1949 U.S. Tax Ct. LEXIS 182">*182 Decisions will be entered under Rule 50.
Profit derived from the sale by a partnership of certain securities, held, capital gain, since the securities sold did not fall within the exceptions of section 117 (a) (1), I. R. C.
12 T.C. 900">*900 The Commissioner determined deficiencies in income tax for the year 1944 in the amount of $ 3,308.99 in Docket No. 18053 and $ 3,251.92 in Docket No. 18064.
The only question in controversy is whether profits realized from the sale in 1944 of certain securities are taxable as ordinary income, as contended by respondent, or as long term capital gains, as contended by petitioners.
FINDINGS OF FACT.
The petitioners filed their individual income1949 U.S. Tax Ct. LEXIS 182">*183 tax returns for 1944 with the collector of internal revenue for the second district of New York.
The petitioners are equal partners, doing business under the name of Van Tuyl & Abbe in New York City. The partnership was formed in 1937, succeeding the firm of Burnett & Van Tuyl.
During the years 1942, 1943, and 1944 the business of the partnership consisted of the purchasing and selling of securities for retail customers and also the purchasing and selling of securities primarily for the profit to be derived from selling for a price in excess of cost.
Van Tuyl handled the retail customers' accounts and the general office detail work. Most of the retail customers were individuals of modest means. Abbe was in charge of the trading department. 12 T.C. 900">*901 Neither partner, nor any employee of the partnership, was a member of the New York Stock Exchange.
Van Tuyl & Abbe bought many securities listed on the New York Stock Exchange for the accounts of its retail customers. It also bought and sold defaulted railroad securities. It was endeavoring to specialize in Georgia Carolina & Northern Railroad Co. first mortgage bonds 6's of 1934. It was trading throughout the country and received1949 U.S. Tax Ct. LEXIS 182">*184 many inquiries as to such bonds from dealers and investment houses interested in buying and selling the same.
Interest on such bonds had not been paid since about 1931 and the principal was not paid on maturity thereof in 1934. In 1942 the railroad company was in the process of reorganization. The bonds had been deposited and negotiable certificates of deposit issued in lieu thereof. Van Tuyl & Abbe made numerous purchases and sales from time to time during 1942, 1943, and 1944 of both such certificates of deposit and bonds, all of which transactions were had with investment houses, brokers, and/or dealers, with one exception, viz., a purchase on the open market sometime prior to October 1942 of Georgia Carolina & Northern bonds of the par value of $ 2,000 for the account of a retail customer. It was not the practice of Van Tuyl & Abbe to recommend the purchase of defaulted railroad bonds to its retail customers.
All purchases and sales of securities were recorded from day to day in a so-called trading ledger, with the exception of transactions in which Van Tuyl & Abbe acted only as broker. The transactions in Georgia Carolina & Northern certificates of deposit were entered on1949 U.S. Tax Ct. LEXIS 182">*185 trading ledger sheets captioned "Georgia Carolina Northern 6-34 CD." The transactions in bonds were entered on trading ledger sheets captioned "Georgia Carolina & Northern 6-34 Bonds." These were designated as "regular" trading accounts.
When an order came in for Georgia Carolina & Northern bonds from a dealer or investment house, Abbe determined whether to fill the order from bonds on hand, if any, or to purchase in the open market at a lower price. Whatever course would be deemed most advantageous to the partnership was taken.
Van Tuyl & Abbe believed that the Georgia Carolina & Northern bonds would gradually advance in price and that, in order to realize a substantial profit, the bonds would have to be held for a long period of time. The partners determined to speculate for their own account and risk in such bonds and other defaulted railroad bonds and consulted their accountant as to the method of handling such transactions on the books of account. Thereafter the following transactions were made:
12 T.C. 900">*902 In October 1942, 14 purchases of Georgia Carolina & Northern certificates of deposit, aggregating $ 57,000 par value, were made and recorded in the regular trading account, 1949 U.S. Tax Ct. LEXIS 182">*186 including the following:
| Date | Purchased from -- | Par value |
| Oct. 14 | Baker Watts & Co | $ 20,000 |
| 15 | Stein Bros. & Boyce | 10,000 |
| 19 | Baker Watts & Co | 4,000 |
| 22 | Mackubin Legg & Co | 1,000 |
| Total | 35,000 |
Under date of October 20, 1942, Van Tuyl & Abbe wrote a letter to the Chase National Bank of New York, New York, as follows:
We would appreciate your seggregating [sic] the following securities in our Special Account and advising us of the numbers of the certificates so separated:
| $ 35,000 | Georgia, Carolina & Northern Railroad Company First Mortgage |
| 6s 1934 Certificates of Deposit | |
| [Other securities designated omitted.] |
We wish to keep the above bonds frozen in our loan after you have given us the numbers of the certificates, and not delivered out of our account until further advice from us.
* * * *
The partnership received in reply a letter from Chase National Bank dated October 26, 1942, as follows:
In accordance with the instructions contained in your letter of October 20th, we have seggregated [sic] the following described bonds and are furnishing you with the numbers as follows:
| $ 35,000. | Georgia, Carolina & Northern Railroad Company 1st Mortgage 6s |
| 1934 Certificates of Deposit Nos. 5271/89, 5266/69 n/o Baker, Watts | |
| & Co., 5317, n/o Lockwood Peck & Co., 5297/305, 4068 n/o Stein | |
| Bros. & Boyce, 5306 n/o Mackubin Legg & Co. | |
| [Other securities designated omitted.] |
1949 U.S. Tax Ct. LEXIS 182">*187 We have noted that you do not wish the bonds to be delivered out of your account until further notice.
* * * *
The segregation of the securities was made by the bank as follows: The $ 35,000 par value certificates of deposit referred to in the above letter were folded in a piece of paper and fastened together with a tape, thus flagging them as frozen securities. The customary notation was also made on the loan card so that the security clerk would not use such securities. They were not otherwise segregated from the remaining securities held as collateral, which were called free bonds.
As of October 30, 1942, an entry was made in the regular trading account transferring $ 35,000 par value Georgia Carolina & Northern certificates of deposit to a special account set up on a trading ledger sheet for the purpose of carrying the frozen securities. The special account was not considered a part of the regular trading ledger and 12 T.C. 900">*903 had its own separate control account designated "Trading Account -- Special" in the general ledger.
On closing and balancing the regular trading account for the month of October 1942, it was discovered that, due to a mathematical error, the account was1949 U.S. Tax Ct. LEXIS 182">*188 short or oversold $ 10,000 par value Georgia Carolina & Northern certificates of deposit. In order to cover the shortage, by letter dated November 13, 1942, Chase National Bank was requested to release for delivery $ 10,000 Georgia Carolina & Northern certificates of deposit Nos. 5297/305, 4068 n/o Stein Bros. & Boyce. The designated certificates of deposit were released by the bank on the same date.
During November 1942 Van Tuyl & Abbe made eight purchases of Georgia Carolina & Northern bonds of the aggregate par value of $ 17,000. To reinstate the frozen account to its original position, Van Tuyl & Abbe, under date of November 21, 1942, wrote the Chase National Bank, requesting it to freeze "in our account $ 10,000 Georgia Carolina & Northern Railway Company First 6s 1934 Actuals and advising us the numbers of the bonds by return mail." Pursuant to such instructions, the following bonds were frozen by the bank:
| Received from -- | Bond Nos. | Par value |
| Carter H. Harrison & Co. on Nov. 12, 1942 | 4480, 4448, 4556 | $ 3,000 |
| W. E. Hutton & Co., included in a delivery of | ||
| $ 5,000 on Nov. 13, 1942 | 2597, 2606 | 2,000 |
| W. E. Hutton & Co., on Nov. 18, 1942 | 3574, 1684 | 2,000 |
| Carter H. Harrison & Co., included in a delivery | ||
| of $ 2,000 on Nov. 20, 1942 | 4901 | 1,000 |
| W. E. Hutton & Co., on a delivery of $ 5,000 on | ||
| Nov. 25, 1942 | 453, 1283 | 2,000 |
| Total | 10,000 |
1949 U.S. Tax Ct. LEXIS 182">*189 On or about August 3, 1943, Van Tuyl & Abbe sold $ 5,000 par value of the frozen bonds. Pursuant to written instructions dated August 12, 1943, of Van Tuyl & Abbe, the Chase National Bank released bonds numbered 453, 1283, 4901, 3574, and 1684. An entry was made in the special account covering frozen securities showing the sale of such bonds. The profit realized on such sale was reported for income tax purposes as a long term capital gain in 1943. No adjustment thereof was made by the respondent.
Pursuant to instructions of Van Tuyl & Abbe, the Chase National Bank effected the exchange of the $ 25,000 par value certificates of deposit frozen by it for the actual underlying bonds which had been deposited at the time reorganization was initiated. Each certificate of deposit called for certain specific numbered bonds, which were received by the bank and held by it as frozen securities.
On or about March 18, 1943, Van Tuyl & Abbe purchased from a dealer four Georgia Carolina & Northern bonds on which several interest coupons were missing. For that reason they were purchased at 35, although the bonds were selling at that time at about 40. These bonds, numbered 1403, 4538, 1492, 1949 U.S. Tax Ct. LEXIS 182">*190 and 4565, were kept in the safety 12 T.C. 900">*904 deposit box of the partnership until the coupon shortage was corrected. Thereafter on August 30, 1943, these bonds were also deposited with the Chase National Bank, to be held by it as frozen securities. The bank continued to hold the $ 34,000 par value of Georgia Carolina & Northern bonds, segregated as above described, until February 1944, during which month the bonds were sold by Van Tuyl & Abbe to security dealers or investment houses. Upon written instructions of Van Tuyl & Abbe, the bank released the bonds for delivery to the purchasers.
In the partnership and individual returns of the petitioners for 1944, the amount of $ 10,970 was reported as the gain realized on the sale of such bonds. It was treated as a long term capital gain in computing taxable income.
From time to time between February 1942 and April 10, 1944, Van Tuyl & Abbe and Stroud & Co., of Philadelphia, participated in certain security transactions, it having been agreed that any profit or loss resulting therefrom would be divided equally between the two firms. The securities were carried in a joint trading account and were held physically by Stroud & Co. Between1949 U.S. Tax Ct. LEXIS 182">*191 February 24 and April 6, 1944, $ 27,000 par value of Carolina Central Railroad Co. 4's of 1949, which had been carried in the joint account and held for more than six months, were sold at a profit of $ 12,668.88. As its share of the profit, Van Tuyl & Abbe received $ 6,334.44 on or about April 10, 1944. This sum was reported in the partnership and individual returns of petitioners for 1944 and treated as a long term capital gain in computing taxable income.
The partnership return does not disclose the use of inventories in computing gross profit from business, i. e., the cost of goods sold was not computed by the inventory method on the return. The space provided for such computation was left blank. To question 5, "State whether inventories at the beginning and end of the taxable year were valued at (a) cost, or (b) cost or market whichever is lower," the answer given was "Securities unsold -- at cost."
In determining the tax liability of the petitioners, the respondent treated the above profits of $ 10,970 and $ 6,334.44, or a total of $ 17,304.44, as ordinary income.
OPINION.
The gain of $ 10,970 and $ 6,334.44 realized by petitioners as partners on the sale in 1944 of $ 34,0001949 U.S. Tax Ct. LEXIS 182">*192 par value bonds of Georgia Carolina & Northern Railroad and $ 27,000 par value bonds of Carolina Central Railroad, respectively, was treated by them for income tax purposes as a long term capital gain. The respondent, in recomputing their tax liability, treated such gain as ordinary 12 T.C. 900">*905 income. The only question to be determined is whether the securities sold by petitioners during the taxable years were capital assets, as defined in section 117 (a) (1) of the Internal Revenue Code. 1
1949 U.S. Tax Ct. LEXIS 182">*193 There is no dispute about the amount of gain realized or the term of holding.
It is the position of the respondent that "the desire on the part of a dealer to switch from inventory to investment, even though certain formalities are observed for the purpose of identifying specific securities and segregating them, where the disposition and sales of the said securities are transacted in the same manner as in the case of its other dealer securities, cannot convert an inventory item into an investment item."
It is established that a taxpayer may be a dealer as to some securities and he may also hold similar or other securities on his own account for purposes other than for resale to customers. As to the latter, he is not a dealer, he is not entitled to compute income on the inventory method, and securities so purchased are properly recognizable as capital assets within the meaning of section 117 (a) (1). Schafer v. Helvering, 299 U.S. 171">299 U.S. 171; Vaughan v. Commissioner (CCA-2), 85 Fed. (2d) 497; certiorari denied, 299 U.S. 606">299 U.S. 606; Hammitt v. Commissioner (CCA-3), 79 Fed. (2d) 494;1949 U.S. Tax Ct. LEXIS 182">*194 Francis Shelton Farr, 44 B. T. A. 683; R. O. Holton & Co., 44 B. T. A. 202; and I. T. 3891, C. B. 1948-1, p. 69, which reads as follows:
Where securities are acquired and held by a dealer in securities solely for investment purposes, such securities will be recognized as capital assets, as defined in section 117 (a) (1) of the Internal Revenue Code, even though such securities are of the same type or of a similar nature as those ordinarily sold to the dealer's customers.
The respondent concedes that a merchant who inventories his wares can acquire a commodity or property for investment, but he argues he can not take merchandise which he has consistently treated as part of his dealer category for tax purposes and by an arrangement, however meticulous, treat it as an investment, perhaps temporarily, while at the same time merchandising it just as he does the same stock in his business, and that a mere desire or intention to switch from inventory to investment is not sufficient to meet the definition of capital assets contained in the statute, citing Vance Lauderdale, 9 T.C. 751. Such argument1949 U.S. Tax Ct. LEXIS 182">*195 is not based on the facts as disclosed by the evidence.
12 T.C. 900">*906 Both petitioners testified that the securities involved were purchased for the firm's own account and risk and held solely in expectation of a rise in the market. The first $ 35,000 par value certificates of deposit purchased in October 1942 were entered in the regular trading ledger, but at the end of the month were taken out of that ledger by an entry transferring them to a special account. Later purchases for the same purpose were treated in the same way. The securities involved were identified by number, fastened together, and earmarked to be held intact. That the securities were not placed in another receptacle is not important. They were clearly separated and distinguishable from the so-called free securities, which, although also held as collateral, apparently were a part of the securities traded in from day to day.
It is true that $ 10,000 par value of the certificates of deposit frozen in October 1942 were released in the month following. However, this was done to correct an oversold position discovered at the end of October resulting from a mathematical error made in that month in the trading ledger. 1949 U.S. Tax Ct. LEXIS 182">*196 It is also true that numerous sales were made, but these sales were made from other free securities on hand or purchased during 1942, 1943, and 1944. Only two sales were made of the GeorgiaCarolina & Northern bonds frozen by the bank: One a sale of $ 5,000 par value in 1943, and the other the sale herein involved of $ 34,000 par value in 1944. Both were treated as long term capital sales.
Under certain circumstances brokers may be "customers." Estate of Harry E. R. Hall, 29 B. T. A. 1255; affirmed in Commissioner v. Stevens (CCA-2), 78 Fed. (2d) 713, in which case, according to the uncontradicted evidence, the partnership purchased securities not for the purpose of speculation or investment, but solely to resell to customers at a profit. However, "a taxpayer who trades for his own account does not sell to 'customers.'" O. L. Burnett, 40 B. T. A. 605; affirmed on this point (CCA-5), 118 Fed. (2d) 659, wherein it was held that taxpayer, "being a trader in securities and commodities for her own account, as distinguished from a 'dealer' in securities and commodities, 1949 U.S. Tax Ct. LEXIS 182">*197 was not entitled to use inventories in determining her net income." It was further held that such stock and commodities purchased and sold by her through brokers for her own account did not constitute property held by her primarily for sale to customers in the ordinary course of her trade or business. The application by the Commissioner of the $ 2,000 limitation on capital losses provided by section 117 (d) of the Revenue Act of 1934 in determining her tax liability was approved.
The case of Vance Lauderdale, supra, cited by respondent, is distinguishable and therefore not applicable here. In that case the two taxpayers formed a partnership in 1939 to engage in the general 12 T.C. 900">*907 business of specialists on the New York Stock Exchange. In June 1942 an employee was taken into the partnership solely for the purpose of acting as alternate on the Stock Exchange while one of the original partners was in military service. As of June 30, 1942, securities which the 1939 partnership had held as its stock in trade and inventories were held by the stock exchange house through which the old and new partnership cleared their transactions in an account labeled1949 U.S. Tax Ct. LEXIS 182">*198 "old accounts," which referred to the old partnership. All but 3,100 of the 20,140 shares held in the "old accounts," together with later purchases of 1,800 shares, were sold prior to December 31, 1943. The 1939 partnership filed a partnership return for 1942, which stated the business of the partnership to be "dealers in securities," reflected the income of the old and new partnerships for that year, and showed an inventory at the end of the year of $ 129,695.26. For 1943 two partnership returns were filed, both showing the formation of the partnership as of 1939. It was held that profit from securities sold from "old accounts" was ordinary income and not capital gain, there being no evidence that the old partnership had been dissolved and its securities distributed to the partners. The evidence showed no change in the operation of the business or in the method of handling the securities. Thus, the formation of the so-called new partnership and the clearing of the securities through the "old accounts" effected no change in the securities involved from stock in trade to capital or investments.
It is our conclusion, upon a careful consideration of all the evidence, that the securities1949 U.S. Tax Ct. LEXIS 182">*199 involved were not property of a kind properly includible in inventory if on hand at the close of the taxable year and were not held by Van Tuyl & Abbe primarily for sale to customers in the ordinary course of its business. They were purchased for the partnership's own account for the purpose of speculation and were capital assets.
With respect to the profit derived from the sale of $ 27,000 par value Carolina Central Railroad Co. 4's of 1949, our conclusion is the same.
Decisions will be entered under Rule 50.
Footnotes
1. 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 * * *↩