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Kluger Associates Inc. v. Commissioner of Internal Revenue

decided: March 17, 1980.


Appeal from three decisions of the United States Tax Court (Honorable Irene F. Scott, Judge) that there were deficiencies in income taxes due from appellants. Affirmed.

Before Waterman and Meskill, Circuit Judges, and Wyatt, District Judge.*fn*

Author: Wyatt

This is a joint appeal by related taxpayers (two corporations (who filed separate returns) and a husband and wife (who filed joint returns)) from three decisions of the United States Tax Court, each entered on October 13, 1978, and each based on the same opinion of the Tax Court (by Honorable Irene F. Scott, Judge), but each affecting different taxpayers. The opinion of the Tax Court is reported in 69 T.C. 925 (1978). The jurisdiction of this Court derives from 26 U.S.C. § 7482(a).

Appellants are David and Bertha Kluger, husband and wife, whose legal residence at all relevant times has been New York, New York; Kluger Associates, Inc. ("Associates"), a New Jersey corporation, whose principal place of business at all relevant times has been New York, New York; and Kluger, Inc. ("Inc."), a New Jersey corporation, whose principal place of business at all relevant times has been New York, New York. Associates and Inc. are personal holding companies as defined in 26 U.S.C. § 542(a). The venue in this Court is proper under 26 U.S.C. § 7482(b)(1). For some reason not made to appear, the taxpayers filed their returns, on which appellee (the "Commissioner") assessed deficiencies, with the district director of the internal revenue district for New Jersey rather than for New York, as would seem to have been the proper place for filing (26 U.S.C. § 6091, 26 C.F.R. § 31.6091-1). For the Klugers and for Inc. the years involved are 1967 and 1968; for Associates, the years involved are 1966, 1967 and 1968.

The principal issue is the adequacy of identification of shares of stock sold by the taxpayers, this affecting the cost of such shares in computing capital gains. The Commissioner determined that the identification was inadequate and, relying on a Regulation appearing at 26 C.F.R. § 1.1012-1(c)(1), applied the first in-first out method in calculating the cost of the shares sold. This lowered the cost of the shares sold, increased the capital gains, and resulted in the deficiencies assessed.

The second issue is whether, assuming that the identification of shares sold was inadequate and that the increase in capital gains was correct, the Commissioner was also correct in increasing the personal holding company taxes of Associates and Inc.

For the reasons hereafter given, we affirm the decisions of the Tax Court.


The taxpayers at all relevant times were in the business of buying and selling shares of stock in great volume for their own account. The shares were listed on an exchange, and the taxpayers bought and sold through brokers.

Shares of stock are represented by certificates, which are numbered for identification. Stock certificates are generally for 100 shares, but often there are certificates representing much larger numbers of shares.

The certificates for the shares were kept by taxpayers in their own custody, not in the custody of their brokers. The taxpayers had a suite of offices in New York City, and David Kluger directed their affairs. The stock certificates were kept in vaults in a bank near the offices.

There were many separate purchases of the same stock in the same company, each at a different time and for a different price. We are told that there were sometimes as many as forty different lots of the same stock. It would have been possible to identify the different lots by certificate numbers.

Many shares were acquired, not by purchase but by some form of capital change. There were stock splits and stock dividends. There were mergers of one company into another; at times a taxpayer owned shares of both companies. When there were mergers, new certificates for shares were issued. On stock splits, stock dividends, and mergers, large denomination (much larger than 100 shares) certificates were frequently issued. The taxpayers often exchanged smaller denomination certificates for a fewer number of large denomination certificates. Sometimes, on sale of part but not all of the shares owned in a given company (this being the usual sale), a large denomination certificate would be delivered and "change" received in the form of smaller denomination certificates.

The taxpayers maintained separate books of account which seem to have been accepted as accurately kept. A separate ledger sheet was kept for each corporation the stock of which was owned. Purchases of the stock were recorded on the top half of the ledger sheet, sales on the bottom half. On purchases, record was made of the date of purchase, number of shares and cost price per share. Sometimes record was made of the certificate numbers representing the shares purchased. The Tax Court found (69 T.C. at 928): "In many instances, however, the ledger sheets reflect no certificate numbers for the various blocks of stock purchased." Shares received on stock splits, stock dividends, and mergers were reflected on the ledger sheets but certificate numbers for these shares were not recorded.

Sales of stock for all the taxpayers were made by David Kluger by telephone instructions to the broker. In all instances here involved the number of shares sold were fewer than the shares owned. Having given the sale instructions, Mr. Kluger then selected the lot or lots from which the shares were to be sold. The selection was noted in writing by date of purchase and the cost price; naturally, the highest cost shares available were selected. The written document showing the selection was given to the bookkeeper. When confirmation of the sale was received from the broker, the number of shares, sale date, sale price and gain or loss were entered on the lower half of the ledger sheet.

In an attempt to identify on the books of the taxpayers the lots from which the shares were sold, a "key" number was placed on the stock ledger sheet next to the information concerning the sale. The key number was the number of the sale transaction in that particular stock, "1" for the first, "2" for the second, and so on. The same key number was placed next to the entries on the ledger sheet concerning the purchase lot or lots which Mr. Kluger had selected as the shares from which the sale was to be made.

Stock certificates had to be physically delivered to the broker to complete the sale. It appears to have been the uniform practice for Mr. Kluger himself to go to the bank vault, secure the certificates needed, and deliver them to the broker. If there were certificate numbers shown on the ledger sheet for the shares to be delivered, the bookkeeper furnished Mr. Kluger with a list of these numbers. If no certificate numbers were so shown, then, as the Tax Court found, "the bookkeeper had no way of knowing which certificates corresponded to that particular keyed sales transaction and could not, therefore, list any certificate numbers to furnish to Mr. Kluger" (69 T.C. at 930).

The Tax Court found that, where certificate numbers were shown on the ledger sheets and where, therefore, it was an easy matter to deliver the specific identified certificates in completion of the sale, nevertheless "as a general rule" Mr. Kluger "did not deliver the certificates whose numbers corresponded to the certificates shown by the . . . ledger sheets as having been sold . . ." (69 T.C. at 931, 933). The Tax Court concluded that the taxpayers "were primarily concerned with delivering the proper number of certificates and not with delivering the specific certificates representing the shares "keyed off' " (69 T.C. at 937).


The cost of shares sold is the basis for determining the capital gain or loss on the sale. 26 U.S.C. §§ 1011, 1012, 1016.

Where all the shares of a corporation owned by a taxpayer are sold at one time, normally it is not difficult to determine their cost. Where, however, the shares were acquired at different times and at different costs (either different purchase prices or different attributed costs, as on mergers, etc.) and fewer than all owned shares are sold, then there may well be a problem to determine the cost of the shares sold. It may be useful to relate in chronological order the more significant developments in the administrative and judicial treatment of this problem.

The earliest regulations, adopted in 1918, dealt with shares sold from lots bought at different times and prices where "the identity of the lots can not be determined". In such a case, it was provided that "the stock sold shall be charged against the earliest purchases of such stock" (Regulations No. 33 (revised), Art. 4, para. 60). This is the "first in-first out", or FIFO, principle.

In April 1935 the Supreme Court decided Helvering v. Rankin, 295 U.S. 123, 55 S. Ct. 732, 79 L. Ed. 1343. Turner, the taxpayer, inherited bonds, sold the bonds, opened a margin account with a broker, bought 1200 UGI shares, received 300 UGI shares as a stock dividend, sold 300 UGI shares, bought 1,000 UGI shares, sold 500 UGI shares, and finally sold 500 UGI shares. Turner was left with 1200 UGI shares. Turner never held any share certificates; they were held by his broker and were always in street names; the sales and purchases were recorded only by debits and credits to Turner's account on the books of the broker. It was thus impossible to identify by certificate numbers what shares were delivered against the sales and what 1200 shares remained. For such cases, the Supreme Court laid down an important rule favoring the taxpayer. Speaking for the Court, Mr. Justice Brandeis declared (295 U.S. at 128-29, 55 S. Ct. at 734):

The Commissioner contends that Turner's communication to his broker of his intention to keep 1,200 (UGI) shares . . . was ineffective to identify the shares to be sold, because, from the very nature of these marginal operations, the shares were incapable of identification by the broker or anyone else. The basis for this contention is the facts that in such transactions no certificate is issued in the name of the customer, or earmarked for or otherwise allocated to him; that all certificates are in the name of the broker or street names; and that all certificates for stock of the same kind are commingled and held by the broker for the common benefit of all dealing in that particular stock. The fallacy of this argument lies in the assumption that shares of stock can be identified only through stock certificates. It is true that certificates provide the ordinary means of identification. But it is not true that they are the only possible means. . . . Particularly is this so when, as here, the thing to be established is the allocation of lots sold to lots purchased at different dates and different prices. The required identification is satisfied if the margin trader has, through his broker, designated the securities to be sold as those purchased on a particular date and at a particular price. It is only when such a designation was not made at the time of the sale, or is not shown, that the "First-in, first-out" rule is to be applied.

Under the Rankin decision, where the certificates are held by the broker, a designation at the time of sale by the taxpayer, by date and price of purchase, of the shares to be sold, is a sufficient identification; it is not essential to ...

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