17 T.C. 210">*210 The respondent determined a deficiency in income tax for the year 1946 in the amount of $ 86,253.32. He determined that the gain from the sale of cattle in 1946 was taxable as ordinary income and was not capital gain under section 117 (j) of the Internal Revenue Code. In the alternative, respondent has raised affirmatively an issue under section 130 of the Internal Revenue Code resulting in a deficiency in income tax for1951 U.S. Tax Ct. LEXIS 107">*109 the year 1946 in the amount of $ 96,863.87. His theory on the alternative issue is that, if the gain from the sale of such cattle is capital gain under section 117 (j), only one-half of that gain is includible in petitioner's gross income in a recomputation under section 130; and that, since such a recomputation shows that petitioner had losses exceeding $ 50,000 in the operation of his dairy farm in 1946 and in each of the 4 years immediately preceding 1946, section 130 is applicable. Other adjustments in the statutory notice of deficiency are uncontested.

FINDINGS OF FACT.

Petitioner is an individual residing in Cortland, New York, and filed his income tax return for the calendar year 1946 with the collector of internal revenue for the twenty-first district of New York at Syracuse, New York.

17 T.C. 210">*211 Petitioner was, during the year 1946, the owner of a dairy and breeding herd of pure bred Guernsey cattle which he started developing in the year 1933. In 1946 petitioner had a herd of 523 Guernsey cattle on his 1500-acre farm which was located near the Town of Cortland, New York. It was one of the best herds of Guernsey cattle in the United States.

Petitioner sustained a loss 1951 U.S. Tax Ct. LEXIS 107">*110 from the operation of his herd each year from 1938 to and including 1946. During 1946, and for several years prior thereto, petitioner purchased cattle and added them to his herd and during the same period petitioner sold cattle from his herd including not only offspring of his herd, but also cattle which he had purchased previously. Petitioner kept a breeding list book, a herd book, and a cattle sales and purchase book, wherein was kept a record of the date of birth of all cattle born on petitioner's farm and the date of purchase and age of all cattle purchased by petitioner. The following table shows the sale of milk and animals from petitioner's herd during 1946:

1951 U.S. Tax Ct. LEXIS 107">*111 For the years 1938 through 1947, inclusive, petitioner's herd contained 179, 222, 336, 386, 395, 462, 487, 484, 523, and 509 animals, respectively.

During the year 1942 petitioner sold 81 raised animals for a total consideration of $ 39,923.92 -- 31 were bull calves born in 1941 and 14 were bull calves born in 1942; in 1943 petitioner sold 125 raised animals 17 T.C. 210">*212 for a total consideration of $ 99,594.41 -- 41 were bull calves born in 1942 and 30 were bull calves born in 1943; in 1944 petitioner sold 116 raised animals for a total consideration of $ 122,414.23 -- 31 were bull calves born in 1943 and 20 were bull calves born in 1944; and in 1945 petitioner sold 120 raised animals for a total consideration of $ 98,414 -- 43 were bull calves born in 1944 and 26 were bull calves born in 1945.

During the years 1942 through 1946, inclusive, petitioner had milk sales of $ 39,649.61, $ 50,383.66, $ 71,047.30, $ 72,947.27, and $ 82,841.65, respectively.

During the years 1944 through 1946 petitioner's gross income from the sale of calves and cows sold to slaughterers or held less than six months was $ 5,586.73, $ 1,323.27, and $ 1,166.02, respectively. Such sums were reported as ordinary1951 U.S. Tax Ct. LEXIS 107">*112 income.

Petitioner has, through the years, attempted to increase the quality of his herd. He has no predetermined number of cattle in his herd and no predetermined number of the offspring of such cattle that are to be sold each year. The number of raised animals sold each year, including 1946, depended upon their quality as evidenced by their inheritance, their formation, and, additionally, in the case of heifers, their milk production.

The first step in the decision to sell raised animals is to dispose of calves that do not have proper inheritance. Petitioner knew that the cow that gave birth to these calves did not have proper inheritance, but she is bred to "get her back in milk again" even though her calves will not be kept. These calves were sold to a slaughterer within two to five days after birth and petitioner reported the proceeds from such sales as ordinary income. The remainder of the calves were entered in the herd book. After the animals, which were not sold to a slaughterer, attained the age of 7 months, they were studied from time to time and those showing characteristics which made them unsatisfactory, in petitioner's opinion, for retention in petitioner's herd. 1951 U.S. Tax Ct. LEXIS 107">*113 were sold. Petitioner retained many more heifers than bulls. These animals were not sold to slaughterers but were sold to other breeders as breeding animals. They sometimes became top animals in other herds, which do not have standards as high as those of petitioner's. Petitioner's herd has been top in classification for several years.

Petitioner, in a further effort to improve the quality of his herd, also purchased animals from other herds to get new blood. During the years 1944 through 1946 petitioner added 13, 12, and 19 animals, respectively, to his herd at a total purchase price of $ 17,950, $ 19,075, and $ 29,035, respectively.

In selective breeding petitioner was unable to tell until a bull was about 5 years old just how good he was as a sire. The first calves are born when the bull is about 2 years of age. Then these calves have 17 T.C. 210">*213 to be raised and produce calves. The second generation of calves have to have a year of production, at least, before it is known just how good the sire is. The only definite way to prove how good a bull is as a sire is after he has sired a large number of calves. In order to determine whether a cow came up to the standards required1951 U.S. Tax Ct. LEXIS 107">*114 by petitioner, namely, good milk production and good transmitting characteristics, petitioner had them in milk production at 2 years of age. Before he could definitely tell how good a cow was at transmitting the good characteristics he required, the cow might be 8 years of age, or older. If her first calf happened to be a heifer, he would have some idea by the time she reached 4 or 5 years of age. If she happened to have bull calves the first two or three times, then she might be 8 or 9 years old before petitioner had any idea just how good she was as a transmitting female.

The quality of petitioner's herd improved over the years as shown by an increase in average milk production per cow by 50 per cent without an increase in the amount of feed used prior to such increased milk production. In addition thereto, the cows in petitioner's herd produced milk economically and reproduced calves at from 12 to 14 years of age. Some of the physical characteristics which were considered by petitioner in determining whether the raised animal should be incorporated into the herd and which were studied as the animal developed were: the brightness of the eyes; the size of the muzzle; the width1951 U.S. Tax Ct. LEXIS 107">*115 of the nostrils; the length of the neck; the sharpness of the shoulders; the depth of the chest and the spring of the ribs; the straightness of the back; the width and level of the rump; and, in the case of cows, the size of the udder and its firm attachment to the body. The animals that did not measure up to the degree of perfection sought were sold because their retention as breeding animals would produce calves that were below standard and the quality of the herd and volume of the milk produced would be quickly lowered.

In the herd book kept by petitioner, a calf was recorded at birth showing its pedigree. The herd book showed three generations but a supplementary book showed six generations. In the sales book petitioner reported the sale of all animals sold by him whether raised or purchased. Upon the sale of a raised animal, all monies received from such sale were recorded as earnings during the year of sale. Petitioner did not inventory his raised cattle.

During the year 1946, about 15 bulls were being bred to cows that were in the herd. About 20 bulls at that time were leased out to various farm breeders in order to determine the caliber of their progeny. In 1946 all1951 U.S. Tax Ct. LEXIS 107">*116 but two of the bulls used for breeding were raised animals. One of the two had been raised, had been sold, and had been repurchased.

17 T.C. 210">*214 In petitioner's herd about 80 per cent natural service and 20 per cent artificial insemination is used. Over a period of 15 years, 51 per cent of petitioner's calf crop is males and 49 per cent females. In a breeding herd it is more important to eliminate bulls sooner than heifers because the numerous progeny of the bulls, if not up to standard, will transmit these traits into the herd. A long-lived cow will have 10 progeny while a bull in natural service will leave up to 500. By artificial insemination the number may be increased to 1,000. The American Guernsey Cattle Club recognizes that a Guernsey bull is capable of breeding at 9 months. A Guernsey cow can be bred at 12 months but in petitioner's herd they weren't usually bred until they were 14 months old.

The tendency of all nature is toward an average, and selective breeding is therefore a continuous operation. In petitioner's herd 15 per cent of the cattle are classified as excellent and 50 per cent very good.

In 1946 there were over 200 calves born on petitioner's farm. A large1951 U.S. Tax Ct. LEXIS 107">*117 percentage of the bull crop was disposed of by petitioner in each year. The heifers were also disposed of if they developed characteristics not wanted by petitioner. In 1946 petitioner sold to slaughterers 28 of the 1946 calves and 15 raised animals born prior to 1946. He sold to other than slaughterers 22 of the 1946 bulls and one 1946 cow, 55 of the 1945 bulls and 13 of the 1945 cows, and some others born in years prior to 1945.

The cattle raised by petitioner which were not sold until they were more than 24 months old and all of the cattle purchased by petitioner, held for more than six months, and incorporated into his herd, were held by petitioner primarily for breeding and milk-producing purposes. The raised cattle aged 24 months and less, which were sold by petitioner during the taxable year, were held primarily for sale to customers in the ordinary course of business.

OPINION.

The first issue in this proceeding is the factual question as to whether cattle raised or purchased by petitioner, and held for longer than six months before sale were part of his breeding or dairy herd or were held primarily for sale to customers in the ordinary course of business. Petitioner contends1951 U.S. Tax Ct. LEXIS 107">*118 that the gain on such sales is taxable at capital gains rates pursuant to section 117 (j) of the Internal Revenue Code. ¹

17 T.C. 210">*215 Respondent determined that the gain from the sale of both the raised and the purchased1951 U.S. Tax Ct. LEXIS 107">*119 cattle was taxable as ordinary income. With respect to the purchased cattle, the testimony adduced at the trial shows that such cattle were an integral part of petitioner's herd and were brought into the herd to inject new blood into it. Respondent submitted no evidence to the contrary and, on brief, made no mention of the purchased cattle. It seems clear, and we hold, that the cattle purchased by petitioner, held for more than six months, and sold in 1946 were held by petitioner primarily for breeding and milk producing purposes and the gain from their sale is taxable at capital gains rates. Albright v. United States (C. A. 8, 1949), 173 F.2d 339.

With respect to the cattle raised by petitioner, held for more than six months, and sold in 1946, the case of Walter S. Fox, 16 T.C. 854 (1951), is determinative.

Of the 138 animals sold in 1946 which had been raised on petitioner's farm, entered into the herd book, and held for more than six months, at least 83 and possibly a greater number were never actually incorporated into petitioner's herd. These 83 animals comprised the bull calves and young bulls that were1951 U.S. Tax Ct. LEXIS 107">*120 disposed of in that year. While there was always the possibility that any individual bull calf might ultimately become a part of petitioner's breeding herd, it is obvious that most of the bull calves born would be sold whether they were good enough for petitioner's herd or not. During the year 1946, only 15 breeding bulls were a part of petitioner's herd. About 20 bulls were leased out at that time to various breeders in order to determine the caliber of their progeny. About 100 bull calves were born each year and it is apparent that petitioner never expected or intended to incorporate into his breeding herd all bull calves born on the farm.

Applying a formula similar to that used in the Walter S. Fox case supra, we conclude that, with respect to the raised cattle, only those over 24 months of age when sold are to be considered as having been part of the herd. The remainder of the raised cattle which were sold in 1946 (24 months of age or less) were held primarily for sale to customers in the ordinary course of petitioner's trade or business and the proceeds from such sales are not entitled to capital gains treatment under section 117 but must be reported as ordinary 1951 U.S. Tax Ct. LEXIS 107">*121 income.

The respondent argues that, since petitioner operated at a loss for each year from 1938 to and including 1946, whether section 130 applies to petitioner depends on the amount of income which is includible in 17 T.C. 210">*216 "gross income" as that term is used in section 130 (a) of the Code. ² He states that the question is also whether any part of the gain realized from the sale of cattle as capital gain is "derived from" a trade or business carried on by the taxpayer, and, in making the recomputation under such section, whether any part of such gain is "attributable to" the trade or business. He concedes that section 130 does not apply if the total gain on the sale of cattle is includible in gross income for the purpose of determining the amount of the loss for each year of the 5-year period required by the section.

1951 U.S. Tax Ct. LEXIS 107">*122 Respondent states in his brief:

Petitioner has argued that he is in the dairy business or the business of producing milk. Under this theory it would seem that none of the gain realized from the sale of cattle which is taxable as capital gain is to be included in gross income "derived from" or "attributable to" petitioner's trade or business. The additional deficiency asserted in the amended answer is predicated on this theory. In any event, it is respondent's position that inasmuch as [if] under Section 117 (j) only one-half of the income derived from the sale of certain animals is subject to tax then this lesser amount is to be used in determining petitioner's net income under Section 130.

In support of his alternative position respondent cites United States v. Benedict, 338 U.S. 692">338 U.S. 692 (1950), and Emma B. Maloy, 45 B. T. A. 1104 (1941). However, because of our decision on the first issue (that petitioner realized both ordinary income and capital gain on the sale of animals) and because the record does not show that the loss sustained by petitioner (on the basis of such decision) exceeded by more than $ 50,000 the1951 U.S. Tax Ct. LEXIS 107">*123 gross income derived from his trade or business in 1946 and each of the four preceding years, section 130 has not been shown to be applicable and on this issue we hold for petitioner.

Decision will be entered under Rule 50.