*127 Decisions will be entered for the respondent.
Petitioners were the members of a partnership engaged in the business of manufacturing men's suits from piece material. At the outbreak of the present war all lines of piece goods were withdrawn from the market. At that time the partnership had on hand only a six-month supply of piece goods. During September 1939 it purchased on margin through a broker certain futures contracts calling for delivery of wool tops in March 1940. At the time these contracts were purchased the partnership intended to take delivery of the wool tops and have them converted into piece material. Towards the close of 1939 piece goods were again offered on the market and the partnership learned that the wool tops to be delivered in March were of an inferior grade and could not be used in its business. During February 1940 it sold the futures contracts at a substantial loss. Held, the loss thus sustained by the partnership was a "short-term capital loss" as that term is defined in section 117 (a) of the Internal Revenue Code and was not a business expense deductible from gross income under section 23 (a) (1) (A); held, further, the partners are *128 not entitled under sections (s). 122, and 189 to deduct from their gross incomes for the taxable year 1941 any "net operating loss carry-over" on account of the loss sustained by the partnership on its wool tops futures contracts.
*398 These*130 proceedings, duly consolidated, involve deficiencies in income tax for the calendar year 1941 determined by the respondent against petitioners in the amounts of $ 3,961.82, $ 4,493.37, $ 4,166.11, $ 3,720.08, and $ 4,169, respectively.
The deficiencies result from the respondent's determination that each petitioner should be taxed with "Income from partnership" of $ 17,564.54 ($ 17,564.53 in Docket Nos. 3354 and 3356) not reported on their individual returns. This adjustment was identically explained in each deficiency notice as follows:
Your distributive share of income from the S. Makransky & Sons partnership has been adjusted to reflect the disallowance of an alleged 1940 operating loss carried over and claimed as a deduction by the partnership in its return for 1941.
By appropriate assignments of error each petitioner contests this adjustment.
The respondent also allowed each petitioner, except Edward Makransky in Docket No. 3354, additional deductions for contributions, but these adjustments are not in controversy.
FINDINGS OF FACT.
Many of the facts have been stipulated. The stipulation and the exhibits thereto are incorporated herein by reference.
Petitioners in Docket No. *131 3353 are the executors of the will of Dorothy Makransky, who died on December 31, 1943. The original petitioner in Docket No. 3353 was Dorothy Makransky, an individual, residing in Philadelphia, Pennsylvania. She filed her income tax return for the calendar year 1941 with the collector for the first district of Pennsylvania.
Petitioners in the remaining dockets are individuals and residents of Philadelphia, Pennsylvania. They too filed their income tax returns for the calendar year 1941 with the collector for the first district of Pennsylvania. At all times material herein Dorothy Makransky and the petitioners in the remaining dockets composed the partnership of S. Makransky & Sons, hereinafter sometimes referred to as the partnership. The partnership filed returns for the calendar years 1940 and 1941 with the collector for the first district of Pennsylvania.
The partnership is the successor to the clothing business of S. Makransky & Sons, Inc., a Pennsylvania corporation. Since prior to 1918 *399 the partnership and its predecessor concerns have been engaged in the city of Philadelphia, Pennsylvania, in the manufacture and sale to retailers of men's ready-to-wear suits. *132 The finished stock of the partnership is sold by retailers under the partnership's trade name of "Devonshire Clothes" or under the name of the retailer.
The partnership obtains piece goods from weavers of woolen or worsted cloth, which are sponged by an independent contractor in order to pre-shrink the cloth and are then manufactured by the partnership into the finished clothing. Orders for the purchase of piece goods by the partnership for the spring and summer line are placed with the weavers principally during the preceding July and August, and deliveries are made to the partnership by the weavers commencing in December and extending through the subsequent months of January, February, and March. Orders for the purchase of piece goods by the partnership for the fall and winter line are placed with the weavers principally during January and February and deliveries are made by the weavers to the partnership commencing in June and extending through the next succeeding three months of July, August, and September.
The partnership employs numerous salesmen to sell its finished product to retailers throughout the United States. In this connection, sample suits and swatches of its prospective*133 spring and summer line are made up by the partnership and furnished its salesmen during September and October. Its salesmen contact prospective purchasers during the fall season for the purpose of obtaining orders for the sale of the finished stocks of the partnership for the following spring and summer. Actual manufacture by the partnership in accordance with the sales orders obtained by its salesmen is conducted by the partnership over the period from about November through the subsequent month of April and sometimes May. As to the fall and winter line, sample suits and swatches are furnished to the salesmen during the preceding March and April. Sales orders are taken by the salesmen during April and May from prospective purchasers and the actual manufacture of its finished stock with which to fill the sales orders is conducted by the partnership during the period of June through October and sometimes November.
All orders for its finished product were accepted by the partnership subject to the following conditions fully set forth in the orders:
We are not responsible for the late or nondelivery of all or any part of this order due to fire, strikes, inability to procure piece*134 goods or due to government orders or any other reason; nor does the delivery of any part of this order obligate us to deliver any other part hereof. We may discontinue shipment of any or all goods due you and cancel this and any other orders for you in case of your failure to make payments as agreed, or of any change in your credit standing These prices are fixed -- excepting if the seller's costs are increased by the *400 imposition of government and/or state taxes, or by laws or regulations governing the working hours or compensation of labor, or by other increases in the rates of wages, in which case the buyer agrees to pay these increases. All orders subject to approval of our Philadelphia office.
During the year 1936 the partnership experimented in the manufacture of piece goods for its inventory requirements through contractors rather than purchasing finished piece goods from various weavers. The books of the partnership reflect payments of $ 12,523.26 and $ 15,196.27 to two different concerns, respectively, for spools of yarn delivered to the partnership over the period August to December 1936.
During the period November 1936 to February 1938 the partnership paid a *135 weaver $ 5,840.62 for weaving the above mentioned spools of yarn into gabardine cloth, and paid a finisher and dyer $ 3,788.78 for finishing and dyeing the woven gabardine cloth. Approximately 15,000 yards of gabardine cloth were produced in this operation, and this yardage, after being sponged, was used by the partnership in the manufacture of its 1937 and 1938 spring and summer lines of finished stock.
In 1938 and 1939 the partnership engaged in the manufacture of additional piece goods for its inventory requirements through contractors. The transaction was carried out through Robert Rubenoff & Sons of New York City, who were and are engaged in the business of converting wool tops purchased by clothing manufacturers and retail chain stores into finished cloth on a commission basis paid by the processors. Wool top is a blend of raw wool obtained from the various wool growing districts of the world. The blending of the raw wool into wool top is performed by a top maker.
On November 16, 1938, the partnership purchased through Robert Rubenoff & Sons 5,181 pounds of wool tops from Nichols & Co., Boston, Massachusetts, for immediate delivery to the Cherry Brook Worsted Co., Woonsocket, *136 Rhode Island. The wool tops were received by the Cherry Brook Worsted Co. on November 19, 1938, and on November 23, 1938, the partnership ordered the worsted company to spin the wool tops into wool yarn. Between February 9 and February 14, 1939, the Cherry Brook Worsted Co. spun a total of 4,725 pounds of yarn, as ordered, and billed the partnership for the spinning, and, in accordance with instructions, shipped the yarn to Sterling Mills, Inc., Worcester, Massachusetts, for weaving into cloth.
The 4,725 pounds of yarn were received by Sterling Mills, Inc., between February 13 and February 16, 1939. During the period February 23 to September 21, 1939, Sterling Mills, Inc., wove the total poundage of yarn into 3,888 7/8 yards of finished woolen cloth, which was delivered to the partnership within this period. The partnership *401 at all times retained title to the yarn and woven cloth. The cost per yard of the wool cloth produced and delivered was $ 2.20.
On September 22, 1939, the partnership purchased through E. A. Pierce & Co., at Philadelphia, Pennsylvania, 100 open contracts for the delivery of 500,000 pounds of wool tops under March 1940 wool tops futures contracts. *137 Each of the contracts called for the delivery of 5,000 pounds of wool tops under its terms and in accordance with its provisions. The total cost of the 100 contracts was $ 589,955 (455,000 pounds at $ 1.18 per pound or $ 536,900 plus 45,000 pounds at $ 1.179 per pound or $ 53,055). At all times herein material the contracts were held in the name of E. A. Pierce & Co. The purchase of the contracts was made through the Wool Associates of the New York Cotton Exchange, Inc., by E. A. Pierce & Co. on the New York Wool Top Exchange. The partnership's commitment was margined at the rate of $ 250 per contract or $ 25,000 for the 100 contracts. E. A. Pierce & Co., in a letter to the partnership under date of September 22, 1939, confirmed the purchase of the contracts for the account of the partnership, as follows:
We hereby confirm our purchase today for your account, 91 contracts of March Wool at 118.0 and 9 contracts at 117.9, (covering invoices for which will be mailed to you from our New York office), together with our understanding that you will margin these commitments at the rate of $ 250.00 per contract. We are not permitted, under the Rules of the New York Cotton Exchange -- *138 on which these contracts were purchased -- to grant a credit extension; otherwise we would have been glad to have done so.
On the confirmation slips sent to the partnership by E. A. Pierce & Co. there was printed in small type the following:
It is understood that the within and all other transactions made for your account by us contemplate actual receipt and delivery of the property and payment therefor and that all property sold for your account is sold upon the representation that you have same in your possession actually or potentially. These transactions are made subject to the rules, regulations and customs of the Board or Exchange on which they are made and subject to any and all Federal and or State statutes to the extent that same may be applicable thereto. The right is reserved by us to close transactions without further notice when, in our judgment margins on deposit with us are below our requirements.
The 500,000 pounds of wool tops would produce approximately 375,000 yards of finished piece goods. Based on the processing costs incurred in the 1938 transaction, wool tops purchased at $ 1.18 per pound could be manufactured into piece goods at a cost of approximately $ *139 2.61 per yard.
On September 26, 1939, the partnership drew a check to the order of E. A. Pierce & Co. in the amount of $ 25,000 and the partnership's account with E. A. Pierce & Co. was credited with this amount. Additional deposit of margin was subsequently required, which totaled $ 78,500 up to and including November 10, 1939.
*402 The credit balance of the partnership appearing on the books of E. A. Pierce & Co. as of November 30, 1939, was in the amount of $ 103,500. On December 9, 1939, the margin was reduced by $ 28,500, resulting in a credit balance as of the close of the year of $ 75,000. During January 1940 the margin was increased to $ 102,000.
The wool tops futures contracts above described were sold by E. A. Pierce & Co. on the New York Wool Top Exchange at the order of the partnership, commencing February 2, 1940, and terminating on February 16, 1940. The total sales price of these 100 contracts was $ 497,205. Commissions paid for selling were $ 3,000, and at the conclusion of the sales the account of S. Makransky & Sons on the ledger of E. A. Pierce & Co. was debited with $ 95,750.
The above $ 95,750 debited to the partnership's commodity account on the ledger*140 of E. A. Pierce & Co. represents the total cost of the 100 contracts of $ 589,955, plus the commission of $ 3,000, less the total sales price of $ 497,205. The commodity account was never debited with the total cost of the 100 contracts, nor with the commission as such. Neither was it credited with the total sales price. It was simply debited with the net difference of these items as indicated above. After the account was debited with the above amount of $ 95,750 there remained a credit balance in favor of the partnership of $ 6,250, which represented the difference between the above mentioned margin of $ 102,000 and the debit of $ 95,750. On or about February 17, 1940, E. A. Pierce & Co. sent the partnership a check for $ 6,250, and the partnership's commodity account on the ledger of E. A. Pierce & Co. was debited with a like amount, which entry closed out this account on the books of E. A. Pierce & Co.
The books of the partnership reflected the transactions in a manner similar to that used on the books of E. A. Pierce & Co.
The partnership did not record separately on its books the cost of the 100 contracts, the commissions charged by E. A. Pierce & Co., or the total sales*141 price of the 100 contracts. On December 31, 1940, it merely charged the net result of these three items, namely, the above mentioned amount of $ 95,750, to "Woolens Purchases" and credited E. A. Pierce & Co. with a like amount, with the explanation: "Cost of hedgings to protect purchases of woolens."
Attached to the stipulation as exhibits are balance sheets of the partnership as of December 31, 1939, and December 31, 1940, and operating statements of the partnership for the calendar years 1939 and 1940. On the balance sheet as of December 31, 1939, appeared an asset called "Deposit Commodity Futures Contract" in the amount of $ 75,000, which was explained in a footnote to the balance sheet as follows: "This deposit has been made against the purchase of commodity *403 futures at prices which were above the market quotations on December 31, 1939."
Section 75 of chapter III of the bylaws and rules of the Wool Associates of the New York Cotton Exchange, Inc., in effect during the years 1939 and 1940, provided in part as follows:
All contracts for the future delivery of wool tops shall be in the following form:
Wool Associates of the New York Cotton Exchange, Inc.
WOOL TOP CONTRACT
*142 New York, N. Y. 19
Sold Deliver to
A. B. have this day Bought and agreed to Receive from C. D. 5,000 pounds of wool tops at the price of dollars and cents per pound for American find Top, Wool Top Exchange Standard, the seller having the option of delivering wool tops of other types or of inferior or superior quality at discounts and premiums, in accordance with the provisions of the By-Laws, Rules and Regulations of the Wool Associates of the New York Cotton Exchange, Inc. * * *
Either party may call for a margin, as the variations of the market or like deliveries may warrant, which margin shall be kept good.
This contract is made in view of and in all respects subject to the By-Laws, Rules and Regulations of the Wool Associates of the New York Cotton Exchange, Inc.
* * * *
Verbal contracts (which shall always be presumed to have been made in the approved form) shall have the same standing, force, and effect as written ones, if notice in writing of such contracts shall have been given by one of the parties thereto to the other during the day on which such contract is made.
It was stipulated at the hearing that by the term "Wool Top*143 Exchange Standard" referred to in the above mentioned uniform wool top contract "is meant an average American fine wool top conforming to grade 64s official United States standards for wool tops, made out of merino wools, oil combed, and containing a normal percentage of 3 percent of oil including natural fat, produced from wool grown in and shorn from living animals in the United States, cleaned, scoured, carded, and combed in accordance with the methods and usages prevailing in the industry, and of average length and color."
During the years 1939 and 1940, wool tops deliverable to the purchaser under the terms of the uniform wool tops contract were restricted to wools shorn from living animals in Australia, South Africa, Argentina, Uruguay, and the United States.
Under the terms of the uniform wool tops contract wool tops blended from wools grown in wool growing districts of the United States were tenderable, but no other blends were acceptable. In addition, wool tops *404 containing not more than 20 percent of pulled wools from the same country of origin and tops containing not more than 5 percent of scoured wools resulting from a previous mill scouring were tenderable under*144 the rules of the exchange.
The following wool tops were not tenderable or deliverable: (1) Tops having a mineral oil content, (2) tops combed in oil on French combs, (3) tops containing more than 1 1/2 percent of any waste or reworked wools originating from other sources than the lot in process, (4) tops containing more than 4 percent oil including natural fat, or (5) tops composed of carbonized or contaminated wools.
Attached to the stipulation as an exhibit is a compilation of instructions to wool top inspectors, as amended by the board of governors of the New York Wool Top Exchange on recommendation of the Wool Top Committee, to become effective on all contracts on and after February 1, 1937.
The partnership borrowed money on short term unsecured loans to meet its pay roll and pay for the cost of its material. During the years 1938 and 1939, the partnership had an aggregate line of credit with three banks in the amount of $ 900,000.
The senior member of the partnership was Harry Makransky. He was responsible for buying the piece goods for the firm and for laying out its manufacturing policies. He had been in the business of manufacturing men's clothing for about 43 years. The*145 comptroller and executive manager of the partnership was Milton Melnick. He was in charge of sales, the firm's accounting and records, the execution of its business policies, and the management of its office. He had been with the firm for over 23 years.
In the manufacture of its clothing the partnership used principally a 14 to 14 1/2 ounce worsted cloth.
During the years 1939 and 1940 the wholesale prices for the suits manufactured by the partnership ranged from $ 18 or $ 18.50 to $ 22.50. They were sold by retailers at prices between $ 35 to $ 40.
Over a period of years the partnership had established a regular clientele, including chain stores and other large concerns, which bought merchandise from it regularly each season. The partnership was an established source of supply for the large buyers, who relied on the firm to produce the goods which they required.
The war in Europe began on September 1, 1939. Following the outbreak of the war, the mills which manufactured piece goods and from which the partnership purchased the goods for their manufacturing needs withdrew all lines. No goods could be purchased.
Harry Makransky had been with the present firm, or one of its predecessors, *146 since prior to the first World War. The business at that time also manufactured from finished piece goods and during that *405 war he had had experience with the difficulties of obtaining the goods for manufacturing. The goods became very scarce, prices rose over 300 percent, and a poorer quality of merchandise was made.
Following the outbreak of the present war, the firm expected that its customers would continue to call upon it for their requirements and that these requirements might even increase. It was estimated that 500,000 yards of cloth a year would be required for the firm's manufacturing. In September 1939 the partnership had on hand and on order sufficient piece goods to provide the material needed to cover the firm's 1939 fall season and the 1940 spring season. With the withdrawal of all lines of piece goods in September 1939, the partnership found itself in a position where it could not make any purchases of additional cloth necessary for the continuance of the business.
Harry Makransky raised the problem with the other members of the firm and Melnick. He told them of the fact that the mills had withdrawn all lines and were not showing any goods for sale, and*147 discussed the bad situation in which this left the firm with respect to the future continuance of its manufacturing operations. He recalled the difficulties he had experienced during the first World War both in obtaining goods and in the prices which had to be paid. The current situation was even worse, since during the first World War goods could be purchased, but now none at all were available. He wanted to do something to solve the situation and to remove the uncertainties. Various discussions were held among the members of the firm to determine what could best be done. The members concluded that the best thing to do was to buy wool tops and manufacture it into cloth. The above mentioned purchase of the 100 contracts followed.
The plan was to take delivery of the tops in the spring of 1940. The manufacture of the partnership's 1940 fall line would normally begin during the preceding June. Based on the partnership's prior experience, delivery of the finished piece goods could be anticipated within 60 to 90 days after delivery of the wool tops.
The partnership consulted a number of persons experienced in the business to assure themselves that facilities would be available*148 for the spinning, weaving, and other processing of the tops into finished yarn. The partnership was assured that there would be no difficulty. It is not unusual for a manufacturer of men's clothing also to manufacture its own finished piece goods from wool tops through agents or contractors.
In their prior experience with the manufacture of their own piece goods, the partnership gave samples of cloth to the mills that make the cloth and instructed them to duplicate the patterns. The samples *406 are made up before the cloth is manufactured, being obtained from repeat numbers, mills, jobbers, and other sources. The same procedure was contemplated in the proposed new program. It was contemplated that the samples would also be furnished to the salesmen for use in March and April of 1940 when they normally would sell the fall 1940 line. It would not be necessary for the salesmen to wait for the finished goods.
On September 21, 1939, Melnick telephoned the Philadelphia office of E. A. Pierce & Co., wool brokers, to inquire as to the purchase of wool tops. He was connected with Hibbard W. Roberts, an account executive. Roberts went to the offices of the partnership and discussed*149 the matter with Harry Makransky and Melnick.
Melnick and Makransky explained their problem to Roberts and advised him of the partnership's decision to purchase wool tops to make their own worsteds to be manufactured into men's suits. They told him that their normal requirements were about 500,000 yards of cloth; that they wanted to buy 500,000 pounds of wool, which they estimated would produce about 375,000 yards of cloth, which they felt was a fair amount; and that they wanted the wool for delivery sometime in the spring, probably March. Roberts advised Melnick and Makransky of the procedure for purchasing the tops and the commissions involved; and that 500,000 pounds would require 100 contracts of 5,000 pounds each. In response to their inquiry, Roberts also informed Melnick and Makransky that the wool tops for March delivery were selling around $ 1.18 a pound.
Roberts was told that the partnership used a 14 to 14 1/2 ounce worsted cloth, and that it wanted wool to make into such goods. They discussed the type of wool that would be received, and Roberts assured them that there was never any difficulty along these lines. No question was raised at this conference as to the possibility*150 that South African Cape wool would be delivered on the contracts. Prior to that time Roberts had not experienced any difficulty in receiving deliveries of wool for such type of buyers.
If a holder of a wool contract received a type of wool which he could not use, he could retender it. The brokers would then get the type of wool he wanted and he would pay the difference in the premium. The broker sells the tops and rebuys what the contract holder can use. Melnick and Makransky were not acquainted with the details of this procedure, but they were assured and understood that there was no problem in getting a suitable wool.
Following the conference, Roberts discussed the order with his firm's research department in New York in view of the size of the order. They inquired about the type of wool the firm was using and *407 the amount of cloth it was using, and did not seem to think that 500,000 pounds was abnormal. Roberts was authorized to accept the order, if the Philadelphia office was satisfied that S. Makransky & Sons was the type of firm with whom they usually dealt. Roberts thereafter advised Melnick that the order was acceptable to his firm. He was instructed to make*151 the purchase, and the order was executed the next day.
Sometime after the contracts were purchased, widespread rumors developed that increased imports of Cape wool from South Africa were in prospect and that such wools would be tendered for delivery on the March 1940 contracts. Cape wool is a fast shrinking wool, used extensively in felts and velours. It is also used for women's wear, including hosiery, because of its fineness and softness. Used in the manufacture of a cloth for men's suits, the Cape wool would give the cloth a softer handle. It is not the type of cloth which large manufacturers of men's suits are acquainted with and find desirable. It was unsatisfactory for the type of clothing manufactured by the partnership.
Roberts had also learned of the rumors of increased imports of Cape wool in response to inquiries of his office as to why the future market on the exchange was selling down. He called Melnick because this was something that he never had any experience with and which would be vital to the Makransky firm. He did not know whether they would be able to use wool from South Africa, and he wanted to put the firm on its guard. He had told Makransky that they*152 would receive the type of wool that they wanted, but after the Cape situation arose he thought they might have difficulty in getting the type of wool Makransky wanted.
In addition to hearing the rumors that deliveries of Cape wool were in prospect, the partnership had also learned from cloth manufacturers that the South African wool was not suitable for the manufacture of the type of cloth which they used in the manufacture of their suits. This was a matter of common knowledge with the trade.
After receiving the call from Roberts, Melnick contacted Harry Makransky, who went to see Roberts. Roberts showed him the flash they had received stating that Cape wools might be received against the contracts, but told him that beyond this they were not informed on the matter. He informed Makransky that under this situation they might have difficulty in getting the type of wool they wanted.
Roberts arranged for Makransky to discuss the situation in New York with one Shlenker. Shlenker was in charge of commodities for E. A. Pierce & Co. In New York Makransky met with Shlenker and E. A. Beveridge, who was in charge of commodities' research for E. A. *408 Pierce & Co. Shlenker and Beveridge*153 confirmed to Makransky the rumors that there were prospects of Cape wools being delivered on the March contracts and that the contract permitted the seller to deliver such wools. Makransky stated that he could not use this type of wool in his business. Shlenker and Beveridge then took Makransky to the office of George H. Baston, in charge of the New York office of the Commodity Exchange Administration. Baston confirmed that the deliverer had the right to deliver tops from Cape wool if he so elected.
Following Makransky's visit to New York, he and the members of his firm and Melnick had a number of further discussions on the situation. Makransky made a further investigation to ascertain whether Cape wools could be used in their manufacturing. He visited a number of the firm's sources of supply, and was told they would not use Cape wools. There had been prior experimentations, and even a small amount would result in a shrinkage.
About the end of the year 1939, contrary to the situation feared in September, piece goods became more readily available, and the firm found that it could place purchases for cloth. During the month of January the market became better. The partnership*154 decided that, since the finished piece goods now could be obtained and Capes were not suitable for their type of worsteds, they would dispose of the March contracts. They concluded that in view of the situation which had developed this was the sound business thing to do.
The partnership purchased the 100 contracts for the future delivery of wool tops as a means of acquiring the wool tops and with the intention and purpose of taking delivery of the wool tops for manufacture into piece goods which they would use in their business of manufacturing men's suits.
The partnership in its return of income for the calendar year 1940 reported an ordinary net loss of $ 87,808.68, which in schedule J it apportioned among its members as follows:
| Dorothy Makransky | $ 17,561.73 |
| Edward Makransky | 17,561.74 |
| Louis Makransky | 17,561.74 |
| Harry Makransky | 17,561.74 |
| Sadye Makransky | 17,561.73 |
The loss of $ 87,808.68 was due principally to the fact that the partnership in arriving at its cost of goods sold included the above mentioned loss of $ 95,750 on sale of the 100 contracts as a part of its "Merchandise bought for sale" reported on its return in the amount of $ 1,318,319.10.
*409 The partnership*155 in its return of income for the calendar year 1941 reported an ordinary net income of $ 5,633.28, which in schedule J it apportioned among its members as follows:
| Dorothy Makransky | $ 1,126.65 |
| Edward Makransky | 1,126.66 |
| Louis Makransky | 1,126.66 |
| Harry Makransky | 1,126.66 |
| Sadye Makransky | 1,126.65 |
In arriving at the above net income of $ 5,633.28 the partnership claimed as a deduction from gross income, among other items, an amount of $ 87,808.68 labeled "Net Loss Carry-over from 1940," which the respondent disallowed in determining the deficiencies herein.
The loss incurred in connection with the purchase and disposition of 1940 March wool tops futures contracts did not constitute on ordinary and necessary expense of the business of the partnership. The loss incurred in connection with the purchase and disposition of the 1940 March wool tops futures contracts did not constitute additional cost of the inventory of the partnership, nor was the loss incurred upon the sale of property which would properly have been included in the inventory of the partnership if on hand at the close of the taxable year.
The purchase of 100 March 1940 wool tops futures contracts by the partnership*156 did not constitute a hedge by the partnership.
The loss of $ 95,750 sustained by the partnership during the taxable year 1940 on the sale of the 100 wool tops futures contracts represented a loss upon the sale of a capital asset held for not more than 6 months.
OPINION.
Petitioners primarily contend that, under sections 23 (s), 122, and 189 of the Internal Revenue Code, they are entitled to carry over the 1940 loss of the partnership of $ 87,808.68 as a "net operating loss carry-over" in computing their individual tax liabilities for the calendar year 1941. Subsection (s) and sections 122 and 189 were all inserted in the code by section 211 of the Revenue Act of 1939. Section 122 was later amended by section 153 of the Revenue Act of 1942. As thus explained, the material provisions of these sections are set forth in the margin. 1
*157 *410 The respondent contends that the loss of $ 95,750 on the sale of the 100 futures contracts sustained by the partnership in 1940 was a "short-term capital loss" as that term is defined in code section 117. If that be true, and since the partnership had no "short-term capital gains" during the calendar year 1940, there would be no net operating loss under 122 (a), no net operating loss carry-over under 122 (b), and no net operating loss deductions under 122 (c), for the reason that under the exceptions and limitations provided in 122 (d) "the amount deductible on account of short-term capital losses shall not exceed the amount includible on account of the short-term capital gains" and, therefore, instead of the deductions exceeding the gross income of the partnership for 1940 under section 122 (a) by $ 87,808.68, the gross income would exceed the deductions by $ 7,941.32. Petitioners, however, contend that the loss of $ 95,750 was not a short term capital loss, but was an ordinary business loss, or, in the alternative, an ordinary and necessary business expense deductible under code section 23 (a), as amended by section 121 of the Revenue Act of 1942, or as additional cost*158 of goods actually taken into inventory during the pear 1940. The material provisions of code sections 117 and 23 (a), as amended, are also in the margin. 2
*159 *411 Was the loss of $ 95,750 on the sale of the 100 futures contracts a short term capital loss? The answer depends upon whether such contracts were or were not "capital assets" as that term is defined in code section 117. Under this definition the term "means property held by the taxpayer" with certain specified exceptions. These exceptions are (1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or (2) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or (3) property used in the trade or business of a character which is subject to the statutory allowance for depreciation.
Petitioners contend that the contracts fall within the first exception as representing property of a kind which would properly be included in the inventory of the partnership if on hand at the close of the year. They argue that if, as originally intended, the partnership had taken delivery of the wool tops, and the wool tops had been on hand at the close of the year, there would be no question as to the inclusion in the inventory*160 of the wool tops. Because of changed conditions, namely, the influx of Cape wools, and the availability again of piece goods, the partnership decided not to take delivery of the wool tops, but to dispose of the futures contracts instead. Petitioners further argue that it is difficult to see a legal or practical justification for drawing a distinction between the tax treatment to be given losses realized on the disposition of materials physically taken into inventory and losses realized where futures contracts are disposed of before actual receipt of the commodities specified in the contracts due to a change in conditions over which the partnership had no control.
In Anna M. Harkness, 1 B. T. A. 127, 130, this statement appears:
It seems to us to be fundamentally unsound to determine income tax liability by what might have taken place rather than by what actually occurred. Even though the practical effect may be the same in either case, the resulting tax liability may be quite different. United States v. Isham, 17 Wall. 496">17 Wall. 496.
In the instant proceedings what actually occurred was a purchase and sale of futures contracts. *161 It is well settled that such contracts *412 are not to be included in the inventory. See sec. 19.22 (c)-1, Regulations 103; A. R. R. 100, C. B. No. 3, p. 66; A. R. M. 135, C. B. No. 5, p. 67; Commissioner v. Covington, 120 Fed. (2d) 768, 771; certiorari denied, 315 U.S. 822">315 U.S. 822; TennesseeEgg Co., 47 B. T. A. 558. In fact the partnership did not include the contracts in its inventory at the close of the year 1939 and it would have been improper to have done so. The only account it had on its books at that time relative to the contracts in question was the account with E. A. Pierce & Co. showing a debit balance of $ 75,000 for the margins that were up at that time. Neither were the futures contracts stock in trade nor property held primarily for sale to customers in the ordinary course of the partnership's trade or business. Commissioner v. Covington, supra.It is obvious that the contracts were not property of a character which is subject to the statutory allowance for depreciation, and we do not understand petitioners to so contend. The contracts *162 were held by the partnership for less than 18 months. It follows, therefore, that the loss of $ 95,750 was a short term capital loss, unless it resulted from a true hedge as that term is commonly and usually understood. That brings us to petitioners' alternative contention that the loss was an ordinary and necessary business expense, because it was incurred in hedging operations.
It has long been the practice of the Commissioner and the courts to treat losses from hedging transactions as essentially insurance and deductible as ordinary and necessary business expense rather than losses from dealings in capital assets. See G. C. M. 17322, C. B. No. XV-2, p. 151; Ben Grote, 41 B. T. A. 247; Commissioner v. Farmers & Ginners Cotton Oil Co., 120 Fed. (2d) 772; Kenneth S. Battelle, 47 B. T. A. 117. "Losses from true hedges are allowed in full." Commissioner v. Farmers & Ginners Cotton Oil Co., supra.In that case the Fifth Circuit also said:
A hedge is a form of price insurance; it is resorted to by business men to avoid the risk of changes in the market *163 price of a commodity. The basic principle of hedging is the maintenance of an even or balanced market position. To exercise a choice of risks, to sell one commodity and buy another, is not a hedge; it is merely continuing the risk in a different form. * * *
In G. C. M. 17322, supra, relating to the treatment of hedging transactions for Federal income tax purposes, after describing the hedging customs of a certain cotton textile manufacturer, it is said:
Such hedges, which eliminate speculative risks due to fluctuations in the market price of cotton and thereby tend to assure ordinary operating profits, are common trade practices and are generally regarded as a form of insurance (the only kind available as protection against such risks) necessary to conservative business operation. Where futures contracts are entered into only to insure against the above-mentioned risks inherent in the taxpayer's business, *413 the hedging operations should be recognized as a legitimate form of business insurance. As such, the cost thereof (which includes losses sustained therein) is an ordinary and necessary expense deductible under section 23 (a) of the Revenue*164 Act of 1934 and corresponding provisions of prior Revenue Acts. * * *
Petitioners contend that the partnership's situation relative to the futures contracts was similar to the situation relative to the "futures transactions (short) in cotton during 1936" in Kenneth S. Battelle, supra. We fail to see any similarity between the two situations. It is true that on its books of account the partnership on December 31, 1940, charged the loss of $ 95,750 to "Woolens Purchases" and credited E. A. Pierce & Co. with a like amount, with the explanation: "Cost of hedgings to protect purchases of woolens."
Petitioner was and is a manufacturer of men's suits from piece goods purchased from worsted mills. The partnership sold its finished products to retailers who were contracted seasonably by its various salesmen. There is no evidence that petitioner used a method of hedging against present sales of its clothing suits by the purchase of future wool tops contracts. On the contrary, the evidence seems to show conclusively that the purchase of the 100 wool tops contracts in September 1939, which it disposed of in February 1940, was not a balancing transaction *165 against sales of clothing, but was an isolated transaction and one made because of the more or less panicky condition which arose after the outbreak of the war in September 1939 respecting the future supply of woolen piece goods. The transaction turned out badly for petitioner and the loss which it suffered could be carried over as an ordinary business net loss and used as a deduction in the next taxable year were it not for the provisions of the the statute which we have quoted in the margin. In view, however, of the statutory definition of capital assets, we feel we must hold that the wool tops contracts were capital assets and that the partnership's transactions in these contracts did not represent hedging transactions as that term is ordinarily understood, and petitioners' loss in the transactions must be adjudged a short term capital loss. Commissioner v. Farmers & Ginners Cotton Oil Co., supra.Certainly, in the latter case, the transactions of the taxpayer more nearly resembled a true hedge than those of the instant case, yet the court held against the taxpayer.
It follows from what we have said that the respondent's several determinations*166 in these consolidated proceedings must be sustained and that petitioners are not entitled to deduct from their 1941 income any net operating loss carry-over on account of the partnership's wool tops futures contracts.
Decisions will be entered for the respondent.
*414 Smith, J., dissenting: The partnership of S. Makransky & Sons, Inc., had a loss in 1940 from the sale of certain contracts for the purchase of wool tops for delivery at a future date. It apprehended, due to war conditions, that it would be unable to secure woolen cloth for its requirements for the manufacture of men's suits. To insure itself a supply of such cloth it purchased the contracts in question. Early in 1940 it was apparent that the apprehended scarcity would not materialize; also that the wool tops which might be delivered to it under its contracts would be of an inferior grade. This being so, it sold its future contracts in February 1940, sustaining a loss upon the transaction of $ 95,750. The opinion of the Tax Court is that the loss is not a legal deduction from gross income upon the ground that it was a short term capital loss and that, since the partnership had no short term*167 capital gains, the deduction of the loss must be disallowed.
It seems to me that the result is unjustified. It certainly should not be reached unless the wording of the statute requires it. Clearly, the investment in the wool tops futures was an ordinary business operation. At the time the contracts were purchased the partnership expected to take delivery of the wool tops. It was simply insuring itself against an apprehended scarcity of material. If the partnership had taken delivery under its contracts and then sold the woolen tops there would be no question, I think, but that the loss which might have been sustained would have been a legal deduction from gross income.
The situation is comparable to that of a corporation which contracts for the purchase of automobile trucks or other machinery to be delivered in the future. Before the time for delivery the corporation finds that it can purchase its requirements of trucks and machinery from another source possibly more advantageously. It therefore gives a certain amount for the rescission of its contract or sells its right for the delivery of the machinery to other parties at a loss. It would seem to me that in such a situation*168 the claimed deduction would be an ordinary and necessary business expense. Every consideration of justice and fair play as between the taxing authority and the taxpayer argues for the allowance of the deduction. It seems to me that it is highly hypertechnical to disallow the deduction as an ordinary and necessary expense.
The Tax Court rejects the petitioners' claim that the amount is deductible as an ordinary and necessary expense. It then says that the amount can not be deducted at all because it was a short term capital loss against which the petitioners had no short term capital gains for the year 1940. It says that the loss did not arise from a hedging transaction and that therefore the loss may not be deducted, *415 in accordance with Commissioner v. Farmers & Ginners Cotton Oil Co., 120 Fed. (2d) 772; certiorari denied, 314 U.S. 683">314 U.S. 683. In that case it was held that where a dealer in cottonseed oil bought refined oil futures because it had insufficient storage facilities for crude oil and had been compelled to sell crude oil at unsatisfactory prices, it merely exchanged its market risk from crude to refined*169 oil, and losses were not deductible in their entirety in computing income tax, since they did not result from true "hedges," notwithstanding price relation between crude and refined oil. The court found:
* * * Petitioner could have demanded delivery of refined oil under any futures contract, but made no such demand, and the contracts were entered into by it with the intention not to demand or receive such delivery. * * *
The facts in that case were somewhat different from those which obtain in the instant proceeding; for here the partnership did intend to take delivery upon the wool tops at the time it purchased the futures contracts.
In the above referred to case the Tax Court decided that the taxpayer was entitled to deduct its loss. 41 B. T. A. 1083. Our decision in that case was reversed by a divided court. The Supreme Court denied a writ of certiorari. But the Supreme Court has many times said that the denial of a writ of certiorari is not tantamount to the affirmance of the decision of the lower court.
It may at once be admitted that an ordinary hedging transaction is one where a person attempts to hedge against a loss by the purchase or sale of*170 a future contract on a stock exchange or a commodity exchange. But I do not think that a hedging contract should be limited to that definition. The partnership with which we are here concerned attempted to hedge against a loss in business operations for 1940 by securing for itself a supply of wool tops from which it could have cloth for the manufacture of men's suits. That seems to me to be as much a hedging contract as one where the contract is simply to protect one's self against a fluctuation in price. It seems to me that it was in essence a hedging contract.
Furthermore, I do not think that the definition of capital gains was ever intended to apply to a contract of this character. To be sure, the partnership when it purchased the future contracts in 1939 had a species of property. It had an investment in the contracts and, undoubtedly, at some time after the purchase it could have sold those contracts to recover back at least a part of the amount it had invested in them.
The situation here seems to me to be comparable to that which obtained in Palmer v. Commissioner, 302 U.S. 63">302 U.S. 63. In that case the taxpayer had received warrants from the *171 American Superpower Co. entitling him to purchase from it shares of stock in other corporations. *416 which it owned. The rights had a large market value at the time they were received by Palmer. He exercised the rights and acquired the shares. The Commissioner determined that Palmer received taxable income by the receipt of the warrants to the extent of their value. The Board of Tax Appeals reversed his determination and that reversal was sustained by the Supreme Court. That Court simply gave a sensible construction to the statute and held that Palmer did not derive taxable income merely from the receipt of the warrants.
So here, I think that we should give a sensible construction to the statute and hold that the net income of the partnership for 1940 was what remained after the deduction of the loss sustained on the sale of the future contracts for the purchase of the wool tops.
Leech, J., dissenting: In general I agree with the foregoing dissent. Since some of my reasons for dissenting may be different, it may be well to state them.
The propriety of the disputed "net operating loss carry-over" turns on the deductibility of a very real loss petitioners sustained in*172 the transaction in wool "futures." Sec. 122, I. R. C. This loss, if deductible at all, must be so as a "hedge" and therefore a business expense, or as an ordinary loss. The majority holds it is neither. I disagree.
Futures transactions, in order to be clasified as a true "hedge," need not occur in any particular step of the business cycle in which the taxpayer is engaged. The term means a form of insurance of the profits of a business. So, if the "futures" were purchased by the partnership to insure the profitable conduct of any step in its business, they were a true "hedge." See Commissioner v. Farmers & Ginners Cotton Oil Co., 120 Fed. (2d) 772; certiorari denied, 314 U.S. 683">314 U.S. 683.
The majority opinion is premised upon, inter alia, the following finding of fact:
The partnership purchased the 100 contracts for the future delivery of wool tops as a means of acquiring the wool tops and with the intention and purpose of taking delivery of the wool tops for manufacture into piece goods which they would use in their business of manufacturing men's suits.
This finding affords substantial, if not incontrovertible, proof*173 of the fact that the purchase of the "futures" here was not in reality a purchase of "futures contracts" at all, but rather the first step in the actual and intended purchase of the wool itself for future delivery. If so, this wool would have been excluded from "capital assets" by the first exception in the definition of that term appearing in section 117 (a) (1) of the Internal Revenue Code, and its sale would have resulted in an ordinary and not a capital loss.
*417 In my opinion, the transaction in "futures" here was either a true "hedge" or resulted in an ordinary loss. In either event the amount of this actual loss was deductible in the computation of the "net loss carry-over." The case of H. Elkan & Co., 2 T.C. 597">2 T. C. 597, if not distinguishable on the facts, I think should be overruled.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(s) Net Operating Loss Deduction. -- For any taxable year beginning after December 31, 1939, the net operating loss deduction computed under section 122.
SEC. 122. NET OPERATING LOSS DEDUCTION.
(a) Definition of Net Operating Loss. -- As used in this section, the term "net operating loss" means the excess of the deductions allowed by this chapter over the gross income, with the exceptions and limitations provided in subsection (d).
(b) Amount of Carry-Back and Carry-Over. --
(1) Net operating loss carry-back. -- If for any taxable year beginning after December 31, 1941, * * *
(2) Net operating loss carry-over. -- If for any taxable year the taxpayer has a net operating loss, such net operating loss shall be a net operating loss carry-over for each of the two succeeding taxable years, except that the carry-over in the case of the second succeeding taxable year shall be * * *
(c) Amount of Net Operating Loss Deduction. -- The amount of the net operating loss deduction shall be the aggregate of the net operating loss carry-overs and of the net operating loss carry-backs to the taxable year reduced by the amount, if any, by which the net income (computed with the exceptions and limitations provided in subsection (d) (1), (2), (3), and (4)) exceeds, in the case of a taxpayer other than a corporation, the net income (computed without such deduction), or, in the case of a corporation * * *
(d) Exceptions and Limitations. -- The exceptions and limitations referred to in subsections (a), (b), and (c) shall be as follows:
* * * *
(4) Long-term capital gains and long-term capital losses shall be taken into account without regard to the provisions of section 117 (b). As so computed the amount deductible on account of long-term capital losses shall not exceed the amount includible on account of the long-term capital gains, and the amount deductible on account of short-term capital losses shall not exceed the amount includible on account of the short-term capital gains: * * *
SEC. 189. NET OPERATING LOSSES.
The benefit of the deduction for net operating losses allowed by section 23 (s)↩ shall not be allowed to a partnership but shall be allowed to the members of the partnership under regulations prescribed by the Commissioner with the approval of the Secretary.
2. SEC. 117. CAPITAL GAINS AND LOSSES.
(a) Definitions. -- As used in this chapter --
(1) Capital Assets. -- The term "capital assets" means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (l);
* * * *
(3) Short-term capital loss. -- The term "short-term capital loss" means loss from the sale or exchange of a capital asset held for not more than 18 months, if and to the extent such loss is taken into account in computing net income.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) Trade or business expenses. --
(A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *↩