Carl Marks & Co. v. Commissioner

Carl Marks & Co., Petitioner, v. Commissioner of Internal Revenue, Respondent

Carl Marks & Co. v. Commissioner

Docket No. 15187

United States Tax Court

12 T.C. 1196; 1949 U.S. Tax Ct. LEXIS 140;

June 30, 1949, Promulgated

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Decision will be entered under Rule 50.

Petitioner, a dealer in foreign securities, transferred all of its domestic securities and certain of its foreign securities out of its inventory to an investment account on December 29, 1941. Held, that the securities so transferred were thereafter held for speculative or investment purposes only and that the profits from the sale of the securities involved are taxable in accordance with sections 117 and 711 (a) (1) (B) of the Internal Revenue Code.

Jacob J. Mertens, Jr., Esq., and Orrin Judd, Esq., for the petitioner.

W. A. Schmitt, Esq., for the respondent.

Hill, Judge.

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HILL

Respondent determined a deficiency in petitioner's excess profits tax for the year ended December 31, 1942, in the amount of $ 193,267, and also determined an overassessment of petitioner's income tax liability in the amount of $ 53,836.54. Respondent conceded part of the deficiency determined at the hearing. The basic question presented is whether the gains realized by petitioner upon the sale of certain foreign and domestic securities in 1942 represented ordinary income or capital gains.

The tax return for the year involved was filed with the collector of internal revenue for the second district of New York.

FINDINGS OF FACT.

Part of the facts have been stipulated and they are so found.

Petitioner is a corporation duly organized under the laws of the State of New York and has its principal place of business in New York City. It is one of the largest dealers in foreign securities in the world, having maintained such a business over a period of 22 years.

On December 29, 1941, petitioner owned foreign securities of a value of $ 1,502,287.20 and domestic securities of a value of $ 139,858.79, or total securities of a value of $ 1,642,145.99.

Prior to December 29, 1941, all foreign and domestic securities were carried in the same ledger. Although all the domestic securities were carried in the inventory with the foreign securities, they were purchased for investment purposes and during 1941 and 1942 were never held primarily for sale to customers in the ordinary course of petitioner's business. During those years petitioner never dealt in domestic securities. They were never considered part of the dealer business. All of the domestic securities were bought and sold through the stock exchange firms by Carl Marks, petitioner's president, and not by any of its traders, as was true with respect to the dealer securities.

The entry of the United States into the war in December 1941 caused a considerable decline in the market value of foreign securities. That decline resulted in such low values that Marks felt petitioner could make more money if it held certain of such securities for a long term. In the opinion of Marks, by appropriate selection for investment of certain of the foreign securities owned by petitioner and the withdrawal of such select securities from those held for sale to customers in the ordinary course of business, it could, by price appreciation over a considerable period of time, realize a greater profit than it could by means of the narrow profit through trading in the dealer account.

It was a rule of the firm that no one working for it could buy or sell securities for his own account or take advantage of any knowledge which could be obtained from his position with the firm. Petitioner, in the course of business, obtains a considerable amount of information, such as that certain debts of various foreign countries may be settled over a period of time, or that certain countries are going to get loans, or that certain interest is going to be paid on defaulted securities. By going into the investment business in a more substantial way the firm could take speculative advantage of such information, and realize the appreciation in value which such information indicated might occur.

Petitioner's selection of the particular foreign securities to be withdrawn from those held for sale in the ordinary course of business and held thereafter as investments was based upon Marks' knowledge of the interest which the securities represented, their price, and his judgment as to the securities which would be best suited for investment and speculative purposes.

On December 29, 1941, petitioner transferred from the dealer account to an investment account securities having a value of $ 354,526.36, of which domestic securities amounted $ 139,858.79 and foreign securities amounted to $ 214,667.57. The domestic securities transferred to the investment account constituted petitioner's entire holding of such securities.

Securities transferred to the investment account at that time were not inventoried or otherwise treated as dealer items on petitioner's books of account at any time after that date. At the time of such transfer petitioner retained in inventory for resale to customers in the ordinary course of its business certain identical foreign securities of a value of $ 109,180.59. This was done partly because petitioner desired at that time to transfer only round amounts of foreign securities to the investment account and partly because it wished to retain certain securities in the dealer account so as not to interfere with petitioner's dealer business. Petitioner did not acquire for the investment account after December 29, 1941, any further amounts of such identical securities. Activity in such securities was confined to the dealer account. Of the 1,500 foreign securities dealt in by petitioner, 17 were of the same type of those held for investment. Other than those above mentioned, no further transfers of securities were made before or after that date from the dealer to the investment account. During the taxable year no transfers were made from the investment to the dealer account.

When both the foreign and domestic securities were transferred to the investment account on December 29, 1941, the following steps were taken to segregate those securities from the others which were held by petitioner for sale to customers.

The particular trader of any of the nine which petitioner employed in charge of the specific foreign securities was advised by order of Marks of the intended withdrawal for investment account and of the reduced amount of securities available in the dealer account for sale in the ordinary course of business. Instructions of the change were also given to the other members of petitioner's staff. The domestic and foreign securities transferred into the investment account were separated and put in a separate bank vault. In the case of the securities so transferred to investment account on December 29, 1941, and all investment securities thereafter purchased or sold, the only person who was authorized to buy or sell such securities was Marks. In contrast, in the case of a normal dealing in foreign securities held for sale in the ordinary course of business, any one of the nine individual traders at the trading desk was given unlimited license to buy or sell in the type of securities in which he was a specialist.

In selling any of those securities transferred to the investment account Marks would give specific instructions for the sale of the security. All memoranda of sales of investment securities were given to Marks. He marked thereon a special notation so that the exact securities sold in the investment account might be delivered. After the securities had been personally identified by Marks the original sales slip was routed to the cashier, who entered it in his sales blotter. The record clerk then gave the original slip to the vault clerk, who put the numbers of the securities on the slip. That slip went back to the cashier, who requisitioned the securities that had been sold. In the course of delivery the numbers were marked off and the proper pair-offs made in the books.

In the purchase of those securities for the investment account after January 1, 1942, which respondent at the hearing conceded were held for investment purposes, the procedure of identifying them in the books of petitioner and selling them was the same as in the case of those transferred to the investment account on December 29, 1941.

During the taxable year 1942 petitioner sold $ 48,667.84 of the $ 139,858.79 of domestic securities which it transferred to the investment account on December 29, 1941, and which it had held for more than six months. It reported a net gain on such securities of $ 8,787.81. The amount of that gain was determined by using as the cost the value of the securities as of December 29, 1941.

During the taxable year 1942 petitioner sold certain of its foreign securities which it had held for more than six months and which it had transferred from the dealer account to the investment account on December 29, 1941. It reported a net gain from such sales of $ 199,511.50. The amount of that gain was determined by using as the cost the value of the securities as of December 29, 1941.

In addition, petitioner sold certain foreign and domestic securities which had been acquired for investment on and after January 1, 1942. Petitioner reported a net gain from such sales in the amount of $ 5,433.37. As pointed out above, respondent has conceded that it was proper for petitioner to treat these securities as capital assets.

In 1941 and prior years it had been the practice of petitioner to determine gross income by taking each security account and determining gain or loss thereon, by using the market value or cost, whichever was lower, of the securities in the particular account as of December 31 of the preceding year, entering the cost of purchases and the proceeds of sale, and also dividends and interest received, and entering the market value or cost, whichever was lower, as of the close of the taxable year, of the securities in the account unsold and remaining on hand. The difference between the debits and credits of each account reflected the gain or loss in such account. That method of determining income was continued as to all securities retained in the dealer account in 1942.

In determining whether investment securities had been held for six months or more petitioner used the date December 29, 1941, as the date of acquisition in the case of foreign securities and the date of acquisition in the case of the domestic securities. All of the securities on which net capital gain was reported in the 1942 return had been held for six months or more from December 29, 1941, except for three domestic securities having a total cost of $ 7,092. Including that amount, the total cost of the investment securities sold in 1942 and acquired prior to that year was $ 191,642.84.

As the idea of the investment business proved successful, petitioner began to enlarge the investment branch of its business. New securities were acquired during 1942 for the investment account whenever Marks thought it desirable to do so.

At the end of each of the years indicated petitioner held for investment and speculation securities having the following values:

1942	1943	1,212,275.27
1944	2,652,830.01
1945	3,297,895.36

Petitioner's total cash receipts and disbursements in the dealer account during 1942 amounted to $ 25,000,000, whereas its sales in the investment account during that year amounted to $ 399,000.

On December 31, 1941, petitioner had securities pledged as collateral with banks of $ 431,291.45 against loans of $ 290,700. On December 29, 1941, petitioner's balance sheet reflected securities on hand of a value of $ 1,210,854.54, although as pointed out above, it owned at that time securities having a value of $ 1,642,145.99. The net value of the pledged securities during the taxable year was included in the balance sheet as an account receivable.

During the taxable year 1942 petitioner borrowed from certain banks for general corporate purposes the amount of $ 362,850. As collateral, petitioner posted certain securities, including therein some of the securities in the investment account.

The gains realized from the sale of the domestic and foreign securities involved were included by petitioner in its 1942 declared value excess profits tax income and normal tax net income subject to computation of normal tax and surtax liability, but such gains were excluded by it from its excess profits net income.

In his statement attached to the notice of deficiency respondent stated as follows with respect to the sale by petitioner of securities in the investment account:

(e) and (f). -- It is held that the profits realized by you on the sale of various securities transferred on December 28, 1941 from your inventories of securities held primarily for sale to customers to investment accounts are taxable as ordinary income and not as capital gains.

OPINION.

The question is whether certain domestic and foreign securities which petitioner carried in its dealer account and which were transferred to its investment account on December 29, 1941, were thereafter capital assets within the definition of section 117(a) of the Internal Revenue Code. If so, the profits realized from the sale of those securities during 1942 are taxable at the capital gain rates in accordance with the provisions of section 117, Internal Revenue Code, and not as ordinary income as respondent contends, and, in addition, the amount of such gain from those securities held for more than six months is excludable from petitioner's excess profits net income for the year 1942 in accordance with the provisions of section 711(a) (1) (B) of the Internal Revenue Code. ^{*153 the investment account on that date and were sold during the year involved. Petitioner contends that the domestic securities were originally acquired for investment purposes and that they were carried in the dealer account erroneously. It admits that the foreign securities were originally acquired for resale to customers in the ordinary course of business, but contends that they were "converted to investments" on December 29, 1941.}

Respondent, as we have pointed out in our findings, has conceded (rightly, we think) that the securities which petitioner purchased for the investment account during the taxable year 1942 constituted investments and that the profits derived from the sale of such securities during that year are taxable as capital gains. He argues, however, that the securities, both foreign and domestic, which were transferred to the investment account on December 29, 1941, were not investments, although it is not disputed that they were carried on petitioner's books, segregated, held, and disposed of in the same manner as those purchased for the investment account subsequent to January 1, 1942. In our view, the distinction between the respective securities, as contended by respondent, is unwarranted and the securities here involved were capital assets and should be treated as such for tax purposes. Certainly it can not be argued that securities once acquired for resale to customers must forever retain their dealer status, when in fact there has been a conversion of those securities from a dealer to an investment account. E. Everett Van Tuyl, 12 T.C. 900">12 T. C. 900. The crucial factor to consider in determining the character of the securities involved is the purpose for which they were held during the period in question, and in this case we believe the facts show that those securities were held for investment purposes after December 29, 1941.

Petitioner took detailed and extensive steps, as shown in our findings, to segregate the handling of the securities transferred to the investment account, both physically and on its books of account. Its holding and disposition of such securities were different from those left in the dealer account. The investment account established on December 29, 1941, was not temporary, but was a permanent arrangement, as shown in our findings. It was continued as an increasingly important unit of petitioner's business.

Our conclusion, of course, embraces the domestic securities transferred to the investment account on December 29, 1941, which we have found as a fact were held only for investment purposes, both prior and subsequent to that date.

Respondent assigns two principal reasons against that result. The first is that securities which were inventoried prior to December 29, 1941, could not be converted into investments "where the disposition and sales of the said securities are transacted in the same manner as in the case of its other dealer securities." Putting it another way, he states "that these securities should remain in inventory because there was no substantial difference in merchandising" the investment securities. Respondent's position, however, appears to be inconsistent, for those securities were carried on petitioner's books and disposed of in precisely the same manner as the securities which he admitted at the hearing were held for investment purposes only during the year involved.

Respondent's second contention is that, because the securities transferred on December 29, 1941, from the dealer account to the investment account were inventoried for sale to customers in the ordinary course of its business, they could not be taken out of dealer inventory unless petitioner obtained the Commissioner's permission so to do, citing section 22(c), Internal Revenue Code, and Regulations 111, section 29.22(c)-5. It has been held by a long line of cases that taxpayers may not include in inventory securities which were shown to be held for investment or speculation rather than for dealer purposes. Schafer v. Helvering, 299 U.S. 171">299 U.S. 171; Seeley v. Helvering, 77 Fed. (2d) 323; Vaughan v. Commissioner, 85 Fed. (2d) 497; Fuld v. Commissioner, 139 Fed. (2d) 465; see also Regulations 111, sec. 29.22 (c)-5. We do not understand that section 22(c) or the regulations go so far as to say that each time a dealer in securities in fact transfers certain of his securities from inventory to an investment account he must get permission from the Commissioner to do so before he can treat them as capital assets. Regulations 111, supra, provides in part as follows:

Sec. 29.22 (c)-5. 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 method be authorized by the Commissioner pursuant to a written application therefor filed with the Commissioner as provided in section 29.41-2. * * * For the purpose of this rule, a dealer in securities is a merchant of securities, whether an individual, partnership, or corporation, with an established place of business, regularly engaged in the purchase of securities and their resale to customers; that is, one who as a merchant buys securities and sells them to customers with a view to the gains and profits that may be derived therefrom. If such business is simply 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, irrespective of whether such buying or selling constitutes the carrying on of a trade or 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 this rule. [Italics supplied.]

Respondent also cites in support of his argument on this point Vance Lauderdale, 9 T.C. 751">9 T. C. 751. That case, however, is distinguishable from the one here, for in it the taxpayer did not establish that the securities were capital assets. One of the partnerships involved, designated the "old partnership," which dealt in those securities did not use any inventory in determining its return of income for the year in question, which had been its practice in previous years. Since the securities therein were still dealer securities and they were still owned by the "old partnership," it was incumbent on it to continue using an inventory in its return of income unless it had previously requested and obtained permission from the Commissioner to change. In other words, the taxpayer there changed its method of accounting without the Commissioner's permission, as is required by the regulations. Regulations 111, sec. 29.41-2. In this case, however, the petitioner has established that the securities involved were converted to investments and that the exclusion of them from inventory was in accordance with the regulations and its method of accounting.

In view of the above, therefore, we hold that those securities sold during 1942 which were part of those transferred from the dealer account to the investment account on December 29, 1941, were capital assets and that the profits which accrued from those sales should be treated taxwise in accordance with the provisions of sections 117 and 711(a) (1) (B) of the code.

It follows that respondent erred in his determination.

Decision will be entered under Rule 50.

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Footnotes

• 1. Of this amount securities of a value of $ 148,416.52 had been acquired prior to January 1, 1942, and $ 493,879.47 had been acquired for investment during the taxable year.↩

• 2. SEC. 711. EXCESS PROFITS NET INCOME.

  (a) Taxable Years Beginning After December 31, 1939. -- The excess profits net income for any taxable year beginning after December 31, 1939, shall be the normal-tax net income, as defined in section 13(a) (2), for such year except that the following adjustments shall be made:

  (1) Excess profits credit computed under income credit. -- If the excess profits credit is computed under section 713, the adjustments shall be as follows:

  * * * *

  (B) Gains and Losses from Sales or Exchanges of Capital Assets. -- There shall be excluded gains and losses from sales or exchanges of capital assets held for more than 6 months.↩