Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 79-80

1979-1 C.B. 86

Section 61
Section 162
Section 165
Section 451
Section 461
Section 1236

IRS Headnote

Broker-dealer; order errors and security differences; treatment. The treatment of certain gains, losses, and expenses resulting from order errors or security differences incurred by a broker-dealer is explained.

Full Text

Rev. Rul. 79-80

ISSUE

What is the proper federal income tax treatment of certain gains, losses and expenses resulting from order errors or security differences that a broker-dealer experiences, as described below?

FACTS

X, a domestic corporation using an accrual method of accounting, is a member of a national securities exchange and has a main office in state Y and branches throughout the country. X operates primarily as a stock broker in the purchase and sale of securities for customers. X also operates as a dealer in buying and selling securities for sale to customers.

Due to a tremendous volume of business, X, solely in its brokerage business, experiences certain security errors during its taxable year. These errors can be broken down into the general categories of order errors and security differences. X has expenses, gains, and losses that result from these order errors and security differences.

Order Errors

When a customer instructs X to purchase or sell a particular security, an order error can occur in any of the following ways:

Order errors not involving another broker:

1. X purchases the wrong security, leaving it short (short position) in the correct security and long (long position) in the wrong security. To correct the error, X must purchase the correct security and sell the wrong security.

2. X sells the wrong security, leaving it long in the correct security and short in the wrong security. To correct this error, X must sell the correct security and purchase a replacement for the security erroneously sold.

3. X purchases more or less than the correct number of securities. If X has purchased an excess number of securities leaving it long in the excess securities, it may correct the error by selling the excess. On the other hand, if X purchased less than the correct number of securities, it will purchase additional shares to correct the shortage.

4. X sells more or less than the correct number of securities. If X oversells, it will correct the error by repurchasing the excess. On the other hand, if X has sold less than the correct number of securities, it will sell the additional number.

Order errors involving another broker:

5. X was instructed to purchase securities and arranged to do so from another broker (OB). However, OB has no record and X has no written confirmation of the purchase. Thus, X is short those securities. X will immediately correct the mix-up by purchasing the desired securities.

6. X was instructed to sell securities and allegedly sold them to OB. However, X has no written proof of the sale, and OB informs X that it has no record of the sale. X is now long in those securities. To correct the error, X will sell the securities immediately.

7. X is informed by OB that it has purchased securities from the latter. Although X has no record of such purchase, OB has written proof. Thus, X must honor the purchase, leaving it long in those securities. If X cannot subsequently identify the customer for whom it purchased the securities after several days of research, it may sell them in the market.

8. X is informed by OB that it has sold securities to the latter. Although X has no record of the sale, OB has written proof. If X cannot identify the customer for whom it sold the securities before the settlement date, X is short in those securities. To correct the error, X will purchase such securities and deliver them to OB.

In all of these examples X realizes a gain or sustains an economic loss on each security as measured by the difference between its purchase or sales price at the time of the involuntary error and the purchase or sales price at the time of the correction of that error.

When X executes a customer order, it immediately sends the customer a confirmation slip. If a customer complaint involving order errors described in examples (1) through (4) is then received by X, it will confirm or deny the fact of its liability through research. If liability is confirmed, X will make a corrective bookkeeping adjustment in the customer's account and notify the customer of the correction. Occasionally X and a customer dispute which of them should be liable for an error and it becomes necessary for them to resort to a compromise or litigation to decide that dispute.

A customer will never detect the order errors described in examples (5) through (8), since they stem from inter-broker transactions and not incorrect entries in the customer's account. Thus, X will discover these order errors from information supplied by another broker.

After confirming its liability for one of the aforementioned order errors, X will postpone the correcting purchase and/or sale in the market usually for not more than 48 hours during which it will determine whether, with respect to another customer, it has detected a "long position" in the security to be purchased or a "short position" in the security to be sold. If X detects a short position in the same security in which it has detected a long position, it will correct the short position by selling the long securities to the customer or other broker to which the short position relates at the market price they would have paid if X had committed no error. Thus, X will sustain an economic gain or loss equal to the amount by which this market price is more or less than the amount X originally expended in purchasing the long securities.

If X cannot match the security to be purchased with a long position or the security to be sold with a short position, it will then execute the corrective purchase and/or sale in the market.

Security Differences

The second category of security errors consists of security differences. They are generally discovered through quarterly vault counts and by annual, unannounced audits by independent public accountants. Their common characteristic is that the quantity of securities actually in X's possession is out of balance with the quantity of securities that X's records indicate should be in its possession. These discrepancies have numerous causes, including (1) the transmittal of securities to transfer agents (TA) for recordation in X's or the customer's name that are subsequently not returned, (2) the mismatch of securities with computer cards by both X and TA, (3) the accidental receipt of securities from the TA that are owned by other brokers, (4) the transmittal to other brokers of the wrong securities resulting in a shortage in one security and an overage in another, (5) over-deliveries to other brokers or customers, (6) other bookkeeping errors, and (7) undetected order errors.

When a long security difference (securities possessed by X in which the owner is unknown) and/or a short security difference (securities X is supposed to have in its possession but can't locate) is established, an analysis phase begins for the purpose of discovering the error(s) that caused the security difference. When shortage-causing errors are located through analysis, appropriate corrective adjustments are made and no expenditure is required. Often it is possible to match a long security difference with a related short security difference. When this happens both differences are liquidated, and X nets one against the other. In analyzing and reconciling the various security differences, a point in time is reached when it becomes impractical to pursue the matter further. At this point X proceeds to liquidate the established short security differences that can neither be reconciled nor matched with related long security differences by buying in the short securities. Similarly, X proceeds to liquidate the established long security differences that can neither be reconciled nor matched by selling out the long securities.

LAW

Section 61 of the Internal Revenue Code of 1954 provides that gross income means all income from whatever source derived.

Section 162 of the Code allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 165(a) and (c) of the Code provides that a deduction is allowable for any loss sustained in a trade or business during the taxable year and not compensated for by insurance or otherwise. Section 165(b) indicates that losses deductible under section 165(a) are those resulting from the sale or other disposition of property. Section 165(f) provides that losses from sales or exchanges of capital assets are allowed only to the extent allowed in sections 1211 and 1212.

Section 1236(a) of the Code provides that in no event shall gain derived by a dealer in securities from the sale or exchange of any security be considered as capital gain unless, before the expiration of the 30th day after the date of its acquisition, the security was clearly identified in the dealer's records as a security held for investment and the security was not, at any time after the expiration of such 30th day, held by such dealer primarily for sale to customers in the ordinary course of the dealer's trade or business.

Section 1236(b) of the Code provides that loss by a dealer shall in no event be considered as an ordinary loss, if at any time after November 19, 1951, the security was clearly identified in the dealer's records as a security held for investment.

Section 1.451-1(a) of the Income Tax Regulations provides that under an accrual method of accounting, income is includible in gross income when all events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.

Section 1.461-1(a)(2) of the regulations provides that under an accrual method of accounting, an expense is deductible for the taxable year in which all the events have occurred that determine the fact of the liability and the amount thereof can be determined with reasonable accuracy.

Section 1.461-1(a)(3)(ii) of the regulations provides that when there is a dispute and the entire liability is contested, judgments on account of damages are deductions from gross income when the claim is finally adjudicated or is paid, depending upon the taxpayer's method of accounting.

SPECIFIC ISSUES:

1. (a) Are the securities that X mistakenly acquires as owner through errors and security differences ordinary or capital assets?

(b) How do the rules of gain and loss from such acquisitions and subsequent dispositions apply to X, a broker-dealer?

2. In the situations listed below, are X's expenses deductible (and if so when) under either section 162 or 165 of the Code?

(i) In correcting order errors not resulting in X's acquisition of a security as the owner.

(ii) In correcting order errors resulting in X's acquisition of a security as the owner.

3. Is the income that X realizes from securities represented by unreconciled long security differences ordinary income or capital gain and when must X include such income in gross income?

ANALYSIS AND HOLDING--ISSUE 1, (a) and (b)

Rev. Rul. 58-40, 1958-1 C.B. 275, holds, under several sets of circumstances involving the purchase and sale of stocks and other securities for ordinary business, as opposed to investment, purposes, that the gains or losses resulting from such sale are ordinary gains or losses. That Revenue Ruling states that in all such cases it is contemplated that the objectives for which the stock or securities are purchased are such as may be accomplished and the stock or securities disposed of within a relatively short time after their acquisition. In Rev. Rul. 78-94, 1978-1 C.B. 58, the Internal Revenue Service stated its position that even a predominant business motive for the acquisition of securities cannot preclude the owner from receiving capital gain or loss treatment on the sale or exchange of such securities, as long as there was a substantial investment motive for acquiring and holding the securities. In all of the situations discussed, X is acting as a broker (i.e., an agent) for a customer in buying or selling securities for the customer. X's mistaken acquisitions of securities either by order error or by an unexplained long security difference are without any investment motive, because in each situation X's intention is to perform a service for a customer and not to acquire ownership of a security or securities.

Section 1236 of the Code is drafted broadly to apply to any acquisition of a security by a dealer. It contains no restriction as to how the dealer acquired the security in question; that is, whether the acquisition was intentional, by error, or in what capacity the dealer acquired the security. Section 1236 is intended to preclude a dealer from treating a transaction as ordinary or capital, depending on whether a gain or loss is involved and which result is best for the dealer. Thus, even though X's mistaken acquisitions of securities by order error or by an unexplained long security difference arise in X's brokerage business, section 1236 can be interpreted to apply to X's acquisitions of these securities since X is a dealer.

Accordingly, gain or loss from such acquisitions or subsequent sales is ordinary gain or loss, provided X disposes of the securities within a relatively short time after the acquisition and section 1236 of the Code does not apply to require capital gain or loss treatment.

ANALYSIS AND HOLDINGS--ISSUE 2, Situation (i)

Expenditures to correct short security differences and order errors not resulting in X's acquisition of securities for its own account are ordinary, necessary, and business-related in origin. Expenditures to correct these short security differences and order errors (other than those that X ultimately settles by compromise or court action) are not incurred until X actually corrects the error by a purchase or sale in the market. Until that moment all events have not occurred to fix the amount of that expense with reasonable accuracy.

Expenditures to correct order errors that are settled by compromise are incurred when the parties agree to a compromise. American Hotels Corp., 46 B.T.A. 629, 631 (1942), aff'd on other grounds, 134 F.2d 817, 819 (2d Cir. 1943). Expenditures to correct order errors involving court action are not incurred until the controversy is finally adjudicated.

Accordingly, X may claim a deduction for those expenditures under section 162 of the Code rather than section 165, but only in the taxable year when X corrects the error by purchase or sale and in disputed cases when an offer in compromise is accepted or a court action is finally adjudicated.

ANALYSIS AND HOLDING--ISSUE 2, Situation (ii)

Expenditures incurred by X in committing and correcting order errors resulting in X's acquisition of securities as owner occur (1) when X purchases the wrong security; (2) when after selling the wrong security, X purchases replacement therefor; (3) when X purchases more than the correct number of securities; (4) when after selling more than the correct number of securities, X purchases replacements therefor; (5) when X purchases securities from another broker for a customer that it subsequently cannot identify; and (6) when X sells securities to another broker for a customer that it subsequently cannot identify. Such expenditures are not deductible under section 162 of the Code since they result in the acquisition of securities held solely for sale. Such expenditures are not depreciable under section 167 because the securities are not wasting assets. See, United States v. Georgia R.R. and Banking Co., 348 F.2d 278, 287 (5th Cir. 1965), and Exposition Souvenir Corp. v. Commissioner, 163 F.2d 283, 285 (2d Cir. 1947).

However, section 165(a) of the Code permits X to deduct the cost of all property acquired in the carrying on of a trade or business that is not deductible under section 162 and otherwise is not recovered upon disposition or from deductions such as depreciation. These securities acquired by X as owner as a result of order errors are neither capital assets under section 1221 nor property used in a trade or business under section 1231.

Accordingly, the gain or loss on the sale of the acquired securities will be ordinary unless the sale does not occur within a relatively short time after X confirms it has acquired a security for its own account and unless, in the case of gain, X meets the requirements of section 1236(a).

The foregoing discussion of order errors is illustrated by the following examples:

(1) X purchased the wrong security at $50 when the correct security was also selling at $50. Later, X rectified the error by purchasing the correct security at $51 and selling the wrong security at $48. X was authorized by its customer to purchase the correct security at its current price ($50). X mistakenly paid $1 more for the correct security than authorized, and this order error of $1 is deductible under section 162(a) of the Code.

X was not authorized by its customer to purchase the wrong security; thus, X became the owner of that security. The loss incurred of $2 ($50 minus $48) when X sold the wrong security is deductible under section 165.

(2) Instead of purchasing the correct security in example (1), suppose X rectifies the error by matching the customer with a correct security, contemporaneously acquired by X at $52 as a result of another order error. The loss incurred of $2 ($52 minus $50) when X sells the above security to its customer is deductible under section 165.

(3) X sold the wrong security at $60 when the correct security was selling at $70. Later, X corrected the error by selling the correct security at $68 and purchasing the wrong security at $63. X was authorized by its customer to sell the correct security at its current price ($70). X mistakenly sold the correct security for $2 less than authorized, and is obligated to reimburse its customer for this amount. This order error of $2 is deductible under section 162(a).

X was not authorized by its customer to sell the wrong security, and so its sale thereof was on its own account. The loss incurred of $3 ($63 minus $60) when X replaced the wrong security is deductible under section 165.

(4) X was instructed to purchase 80 securities, but mistakenly purchased 90 securities (at $15 per security). Shortly after discovering the error, X sold the excess of 10 shares at $14 per security. X was only authorized by his customer to purchase 80 securities, and so its purchase of the 10 additional securities resulted in X becoming the owner of those securities. The loss incurred of $10 ($150 minus $140) when X sold these 10 securities is deductible under section 165.

(5) X was instructed to purchase 10 of the same kind of securities involved in example (4), at $13 per share. Instead, X mistakenly purchased 10 of the wrong securities. Suppose that X rectifies the error by matching the customer in this example with the 10 excess securities involved in example (4). The loss incurred of $20 ($150 minus $130) when X sells such securities to its customer is deductible under section 165.

(6) X was instructed to purchase 50 securities, but mistakenly purchased only 40 securities (at $20 per security). Later, X corrected the error by purchasing 10 additional securities at $22 per security. X was authorized by its customer to purchase 50 securities at the current price ($20 per security). It mistakenly purchased 10 of the securities at $22 per security ($2 per security more than authorized), and this order error of $20 (10 X $2) is deductible under section 162(a).

(7) X was instructed to sell 65 securities, but mistakenly sold 75 securities (at $25 per security). Shortly after discovering the error, X corrects the error by purchasing 10 securities at $28 per security. X was only authorized by its customer to sell 65 securities, and so its sale of the 10 additional securities was a sale of securities it owned. The loss incurred of $30 ($280 minus $250) when X replaced these 10 securities is deductible under section 165.

(8) X was instructed to sell 110 securities, but mistakenly sold only 100 securities (at $30 per security). Later, X corrected the error by selling an additional 10 securities at $26 per security. X was authorized by its customer to sell 110 securities at the current price ($30 per security). It mistakenly sold 10 of the securities at $26 per security, $4 per security less than authorized, and is obligated to reimburse its customer for this amount. This order error of $40 (10 X $4) is deductible under section 162(a).

(9) X was instructed to purchase 10 securities, and arranged to do so with another broker (at $35 per security). However, the other broker had no record of the transaction, and X had no written documentation. X must now pay $40 per security to correct the error. X was authorized by its customer to purchase 10 securities at the current price ($35 per security). X had to pay $40 per security, $5 per security more than authorized, and this order error of $50 (10 X $5) is deductible under section 162(a).

(10) X is informed by another broker than X purchased 50 securities from the other broker at $45 per security. Although X has no record of such transaction, the other broker has written proof. X cannot identify the customer for whom it purchased the securities. Shortly after discovering the error, X sells the securities at $39 per security. Since X has no detectable customer authorization for the purchase of the 50 securities, the purchase made X the owner of the 50 securities. The loss incurred of $300 ($2,250 minus $1,950) when X sold the 50 securities is deductible under section 165.

(11) X was instructed to sell 20 securities, and arranged to do so with another broker (at $50 per security). However, the other broker has no record of the transaction, and X has no written documentation. X sells the 20 securities at $43 per security to correct the mix-up. X was authorized by its customer to sell 20 securities at the current price ($50 per security). X sold the 20 securities at $43 per share, $7 per security less than authorized, and is obligated to reimburse its customer for this amount. This order error of $140 (20 X $7) is deductible under section 162(a).

(12) X is informed by another broker that X sold 10 securities to the other broker at $60 per share. Although X has no record of such transaction, the other broker has written proof. X cannot identify the customer for whom it sold the securities. X purchases 10 shares at $68 per share in order to satisfy its obligation to the other broker. Since X has no detectable customer authorization for the sale of the 10 securities, the purchase and sale of the 10 securities involved securities owned by X. The loss incurred of $80 ($680 minus $600) on the purchase and sale of the 10 securities is deductible under section 165.

ANALYSIS AND HOLDING--ISSUE 3

Although X physically possesses the long securities (LS's) represented by long security differences at the time of their discovery, for the reasons that follow their value is not includible in X's gross income at that time or for a reasonable time thereafter while X researches the source of those differences. First, X never asserts dominion over LS's as its own until further research to reconcile those differences is useless. Until that time, LS's are treated as unclaimed securities owned by others. Second, a review of the errors from which they stem suggests that most of the value of LS's is not potential income. After research of the sources of the errors a substantial part is eliminated by discovery of the causes of the errors. Thus, prior to the research and a decision to assert dominion over the LS's, the amount involved cannot be determined with reasonable accuracy within the meaning of section 1.451-1(a) of the regulations.

Accordingly, (1) In accordance with sections 61 and 1236 of the Code X must include in gross income as ordinary income the value of securities represented by LS's when further research as to ownership is impractical. X's decision that further research is impractical should be evidenced, as for example, by an instruction to its floor member or appropriate employee to sell the excess securities. However, X's action in determining the proper time to assert ownership of the securities will not always be binding for tax purposes, particularly if the choice of that time is not supported by the surrounding facts and circumstances.

(2) When X actually sells LS's, it will realize additional gain or loss, depending on whether the sales price is greater or lesser than the value of the securities that X previously included in income. The additional gain or loss will be ordinary income or loss, provided X disposes of the securities within a relatively short time after it is reasonable to assume that a "sell" instruction should have been issued and the requirements of section 1236 of the Code do not apply to require capital gain or loss treatment.