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Vaughan v. Commissioner of Internal Revenue

August 10, 1936


Appeal from the Board of Tax Appeals.

Author: Hand

Before MANTON, L. HAND, and AUGUSTUS N. HAND, Circuit Judges.

AUGUSTUS N. HAND, Circuit Judge.

This is a petition by the taxpayer William W. Vaughan, and a cross-petition by the Commissioner of Internal Revenue to review a decision of the Board of Tax Appeals sustaining in part the Commissioner's determination of a deficiency of income tax for the calendar year 1929.

The taxpayer as a member of the firm of Vaughan & Co. conducted a stock brokerage business in the city of New York in partnership with his father from 1901 until the death of the latter in 1920. Thereafter he carried on the business as sole proprietor under the name of Vaughan & Co. until March 19, 1929. At that date he entered into an agreement with Burns and Toomey, old employees, under which the three were to become associated in the stock brokerage business under an arrangement whereby each was to share in the profits and contribute to the losses in certain proportions, subject, however, to the guaranty by Vaughan that the other two should, irrespective of the amount of profits of the business, receive and retain a certain minimum as a drawing account and also subject to an agreement on his part that they would not have to contribute to firm losses except from such profits as they might receive over and above their drawing account. The agreement recited that the "parties hereby associate themselves together as copartners upon the terms and conditions hereinafter set forth to carry on a general brokerage business in stocks, bonds and other securities." Vaughan provided all the capital and was given a discretionary power to broaden the business if he thought best so as to include transactions in unlisted securities and commodities. It also provided that he might engage in transactions for the purchase and sale of securities and of commodities in his individual right and carry on the business of dealer therein, but such transactions should be deemed partnership transactions and losses should be shared and expenses borne as in the case of other business of the firm.

During the period when Vaughan was conducting the business as sole proprietor, as well as after he formed the association with Burns and Toomey, his activity was generally that of a specialist on the floor of the New York Stock Exchange, of which he had been a member for many years, in respect to five different stocks, to wit: Pennsylvania Railroad, certificates of Great Northern Iron Ore Properties, stocks of Advance Rumley Corporation (common and preferred), and Callahan Zinc & Lead Company.

A "specialist" is one who, having a position at a designated "post" on the floor of the Exchange, maintains a book in which he enters all offers and bids for the stocks in which he specializes, thus indicating the "market" for the stocks. The offers and bids are ordinarily made by other members of the Exchange. But the specialist is required to be ready at the demand of other brokers to quote the market price and to buy and sell at the closest fluctuations possible. Where the "bid" and "asked" prices furnished by the brokers coincide and the transaction is thereby effected, the specialist acts as a broker in the transaction. But where there is too wide a "spread" between the "bid" and "asked" prices, in order to create a market, he either buys or sells the stock for his own account. Thus he becomes the owner of any stock acquired in this way. In connection with such activity it became advantageous for Vaughan to carry stock of his own, so that when he sold stock at less than the price offered he would have it available for delivery and would not have to "sell short" or borrow the stock.

In addition to his business as a specialist, he bought and sold other stocks listed on the New York Exchange which he dealt in for profit. He testified that he bought these stocks "for the purpose of being a dealer and supplying customers when they wanted to buy them," and not "for the purpose of keeping them as investments," and that this statement would apply not only to the stocks in which he acted as a specialist but also to the other stocks.

The question before us is whether the taxpayer, or the partnership of which he was a member, was a "dealer" in securities, entitled to inventory them in computing pet income for the year 1929.

Article 105 of Regulations 74 provides that: "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. * * * Taxpayers who buy and sell or hold securities for investment or speculation and not in the course of an established business, * * * are not dealers in securities within the meaning of this rule."

The Commissioner held that neither Vaughan nor Vaughan & Co. were "dealers" in securities but were mere traders, and hence not entitled to inventory their securities under the Regulations. The Board of Tax Appeals held that inventories should not be allowed because of failure to show on the returns that the income was computed on an inventory basis and determined a tax deficiency accordingly. We hold that inventories should be allowed as to some of the securities but not as to others.

The contention that inventories may not be employed because the returns did not include a statement that inventories were used is without merit. We have already considered a similar objection in our decision in Commissioner v. Stevens, 78 F.2d 713, and there held that the failure to supply such information in the return, when prescribed by the regulations, did not preclude the use of inventories, "where * * * the actual method employed conformed, as nearly as possible, to the best accounting practice in the trade and most clearly reflected income, and where there has been a substantial compliance with the statute and regulations."

We think that under the regulations Vaughan and the firm of Vaughan & Co. were "dealers" in the five stocks in which they acted as specialists. As specialists they were required by the practice of the New York Stock Exchange to have on hand a supply of the stocks in which they dealt, so as to round out orders in cases where the bid and asked prices did not match, and to make deliveries where they were selling stocks to maintain a market. But we cannot see that they were "dealers" within the meaning of the Regulations in the other securities, which were held and traded in in relatively small quantities, and had no necessary connection with their business except for speculation. We do not think it possible that they purchased or carried such stocks as a supply for customers.Whether they were ever to use them at all depended on the speculative advantage that might arise to themselves. The stocks carried by them as specialists are their real stock in trade necessary for making a market and required for sale to customers in connection with the performances of that function.

On January 1, 1929, Vaughan had on hand a few shares of stock of Texas Corporation, Belding Hemingway, Colorado Fuel & Iron, Kelly Springfield, and Martin Perry Corporation (only 1280 shares altogether). He likewise had on hand some Mexican bonds and scrip which, like the above stocks, he continued to hold through the year without having any transactions in them. Something more ought to have been shown other than Vaughan's mere statement that he held these securities "for the purpose of being a dealer and supplying customers when they wanted to buy them," in order to satisfy us that they represented a necessary or reasonable equipment for his business. The stocks of the Chicago, Rock Island & Pacific and the Interborough which he carried were in a similar position. On January 1, 1929, he held 100 shares of the former corporation, purchased 300 more before March 19, sold the entire 400 prior to the latter ...

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