Burke Grain Co. v. Commissioner

*334 This proceeding involves a determination of deficiencies in income and excess profits taxes for the petitioner's fiscal year ended July 31, 1933, in the amounts of $261.99 and $122.14 respectively, and a claimed overpayment in the amount of $1,105.14. The only issue is whether the petitioner is entitled to deduct a loss from embezzlement in the taxable year.

FINDINGS OF FACT.

The petitioner is, and was during its fiscal year ending July 31, 1933, a corporation organized under the laws of the State of Lowa, with its*1050 principal place of business in Sioux Falls, South Dakota. It carried on a general brokerage business in commodities and securities. It was a nonclearing member of the Chicago Board of Trade.

In purchasing securities and commodities for its customers the petitioner required a deposit or margin. Commissions were not charged to the customers at the time of purchase of commodities but only when the particular transaction was completed by a sale. At that time the account would be settled with the customer by deducting the commission and loss, if any, and paying over to him the remainder of his deposit and the profit, if any, unless the customer *335 desired to leave his balance with petitioner for further trading. The petitioner purchased commodities for its customers through a Chicago correspondent who was a clearing member of the Chicago Board of Trade. This correspondent charged the petitioner's account with the full amount of the commissions charged to customers, and at monthly intervals credited back to petitioner one-half of such commissions and rendered a complete statement of transactions for the period.

Since petitioner was not a member of the New York Stock*1051 Exchange it did not charge commissions for buying and selling securities thereon but only a service charge which was computed by petitioner's president for each purchase and sale. When a stock was sold the service charge and tax were deducted, together with the loss, if any, and the balance of the customer's margin and the profit, if any, were paid to the customer or retained for his account.

Petitioner's earnings from service charges and commissions were correctly entered on its books. Its gross profits for the fiscal year ending July 31, 1933, totaled $48,007.27.

From 1927 to 1935 one John Gallagher was employed as bookkeeper and cashier by petitioner. He is the husband of a sister of S. A. Burke, the latter being president and owner of 90 percent of the stock of petitioner. During petitioner's fiscal year ending in 1933 Gallagher embezzled $11,000 of the petitioner's funds. His method was to appropriate part or all of deposits or margin payments received by him from customers, entering on the cash receipts book only the amount remaining after the theft but entering in the customer's ledger account the amount actually received. A control account of the amounts payable*1052 to customers purportedly based upon the ledger accounts was actually taken from the journal entries, so that the difference between this control and the ledger accounts represented the amount embezzled.

The embezzlement was discovered in late 1934, and petitioner notified its correspondent and the Chicago Board of Trade and asked that an audit be made by them. Upon completion of this audit in the early part of 1935 the Board of Trade required that petitioner obtain $60,000 additional capital to cover the defalcations, which extended over several years, and to reestablish solvency. This capital was immediately contributed by petitioner's principal stockholder, S. A. Burke.

The petitioner had no bond to cover the theft. No recovery was possible against the embezzler, as both he and his wife were without assets, and he has been unable to obtain employment since his discharge except for a few odd gardening jobs. He and his family are supported by three of his children. No claim against him was ever set up as an asset on petitioner's books.

*336 The petitioner has not in any tax year claimed or been allowed a tax deduction by reason of this embezzlement.

Petitioner's*1053 business and corporate records were taken over in 1937 by a successor corporation, Burke & Co., which in January 1938 was adjudicated a bankrupt and a trustee appointed.

OPINION.

OPPER: Petitioner, a corporation engaged in the brokerage business, claims an overpayment on the ground of a loss suffered through embezzlements which, although occurring in the tax year, were not in fact discovered until approximately two years later. Respondent resists the claim upon three principal grounds - first, that the loss was not sustained in the tax year because the funds embezzled were margin deposits made by petitioner's customers and therefore trust funds, and on the authority of John H. Farish & Co. v. Commissioner, 31 Fed.(2d) 79, and similar cases the loss was not sustained unless and until restitution had been made by the taxpayer; second, that no acceptable proof of the amount of the loss appears in the record; and, third, that any loss sustained was compensated for by a payment made to petitioner by its principal stockholder.

The first argument rests upon the erroneous assumption of law that a margin deposited by a client with a broker creates a trust relationship. *1054 The rule on this subject, as stated in Meyer on "The Law of Stock Brokers And Stock Exchanges" (p. 252), is that "with respect to funds entrusted to the broker for the purchase of securities on margin, or as collateral to secure a marginal account the broker becomes the debtor of his customer and not the trustee, and is at liberty to mingle them with his own funds and use them for his own purposes." The same rule extends to the proceeds of short sales. Idem.The cases sustaining these propositions are decisions of the courts of New York State. We have been referred, however, to no contrary authority under the law of Iowa, of South Dakota, or of any other jurisdiction, and as was said by the Supreme Court in Richardson v. Shaw,209 U.S. 365, 377 (a case cited by respondent although for a different proposition), "The rule thus established by the courts of the state where such transactions are the most numerous, and which has long been adopted and generally followed as a settled rule of law, should not be lightly disturbed * * *." There is an apparent conflict between the so-called Massachusetts rule and that more generally accepted as to the location of title*1055 to securities held under a margin arrangement. Richardson v. Shaw, supra.But whether title to the securities is considered to be in the broker or in the purchaser does not affect the conclusion that as to any balance of accounts the relationship between broker and client is that of debtor and creditor. Hammon v. Paine, 56 Fed.(2d) 19, 22, 23; *337 Lavien v. Norman, 55 Fed.(2d) 91, 93; People v. Thomas, 83 (N.Y.)App.Div. 226; 82 N.Y.S. 215, 219. This outcome is not impaired by the testimony of petitioner's president. He stated that the margin payments were "very similar, I would say, to a deposit in the bank," For these reasons we consider the doctrine exemplified by the Farish case to be inapplicable and conclude that on this point the proceeding before us is governed by Peterson Linotyping Co.,10 B.T.A. 542; Southern School-Book Depository, Inc.,10 B.T.A. 930; Piggly Wiggly Corporation,28 B.T.A. 412, and *1056 Gottlieb Realty Co.,28 B.T.A. 418, in which it was determined that a loss by theft or misappropriation is deductible in the year when the act takes place, regardless of the time of discovery. Parker Wire Goods Co.,8 B.T.A. 448, 453.

The second contention advanced by respondent arises collaterally from a requested ruling upon evidence. Depositions of the embezzler introduced at the hearing were received without being read into the record upon the understanding that all questions as to the admissibility of such testimony would be taken under advisement and ruled upon as part of the present decision. Respondent objects to the receipt of testimony so given in so far as it relates to the amount of the loss. His position is that the petitioner's books were the best evidence and that failure to produce them or satisfactorily explain their absence precludes receipt of secondary proof. While this position may be supportable with respect to questions concerning the contents of the books, the matter at issue here is a fact as to which the embezzler himself necessarily was in possession of personal knowledge, and as to which the books themselves would*1057 be purely corroborative. His testimony was not limited to the detailed schedule of peculations for which petitioner's books may have been the original source, but he was also asked:

Q. Mr. Gallagher without reference to petitioner's exhibit 1 at all, are you able to testify as to approximately how much money you extracted and stole from the Burke Grain Company during the period between July 31, 1932 and ending July 31, 1933?

This in our view was admissible without doing violence to the "best evidence" rule. Meade v. Keane, 16 Fed.Cas.No. 9373; affd., 3 Pet 1; Stern v. Local Board of Review, 135 Iowa, 539; 113 N.W. 339. It seems sufficient to shift the burden of going forward to the respondent, and, in the absence of contrary evidence, to justify our finding of fact that the amount of the loss was $11,000.

Finally, we are unable to conclude that payment made by petitioner's principal stockholder was a compensation for the loss. He *338 testified that the payment was a "capital assessment" and that "We had to have*1058 that much money to make the company solvent and have that much working capital which the Board of Trade required * * * and we charged the loss up to capital." While it is clear that the payment could not have been a loan since the solvency of petitioner would not thereby have been improved, the evidence justifies the conclusion that it was a capital contribution. The result would be to leave the petitioner worse off by the amount of the loss even though liability to the stockholder was represented by the increase in his capital account instead of by a loan. And from the standpoint of the stockholder the funds so contributed are to be regarded as an additional investment in the stock and do not justify any claim to a loss on his part. W. F. Bavinger,22 B.T.A. 1239; cf. Daniel Gimbel,36 B.T.A. 539, 542. In addition, of course, the contribution was made long after the tax year, and apparently without any legal obligation to do so.

For the foregoing reasons we conclude that petitioner sustained an uncompensated loss of $11,000 in the present tax year and that it is entitled to the benefit of a deduction therefor.

Decision will be entered under*1059 Rule 50.