Hamill v. Commissioner

ALFRED E. HAMILL, PETITIONER, ET AL., 1v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Hamill v. Commissioner Docket Nos. 71808-71810, 72923-72926. United States Board of Tax Appeals 30 B.T.A. 955; 1934 BTA LEXIS 1242; June 19, 1934, Promulgated *1242 A partnership engaged in handling commercial paper and securities in various ways, including the purchase of a relatively small amount of securities for resale, held, upon the evidence, not entitled to the use of an inventory as to such small part of its business. Addison S. Pratt, Esq., for the petitioners. Lloyd W. Creason, Esq., for the respondent. STERNHAGEN *956 The petitioners are members of the partnership of Hathaway & Co., and as to each of them the Commissioner increased his share of partnership income for 1930, "due," as the Commissioner stated it, "to the disallowance [as to the partnership] of a write-down based on inventories of securities in the hands of non-dealers." This resulted in the determination of the following deficiencies: Hamill, $3,752.95; Ellert, $1,822.30; McCarthy, $842; Hathaway, $1,232.93; Smith, $5,220.39; Thorne, $1,779.75; Wallace, $1,748.48. The petitioners claim the right to deduct as a loss a drop in value of certain securities, claiming to be dealers as to such securities, and that such loss is within the statute and the regulations as to inventories. Many of the facts are stipulated, but the nature*1243 and character of the business and the detailed manner of its operation, as well as some of the facts as to the transactions in the particular securities in question, are gathered from the testimony of a member of the firm. FINDINGS OF FACT. In 1930 petitioners were members of Hathaway & Co., a partnership. The firm, originally organized in 1874, was engaged primarily in the purchase at a discount of promissory notes from those seeking loans and the resale of these notes to banks and trust companies throughout the United States. It sometimes made cash advances to customers before rates on notes were fixed, and sometimes had the notes assigned to it before turning over the proceeds to the customers. It sold commercial paper usually under an option which gave the buyer 10 days or more for credit investigation. The purchasing bank paid for the paper when it took it. In a negligible number of instances the paper was returned by the purchaser and resold to another bank. In 1922 the volume of commercial paper bought and sold began to decrease, and the partnership enlarged the scope of its business, engaging in the purchase and sale of short term railroad equipment trust notes. *1244 In 1926 it took out licenses in several states for underwriting securities, and has developed a business in this field, marketing in the same manner as before. It also began to participate in stock pools or syndicates, and to buy and sell securities on customers' accounts, but was not a member of any stock exchange. It sometimes purchased securities on a customer's specific order, making delivery the following business day, and also bought securities on its own account, which it offered for sale to customers. It bought nothing for permanent investment. In its underwritings and contracts with syndicates or pools, it took over an allotment of securities for distribution to the public, receiving a commission for its marketing services, but in case of failure *957 to dispose of the amount allotted, it was usually obligated to keep the remainder, paying therefor the market price less commission. It segregated its commercial paper and securities business into two departments. Advertising was done by circular or personal contact. Its daily outstanding loans from banks for the conduct of its activities during 1930 averaged $4,100,000. The following schedule reflects the*1245 volume of its purchases and sales of commercial paper and securities in 1930: Par value Commercial paper issued by 221 corporations, partnerships and individuals $206,370,804.60 Equipment trust notes of 68 railroads 2,617,500.00 Bonds of seven foreign nations 164,000.00 Bonds of fourteen foreign states and municipalities 641,000.00 United States 4th Liberty Loan bonds 615,000.00 Domestic bonds of 27 states and municipalities 4,539,750.00 Tax warrants of seven cities 1,171,450.00 Bonds of 50 corporations 1,687,000.00 Stocks of 22 corporations 600,000.00 Total 218,406,504.60 It also bought or sold through brokers upon the specific orders of individual customers 10,482 shares of stock, rights, warrants, and scrip of 69 corporations in 190 transactions. It sold on commission for one of its customers bonds of a par value of $728,000. Profits and losses on its transactions were entered in one general account on its books; separate memorandum accounts were kept for information purposes. Hathaway & Co.'s books show that in 1930 it sold 3,248 shares of stock in 8 corporations, which had been held at the close of 1929. At the close of 1930 it*1246 had on hand bonds and shares of 10 corporations. The difference between their market value (or cost if bought in 1930) on January 1 and on December 31, 1930, was $92,242.50. Some of these securities had been acquired on Hathaway & Co.'s own account; some had been received in cancellation of a customer's indebtedness to the firm; and some were acquired as the undisposed remainder of underwriting allotments which the firm was obligated to take. Hathaway & Co. filed an income tax return for 1930 in the second district of New York. It deducted $121,415 from gross income as an inventory loss on the 10 blocks of securities which it held at the close of 1930. The Commissioner disallowed the entire loss deduction. OPINION. STERNHAGEN: Since each of these proceedings is derivative from the determination of the partnership income, the partnership will be treated as if it were the single party in interest. On the partnership *958 return for 1930 (not in evidence), it deducted $121,415 as an inventory loss, and this item the respondent disallowed with a somewhat ambiguous statement. At the beginning of the trial the petitioners conceded that the deduction was in any event*1247 too large because the partnership had in its computation omitted to apply the first-in first-out rule to securities which had been sold during the year, thus applying to the remaining inventories securities an improper cost basis. The issue is thus confined to the propriety of a deduction of $92,242.50. This figure represents a "write-down" of 10 blocks of securities owned at the end of 1930 to their market value on December 31. The securities being still on hand at that time, such deduction is only available to the partnership if it has the right to the use of an inventory in the computation of its taxable income. This is the issue. The method of determining taxable income by the use of inventories has always been recognized as special and as involving problems of general administration peculiarly cognizable by the Commissioner. Cf. . Section 22(c), Revenue Act of 1928, is necessarily the foundation for any claim of a taxpayer relating to an inventory. Like its predecessors in earlier statutes, the section is as follows: Whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly*1248 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 clearly reflecting the income. Fortified with such a clear sanction in the statutory grant of power, the administrative determination in such a case must survive all but the strongest attack. Short of being arbitrary or capricious or based on a clear demonstration of error, the determination in any single instance ought not to be disturbed. This is not a matter of jurisdiction, for the Board clearly has the power of review, , but is rather an attitude of the Board in the exercise of its jurisdiction not to interfere lightly with general administrative matters which the Congress has entrusted to the Commissioner's discretion. In , the Supreme Court said, in 1930: First, whether in a particular business inventories are necessary for the determination of income is a practical*1249 question left by the statute to the judgment of the Commissioner. On that account he and the company did not differ. In every year, it, without any question or protest, used inventories in making its return. The dispute was merely on the method of valuation to be adopted for that part of the stock which it calls its normal stock. *959 And in closing its opinion, the Court said: "The company's case falls far short of meeting the heavy burden of proving that the Commissioner's action was plainly arbitrary." In 1931 the Circuit Court of Appeals for the Fourth Circuit said, in : As will be seen from the Act, Congress plainly placed the question of the proper use of inventories within the opinion of the Commissioner, and that question was left by Congress to the discretion of the Commissioner. In such a case a heavy burden of proving that the Commissioner's action was plainly arbitrary rests upon the taxpayer. . Where a statute commits to an executive department of the government a duty required in the exercise of an administrative*1250 discretion the decision of the executive department, as to such questions is final and conclusive, unless it is clearly proven arbitrary or capricious or fraudulent, or involving a mistake of law. * * * A study of the records leads us to the conclusion that the action of the Commissioner was not only not arbitrary or capricious but was correct. These cases indicate a heavy burden upon the taxpayer who undertakes to overthrow an administrative determination in respect of inventories - a burden undoubtedly heavier than that of overthrowing a purely factual determination upon which the ultimate determination must depend. It was apparently in the latter class of dispute that the Circuit Court of Appeals for the Second Circuit regarded , although the dissenting opinion therein support a doubt. The difficulty of having such questions as this determined judicially, whether by the Board or by the courts, is manifest. ; certiorari denied, *1251 ; ; certiorari denied, . The statute apparently contemplates not so much the right of taxpayers to use inventories as their duty to do so when necessary clearly to determine income, together with a power in the Commissioner to enforce the duty, . While this does not justify the Commissioner in arbitrarily requiring inventory in one case and not in another similarly situated, the issue here is not framed along that line. The language of the statute alone would give no right to a taxpayer to demand the use of an inventory if his income could be clearly determined without it. This Board has no data, outside the evidence in any case, to indicate whether as to any taxpayer or class of taxpayers inventories are necessary. The Commissioner, however, has not restricted the use of inventories to cases of necessity, but has made their use permissive to all who meet the conditions prescribed by his general regulations. Perhaps we should assume from Regulations 74, article 105, that *960 as to all dealers therein described*1252 the use of inventories has been found to be necessary to a clear determination of income, although it seems hard to believe that frequently income of such a dealer could not be accurately computed by awaiting the ultimate disposition of the securities and then offsetting cost against sale price. The regulation is 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 inventories 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 engaged in the purchase of securities and their resale to customers; that is, one who as a merchant*1253 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 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 this rule. The petitioners have presented their case largely as if the only question to be determined is whether the partnership was in 1930 a dealer in securities, an affirmative decision on that question resulting in the approval of the deduction claimed. The issue, however, is not so simple, and it has not been so simply pleaded. Claimed under article 105, the deduction must be brought in all respects within it. It is not enough that the taxpayer has bought some securities for resale, as is clear from the evidence, at least as to some of the comparatively small number of securities*1254 on hand December 31, 1930. Even if, by such evidence, he is to be held to be a dealer pro tanto, he must also show that the other conditions imposed by the regulation upon such a dealer have been fulfilled. The partnership predicates its argument largely upon the postulate that its character as a dealer has existed since 1874 because of its commercial paper business, which is a large part of the whole. But, so far as this record shows, it has never accounted for its commercial paper transactions by the inventory method and has never used such *961 method in its tax returns. Furthermore, it does not appear that the inventory method hws been consistently applied to the small part of the business consisting of buying and selling other "securities", even assuming that the segregation of such part is practical and has been made. "What the inventory practice is of some importance; that the practice should be uniform is of the highest importance." . The Circuit Court of Appeals, in *1255 , held that a bank which, in addition to its general banking business, was a dealer in securities to a large and substantial extent was, upon the evidence, entitled to use an inventory including short term Government notes; but we do not understand that opinion to hold that where the portion of the business is slight the Commissioner is equally required to permit inventories to be used. Here the proportion of business to which the inventory is sought to be applied comprises less than one half of one percent of the total business. The distinction between commercial paper and the partnership's dealings therein, on the one hand, and securities (stocks, bonds, equipment trust notes, etc.), and the partnership's diverse methods of doing business in relation thereto, on the other hand, is subtle. The evidence in this case leaves the classification not clear or free from doubt. There is substantial room for confusion in an attempt to vary the treatment for tax purposes of the activities of a single taxpayer who in the same year engages in underwriting, in syndicate and pool participation, in brokerage, in financing, and in purchase*1256 and sale. Trading, dealing, investment, and speculation are not sharply defined. We can readily believe that there would be substantial administrative difficulty in auditing the petitioner's accounts for the purpose of determining income, part of which is to be based on inventories and most of which is not. 2 As to most of its business, it appears that the turnover is so rapid that there is no occasion for theuse of inventory. The conclusion, therefore, must be that the record is insufficient to establish either the necessity of inventories as contemplated*1257 by the statute or the fulfillment of the condition prescribed by the Commissioner in his regulations for the permission to use inventories. The determination of the deficiency is, therefore, sustained. Judgment will be entered under Rule 50. Footnotes 1. Proceedings of the following petitioners are consolidated herewith: Arnold M. Ellert; John McCarthy; Stewart S. Hathaway; Howard C. Smith; John Norrish Thorne; and G. Bruce Wallace. ↩ 2. The difficulty is illustrated in the following cases involving inventory of securities: ; ; ; ; ; ; ; ; ; . ↩