be used or marketed in a business. 3 The authorities indicate that, in order to have a bona fide hedge, there must be: (1) A risk of loss by unfavorable changes in the price of something expected to be used or marketed in one's business; (2) a possibility*90 of shifting such risk to someone else, through the purchase or sale of futures contracts; and (3) an intention and attempt to so shift the risk.
*914 The only evidence of record which even tends to show that petitioner's transactions in cotton futures were hedges is that petitioner, by form letters, had represented to brokers that the transactions in cotton futures in which he would request "exemption from the original margin*91 requirements" covered by a designated rule of the exchange, would fall into one or more of the categories listed in the form letters as hedges; that in initiating the said transactions herein with the brokers he had designated them as hedging transactions and the carrying futures broker, in each instance, had carried the transactions as hedges on its books and records. There is no suggestion or claim that the brokers required any showing or made any determination that the transactions were in fact hedging transactions.
On the other hand, the facts which are shown relative to petitioner's operations and to the transactions themselves fail to disclose any basis or justification for designation of the futures transactions as hedges. Petitioner had no inventory of spot cotton at the beginning or close of the taxable year, and unless there was in fact a purchase of 267 bales to cover a sale made to Duncan Cotton Company in 1953, he made no purchase of spot cotton during the taxable year. He was not a producer or processor of cotton. He owned no cotton during the year and his only sales for his own account were the sales of 812 bales of embezzled cotton. It is true that he had bought, *92 and presumably sold, some spot cotton in the 4 years preceding the taxable year. But there is no proof to show that his transactions in cotton futures even in prior years, to say nothing of such transactions in the taxable year, were in any respect hedges connected with his purchases of spot cotton. Such being the state of the record, we may not properly conclude that the transactions herein were in fact hedging transactions, rather than a speculative buying and selling of futures by petitioner.
What we have said above also disposes of the contention that if the futures transactions were not "true" hedging transactions, they were an integral part of petitioner's warehouse business and that the losses sustained were ordinary losses under the decision of the Supreme Court in Corn Products Refining Co. v. Commissioner, supra. Not only is there no showing that the futures transactions were an integral part of or even related to petitioner's warehouse operations, but the facts which are of record tend to show that they were not.
Petitioner's final contention is that his activities covering his cotton futures transactions occupied most of his working time, and accordingly were*93 such as to make those activities, in and of themselves, the conduct of a business, to the end that the losses sustained were losses incurred in the ordinary course of a business regularly carried on, and were deductible as such.
*915 The same argument was advanced and rejected in Farroll v. Jarecki, 213 F. 2d 281, certiorari denied 252 U.S. 830. In that case, Farroll, the taxpayer, during the taxable year entered into more than 10,000 separate transactions involving approximately 81 million bushels of grain and amounting to more than $ 84 million. He averaged at least 41 separate transactions and over $ 340,000 of commitments per day. He was a general partner in a brokerage firm, but entered into the transactions in question for his own account. The court held the losses sustained were capital losses within the meaning of the statute, not ordinary losses. To the same effect is Craig M. Smith, 33 T.C. 465. See also O. L. Burnett, 40 B.T.A. 605, affirmed on this issue 118 F. 2d 659.
We accoardingly conclude and hold that petitioner's*94 losses during the taxable year on his trading in futures contracts were capital losses, and are not deductible as ordinary business losses.
Decision will be entered under Rule 50.
Footnotes
1. Whether the 573 bales had to do with loans to producers by the Cotton Producers Association, loans related to Commodity Credit Corporation transactions, or other loans, is not shown.↩
2. The parties have stipulated that petitioner in 1953 sold 334 bales of cotton to Duncan Cotton Company and to cover that sale Muldrow in 1954 paid for the purchase of 67 bales and in 1955 paid for the purchase of 267 bales. Whether the sale in 1953 was for deferred delivery or delivery was made with cotton which was replaced in 1954 and 1955, does not appear. In any event, the parties make no point of these purchases in their arguments herein.↩
3. Petitioner's 1955 return indicates numerous cotton futures transactions through Courts & Co. in 1954 and in 1955 prior to December 21, 1955. Whether a prior letter to Courts & Co. relating to cotton futures transactions likewise failed to designate specific types of hedge transactions in which petitioner advised he would deal exclusively is not shown.↩
4. Spot cotton means actual cotton.↩
5. Linters is the short fibers remaining on the cotton seed after the cotton is ginned.↩
3. The Treasury regulations recognize that it is possible to have a hedge against concurrent futures. Regs. 111, sec. 29.502-1(6). But the expert testimony herein indicates that this can occur only in unusual circumstances -- as for example, where one has hedged a risk in an actual, by buying futures; has found, after the risk in the actual has expired, that he cannot "lift" the hedge, because of the narrowness or the closing of the market in which the futures were acquired; and, hence, that in order to obtain protection, he must go to a different market to buy or sell offsetting futures.↩