*1071 1. From January 1 to March 18, 1929, inclusive, the petitioner, as sole proprietor, conducted a stock brokerage business under the name of Vaughan & Co. On March 19, 1929, the petitioner entered into a profit-sharing agreement with two former employees under which they were to receive 40 percent of the profits and the petitioner 60 percent. The petitioner furnished all the capital. The agreement provided that the two former employees should not contribute to the losses except out of the profits. Held, that the petitioner is entitled to deduct from his gross income of 1929 the total loss of the business from March 19 to December 31, 1929.
2. The petitioner was a member of the New York Stock Exchange throughout the year 1929 and a specialist in a number of securities dealt in on the Exchange, in which capacity he purchased and sold the specialty stocks. Prior to March 19, 1929, the securities were purchased for the account of the petitioner; after March 18, 1929, the securities were purchased for the account of Vaughan & Co. Both the petitioner and Vaughan & Co. inventoried securities on hand at the end of 1929 at their market value in determining the petitioner's income*1072 and also that of Vaughan & Co. Neither the petitioner nor Vaughan & Co. reported in their returns the basis upon which inventories were taken or that the net income was computed by the use of inventories. Held, that petitioner and Vaughan & Co. were not entitled to compute net incomes on the basis of inventories at market values.
3. In 1929 the petitioner sold certain shares of bank stock which were in no way connected with his trade or business and realized a large profit therefrom. Inasmuch as the securities had been owned by the petitioner for a period of more than two years prior to the date of sale, it is held that the profit arising from the sale constituted capital net gain.
*549 This proceeding is for the redetermination of a deficiency in income tax for 1929 in the amount of $193,308.76. The points in issue are: (1) Was the petitioner during 1929 a dealer in securities entitled to inventory his securities in computing his income for 1929? (2) Was Vaughan & Co. a dealer in securities entitled*1073 to use inventories in computing its income for 1929? (3) Is the petitioner entitled to deduct from his income for 1929 the entire amount of the loss sustained by Vaughan & Co. upon its operations from March 19 to December 31, 1929? (4) Was the profit of $1,252,200.84 realized by the petitioner in 1929 from the sale of bank stock ordinary income or capital gain?
FINDINGS OF FACT.
From 1901 to 1920 the petitioner was a member of the firm of Vaughan & Co., which conducted a stock brokerage business in New York City. The other member of the firm was the petitioner's father, who died in 1920. From the date of his death the petitioner carried on the business under the same name as sole proprietor. On March 19, 1929, the petitioner entered into an agreement with Matthew J. Burns and John W. Toomey, old employees, under which they were thereafter to receive 21 percent and 19 percent, respectively, of the profits of the business. The entire capital was furnished by the petitioner. The agreement above referred to provides:
*550 1. The parties hereby associate themselves together as co-partners upon the terms and conditions hereinafter set forth, to carry on a general brokerage*1074 business in stocks, bonds and other securities in the City of New York and elsewhere, under the firm name of Vaughan & Co.
2. The duration of the partnership shall be one year beginning April 1, 1929, to and including March 31, 1930, * * *
3. * * *
All loans made by a partner to the partnership and the interest of each partner in the capital shall bear interest at the rate of six (6%) percentum per annum, the same to be credited on the books and to be payable quarterly.
Out of the partnership profits there shall first be set apart to the parties of the first and third parts the annual sum of $25,320. each, for the use of their respective memberships in the New York Stock Exchange, in the same manner between the parties as though an expense of the business, the same to be credited and be payable in monthly installments. Of the sums thus to become due to the party of the third part, he hereby assigns to the party of the first part an amount equivalent to interest at the rate of six (6%) percentum per annum upon his indebtedness to the party of the first part, and entries in the firm books shall be made accordingly. After the foregoing sums have been set apart, the partners*1075 shall share in the earnings and profits of the partnership (and contribute to the losses subject to the provisions hereinafter contained) in the following proportions, namely: The party of the first part sixty (60%) percent., the party of the second part twenty-one (21%) percent., the party of the third part nineteen (19%) percent.; the same to be ascertained and paid at the end of the year or oftener if so determined by the parties.
5. The partners shall receive as drawing accounts the following sums per annum, the same to be paid to them monthly and to be charged against their respective shares of the profits, viz: the party of the first part $19,500.; the party of the second part $7,800.; and the party of the third part $5,200.
The party of the first part hereby guarantees that the parties of the second and third parts shall each receive and may retain their drawing accounts so long as they respectively are partners, irrespective of the amount of profits of the partnership, and if the partnership profits are insufficient the monthly payment for the drawing account may be paid out of the share of the party of the first part in the partnership capital, or will be advanced by*1076 him.
6. For any loss, claim or damage sustained by the partnership or any partner by reason of any act or omission constituting a breach of duty or of the terms of this agreement on the part of any partner, or the committing of any tort, the offending partner shall be solely personally liable, and against the same shall indemnify and save harmless the partnership and the other partners. Otherwise the parties of the second and third part shall not be obligated to contribute to any partnership loss except out of such profits as they shall have received or be entitled to over and above the amount of their respective drawing accounts. [Italics ours.]
The business conducted under the name of Vaughan & Co. from March 19 to December 31, 1929, will hereinafter sometimes be referred to as the partnership.
The partnership filed a partnership return for the period March 19 to December 31, 1929, showing a net loss which was allocated to the petitioner and Burns and Toomey in accordance with the allocation to be made of profits, if any had been made. In his income tax return for 1929 the petitioner claimed a deduction from gross income *551 of 60 percent of the net loss*1077 of the partnership as shown by its books of account. In the audit of the partnership return the respondent disallowed the deduction of an inventory loss and reduced the net loss of the partnership as shown by its return from $158,386.13 to $63,989.89, 60 percent of which, or $37,973.94, was allowed as a deduction from the petitioner's gross income in the determination of the deficiency.
From 1901 to the present time the petitioner has been a member of the New York Stock Exchange and a specialist, and the only specialist dealing in the shares of stock of the Pennsylvania Railroad Co., Advance Rumley Corporation (common and preferred shares), and Callahan Zinc & Lead Co., and in certificates of the Great Northern Iron Ore Properties. It is the custom of the New York Stock Exchange, and has been so ruled by the governors thereof, that all specialists must have a free and open market in their stock and be ready to buy and sell at the closest fluctuations possible. For that purpose the specialist may buy and sell the specialty stocks for his own account. Where there is a wide spread between the bid and asked prices, the specialist, in order to create a market, may increase the bid*1078 and take certain shares for his own account; again, where he has the stock on hand he may offer shares at less than the price at which they are offered by any other broker in order to create a sale.
At the beginning of business on January 1, 1929, the petitioner, as a specialist, had on hand 2,637 shares of Pennsylvania Railroad Co. stock, 2,300 shares of Advance Rumley common, 2,200 shares of Advance Rumley preferred, 3,375 certificates of Great Northern Iron Ore Properties, and 4,200 shares of Callahan Zinc & Lead Co. Between January 1 and March 18, 1929, the petitioner as specialist purchased 121,400 shares of Pennsylvania Railroad Co. stock and sold 124,041 shares; purchased 7,900 shares of Advance Rumley common stock and sold 10,200; purchased 1,200 shares of Advance Rumley preferred and sold 3,400; purchased 55,700 Great Northern Iron Ore certificates and sold 55,200; purchased 3,600 shares of Callahan Zinc & Lead Co. stock and sold 5,400. At the close of business on March 18, 1929, petitioner was neither short nor long of Pennsylvania Railroad Co. stock or of Advance Rumley common and preferred stock, and had on hand 7,875 Great Northern Iron Ore certificates and 2,400*1079 Callahan Zinc & Lead Co. shares.
After March 18, 1929, the petitioner did all his trading as specialist for the partnership and none for himself. He did not buy and sell for his own account either any of the shares that he dealt in as specialist or other listed shares. The Great Northern Iron Ore certificates and the Callahan Zinc & Lead Co. shares which he had on hand at the close of business on March 18, 1929, he also had on hand at the close of the year.
*552 After the organization of the partnership petitioner operated as specialist the same as before. He bought and sold hundreds of thousands of shares of stock in which he acted as specialist. He had on hand for the account of the partnership at December 31, 1929, 10,218 shares of Pennsylvania Railroad Co. stock, 4,100 shares of Advance Rumley common stock, 10,500 Great Northern Iron Ore certificates, and 3,100 shares of Callahan Zinc & Lead Co. stock.
Both the petitioner and the partnership kept their books on the accrual basis and the income shown in the 1929 returns of both was computed by the use of inventories. This was also the manner in which the petitioner's income tax returns for many years prior to*1080 1929 were prepared. Inventories were made at the end of each month, the securities being valued at the last sale of the month. A computation of profit and loss for the month was made and the profit and loss account so made up was used in preparing income tax returns. No reference was made in the 1929 return of the petitioner or of the partnership to the fact that the income had been computed by the use of inventories, nor was there a statement attached thereto showing the necessity for the use of inventories in the business. The petitioner's income tax returns from 1924 to 1928 likewise did not show that inventories had been used in the preparation of the net incomes reported.
The inventories shown on the books of petitioner and the partnership and used in computing their respective incomes, as shown on their returns, were as follows:
| Number of shares | Cost | Inventory per books | |
| Petitioner's stock | |||
| Gt. Northern Ore Cfts | 7,875 | $248,368.75 | $157,500.00 |
| Texas Corp | 330 | 22,110.00 | 18,480.00 |
| Callahan Mining Co | 2,400 | 8,400.00 | 2,400.00 |
| Belding Hemingway | 100 | 1,400.00 | 462.50 |
| Colo. Fuel & Iron Co | 500 | 38,750.00 | 18,500.00 |
| Kelly Springfield Tire 6% pfd | 100 | 9,900.00 | 26,000.00 |
| Martin Parry Corp | 8,200.00 | 783.25 | |
| Total | 337,128.75 | 200,725.75 | |
| Write down | 136,403.00 | ||
| Write down on Mexican securities | 13,239.63 | ||
| Total write down | 149,642.63 | ||
| Partnership's stock | |||
| Advance Rumley com | 4,100 | 67,500.00 | 47,150.00 |
| Advance Rumley pfd | 700 | 14,887.50 | 14,000.00 |
| Penn. R.R. Co | 10,318 | 772,978.50 | 766,111.50 |
| Penn. R.R. Co rights | 6,618 | 23,398.90 | 19,848.00 |
| Great Nor. Ore. ctfts | 10,700 | 231,787.50 | 214,000.00 |
| Callahan Mining Co | 3,100 | 3,525.00 | 3,100.00 |
| Penn. R.R. Co | 39,254 | 121,401.88 | 117,762.00 |
| Cons. Gas Co | 1,100 | 160,100.00 | 110,000.00 |
| Amer. Radiator | 1,000 | 53,000.00 | 31,500.00 |
| 1,448,629.28 | 1,323,471.50 | ||
| Difference | 125,157.78 |
*1081 *553 The net income reported by the petitioner for 1929 was the amount after taking deduction from gross income of $149,642.63, representing shrinkage from cost to market of the securities carried in his individual inventory. This was disallowed by the respondent in the determination of the deficiency of the petitioner.
Likewise, the partnership in computing a net loss of $158,386.13 for the period March 19 to December 31, 1929, deducted from gross income a shrinkage in the value of the inventoried securities in the amount of $125,157.78. This was likewise disallowed by the respondent in the computation of the partnership loss, 60 percent of which was allowed by the respondent as a deduction from gross income in the computation of the deficiency.
Petitioner in 1929 sold 3,500 shares of Corn Exchange Bank & Trust Co. stock, realizing a profit therefrom of $1,252,200,84. Some of this stock had been owned by the petitioner for more than 20 years. But the greater portion of it was inherited by the petitioner from his father upon his death in 1920. These securities were kept by the petitioner separate and apart from his stock brokerage business. They were never carried*1082 in the inventories kept for the business, nor held primarily for sale in the course of petitioner's trade or business.
OPINION.
SMITH: The first question for decision is whether the petitioner is entitled to deduct from his gross income the total loss of the partnership business from March 19, 1929, to the end of the year. In his return the petitioner deducted only 60 percent of such loss, which was the amount of the loss allocated to him on the partnership return filed. He now makes the contention that, inasmuch as the operations of the partnership to December 31, 1929, resulted in a loss, he is entitled to deduct the entire amount of the loss by reason of the provisions of the partnership contract that the other partners "shall not be obligated to contribute to any partnership loss except out of such profits as they shall have received or be entitled to over and above the amount of their respective drawing accounts."
The respondent has determined that the business of Vaughan & Co. for the period March 19 to December 31, 1929, was operated at a loss of $63,989.89. This loss resulted from closed and completed transactions. Under the contract which the petitioner had with*1083 Burns and Toomey that loss was the petitioner's loss. Burns and Toomey were not required to bear any portion of it. If, in subsequent fiscal periods, the business was operated at a profit, the petitioner was required to report the profits distributable to him. But the result of future operations would not affect the result of operations *554 for the period in question in this proceeding. The petitioner's contention that he is entitled to deduct from his gross income the total loss of Vaughan & Co. for the period March 19 to December 31, 1929, is sustained.
The second question in issue is the right of the petitioner and of the partnership to use inventories at market value in the computation of their respective net incomes. The evidence shows that for years prior to 1929 the petitioner had made his returns by the use of inventories at market value and that his returns had been checked by revenue agents and no question raised as to his right to compute net income upon the basis of such inventories, even though the returns did not show that the net income had been computed by the use of inventories. The respondent has disallowed the use of inventories on the basis of market*1084 value for the year 1929 upon the ground that neither the petitioner nor Vaughan & Co. were dealers in securities within the contemplation of the Commissioner's regulations.
Section 41 of the Revenue Act of 1928 provides in part:
SEC. 41. GENERAL RULE.
The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * *
Section 22(c) of the same act provides:
(c) Inventories. - Whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most*1085 clearly reflecting the income.
Pursuant to the last cited provision of the statute the respondent has prescribed article 105 of Regulations 74, which reads as follows:
ART. 105. Inventories by dealers in securities. - A dealer in securities, who in his books of account regularly inventories unsold securities on hand either -
(a) At cost;
(b) At cost or market, whichever is lower; or
(c) At market value, may make his return upon the basis upon which his accounts are kept; provided that a description of the method employed shall be included in or attached to the return, that all the securities must be inventoried by the same method, and that such method must be adhered to in subsequent years, unless another be authorized by the Commissioner. For the purpose of this rule a dealer in securities is a merchant of securities, whether an individual, partnership, or corporation, with an established place of business, regularly *555 engaged in the purchase of securities and their resale to customers; that is, one who as a merchant buys securities and sells them to customers with a view to the gains and profits that may be derived therefrom. If such business is simply*1086 a branch of the activities carried on by such person, the securities inventoried as here provided may include only those held for purposes of resale and not for investment. Taxpayers who buy and sell or hold securities for investment or speculation and not in the course of an established business, and officers of corporations and members of partnerships who in their individual capacities buy and sell securities, are not dealers in securities within the meaning of thie rule.
The claim of the petitioner that he is entitled to compute his net income for the calendar year 1929 upon the basis of inventories at market value on December 31, 1929, is not sustained. The evidence is conclusive that on and after March 18 the petitioner was not a merchant in securities as an individual. He did not buy and sell securities as a dealer in securities after the creation of the partnership.
In , we held that a specialist on the New York Stock Exchange was entitled to compute income by the use of inventories at market value. In *1087 , upon somewhat different evidence, we reached a contrary conclusion. Cf. . In the circumstances of this case we do not find it necessary to attempt to distinguish those cases. For here, the partnership has not complied with the respondent's regulations with respect to the filing of a return on an inventory basis. The respondent's regulations, article 105 of Regulations 74, are specific that dealers in securities may make their returns upon the basis of inventories "provided that a description of the method employed shall be included in or attached to the return." In , we approved the above article as being "reasonable, and designed to carry out fairly the terms and intent of the statute." The partnership return filed for Vaughan & Co. for its fiscal period ended December 31, 1929, not only did not show the basis upon which inventories were taken, but failed to show that the net income was computed upon an inventory basis. The spaces on the return form after the titles "Inventory at beginning of year" and "Less inventory at end of*1088 year" were left blank. The respondent contends that this failure of the partnership to comply with his regulations is sufficient ground for denying to the partnership its present contention. We are of opinion that the position of the respondent is well taken. As stated by the Supreme Court, "Men must turn square corners when they deal with the Government." .
We can not find in the present proceeding that the use of inventories is necessary in the determination of the net income of either *556 the petitioner or the partnership. The respondent is not attempting to tax the petitioner upon any greater net income than would be obtained by taxing him upon net income obtained by the use of inventories on the basis of cost. The petitioner is simply claiming the benefit of the deduction from gross income of a shrinkage in the value of securities not sold. The contention of the petitioner is not sustained.
The final point in issue is whether the petitioner is entitled to be taxed under the capital gains provision of the statute, section 101 of the Revenue Act of 1928, upon the gain of $1,252,200.84 realized*1089 from the sale of 3,500 shares of Corn Exchange Bank & Trust Co. stock. The respondent has disallowed the claim of the petitioner upon this point. On brief the respondent contends that the petitioner at all times held the stock "primarily for sale whenever he could get his price therefor."
Section 101(c)(8) of the Revenue Act of 1928 provides:
(8) "Capital assets" means property held by the taxpayer for more than two years (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 in the course of his trade or business. * * *
The last clause of the above quoted definition of "capital assets" first appeared in the Revenue Act of 1924. The reason for the addition of this clause to the definition was explained by Chairman Green of the Committee on Ways and Means, in his report accompanying H.R. 6715, as follows:
The last part of the definition of capital assets is changed to remove any doubt as to whether property which is held primarily for*1090 resale constitutes capital assets, whether or not it is the type of property which under good accounting practice would be included in the inventory. [Report 179, 1st Sess., 68th Congress.]
A similar explanation is found on page 18 of "Statement of Changes" made in the Revenue Act of 1921 by H.R. 6715 and reasons therefor prepared for the use of the Committee on Finance, March 6, 1924, which incorporates the preceding excerpt from Mr. Green's report. In ; affirmed upon the point in question in , the Board held that an individual who owned real estate, which, in the ordinary course of his business as a real estate dealer, he was endeavoring to sell, could not claim that profits arising from the sales of such land were capital assets, even though they had been owned for a period of more than two years.
The question here is whether the petitioner, who was a stock broker, held the bank shares in question for sale in the ordinary *557 course of his trade or business. The petitioner testified that his father was a director of the Corn Exchange Bank and that he made his first purchases of stock*1091 in that bank more than 20 years ago; that when his father died in 1920 he inherited most of the shares of stock in the bank which he owned in 1929; and that he had exercised rights to acquire, and had acquired, additional shares of stock whenever they had been issued by the bank. The par value of the shares was reduced from $100 to $20 per share in 1929 and the petitioner received five shares for each share then held. The petitioner never considered his investments in the bank stock as in any wise connected with his brokerage business; the shares were not for sale by him. He testified:
I heard quite a number of rumors [in 1929] that the City Bank were going to buy the Corn Exchange out. I was going away on vacation, and I was down in Chesapeake Bay, got an evening paper and saw that the City Bank had bought control of the Corn Exchange Bank; but when I left, four weeks before that, Mr. Frew told me that there was no chance of it. I came back and I didn't want to be a party to anything with the City National Bank, and when they booted the price * * * high enough, I sold my stock.
Q. Did you ever buy any of it back? A. To my sorrow, yes, sir.Q. And what was the*1092 occasion of that?
A. When the City Bank refused to go through with the contract.Q. In buying all this Corn Exchange Bank stock, what was your purpose in buying it? * * * were you buying it for resale or investment, or for what purpose?
A. Sentimental; my father was connected with it for a great many years.
Q. Did you buy it with the intention of keeping it or selling it?
A. I gave my office a price at some time, if I lived long enough, they could sell it.
The evidence clearly shows that after the petitioner, on or about March 19, 1929, made the agreement with Burns and Toomey whereby they were to receive certain percentages of the profits of the business, the petitioner was not a dealer in securities. All of his activities after March 18 were connected with the business of Vaughn & Co. He was not engaged in business as an individual. The evidence is conclusive that the shares of bank stock were not held primarily for sale by the petitioner "in the course of his trade or business." The petitioner's contention that the profit realized from the sale of the shares is taxable as capital net gain is sustained.
Reviewed by the Board.
Judgment will be entered*1093 under Rule 50.