Bentex Oil Corp. v. Commissioner

Bentex Oil Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent Bentex Oil Corp. v. Commissioner Docket No. 27450 United States Tax Court 20 T.C. 565; 1953 U.S. Tax Ct. LEXIS 134; 2 Oil & Gas Rep. 1469; May 29, 1953, Promulgated *134 Decision will be entered under Rule 50. Held, the organization, of which petitioner was a member, was a joint venture or partnership engaged in an oil drilling operation, which joint venture was entitled to an election either to deduct as necessary expenses or to capitalize intangible drilling costs. Marvin K. Collie, Esq., and C. E. Bryson, Esq., for the petitioner. J. Marvin Kelley, Esq., and Paul M. Newton, Esq., for the respondent. Van Fossan, Judge. VAN FOSSAN *566 Respondent determined deficiencies in income and excess profits taxes of the petitioner for the taxable years 1942, 1944, and 1945, as follows: Deficiency Year Excess Income tax profits tax [1942] $ 2,960.03 [1944] $ 42,853.92 [1945] 27,776.63 Petitioner alleges error only as to foregoing deficiencies*135 in excess profits tax determined for the years 1944 and 1945. The primary question presented is whether petitioner, in computing its excess profits credit for the years involved, is entitled to capitalize intangible drilling and development costs incurred and paid by Benedum-Trees Oil Company (Puig Operations) and deducted by it in 1938 and 1939, in computing the distributable income or loss on that operation. The allowance of deductions in the years 1937, 1938, and 1939 of intangible drilling and development costs, with respect to Hiawatha Oil and Gas Company Joint Venture, Duval County, Texas, and Benedum-Trees Oil Company, Troy Field Joint Venture, Nevada County, Arkansas, in the computation of petitioner's excess profits credit for the years before us, as set forth in the statement attached to the Commissioner's notice of deficiency, is not in controversy in this proceeding. If the expenses in question are capitalized the petitioner's base period net income for 1938 and 1939 must be increased and a corresponding increase must be made in its excess profits credit. The respondent, in his amended answer, has alleged that the petitioner is here taking a position with respect to *136 expensing the drilling and development costs of the Puig Lease Operations inconsistent with that taken by it in 1938 and 1939. The respondent has further alleged that should petitioner's present position be sustained, it will then owe additional income tax for the years 1938 and 1939 in amounts not less than $ 5,777.31 and $ 149.41, respectively, plus interest, which amounts respondent claims under section 734 of the Internal Revenue Code. Petitioner admits the inconsistency of its current position and concedes that if such present position be upheld, the foregoing claims by respondent are proper and correct. *567 FINDINGS OF FACT. The petitioner, Bentex Oil Corporation (sometimes herein called Bentex), is a corporation organized September 10, 1936, under the laws of the State of Texas. Petitioner maintains its principal office and place of business in Houston, Texas, and has, since its organization, been engaged in the business of producing oil and gas and other petroleum products. The income and excess profits tax returns of petitioner, for the years here concerned, were filed with the collector of internal revenue for the first district of Texas, at Austin, Texas. Upon *137 its organization, the petitioner acquired the full working interest in a lease known as the Harmon Lease. Development thereof was commenced in the latter part of 1936 by petitioner. It incurred and paid intangible drilling and development costs in the amount of $ 27,881.05. Such costs were capitalized in petitioner's 1936 income tax return pursuant to its exercise of the election provided in the pertinent regulations. In 1937, the petitioner, with Benedum-Trees Oil Company, a corporation (sometimes herein called the Company), and M. E. Davis, jointly acquired and became the coowners of an oil and gas lease on lands in Duval County, Texas, known as the Puig Lease, their respective interests being two-eighths, five-eighths, and one-eighth. Such ownership continued in 1938 and 1939. After exploration, production of oil was obtained upon the Puig Lease. The wells thereon were drilled by drilling contractors. A certain percentage of the oil so produced was assigned to the drilling contractor in 1938 and 1939, and the pipe line company paid it $ 27,100.20 and $ 50,908.38, respectively, in those years. The petitioner, the Company, and M. E. Davis joined together for the purpose of operating*138 the Puig Lease for profit, and, by virtue of such operation, the owners thereof shared the income and losses in proportion to their respective interests in the venture. That venture has been carried on as a business operation from 1937 up to the present time. The coowners had no formal agreement or definite arrangement with respect to the exploration or operation of the lease. Such agreement as existed was entirely oral. As a matter of procedure, the parties would orally agree periodically regarding the drilling or deepening of a particular well. No coowner could force or commit another coowner to undertake any exploration or operation. Any party could dissent with respect to an action and abstain from participation therein. Each sold his or its share of the production directly to and received the proceeds therefor directly from a purchaser. At no time did any coowner have the authority to sell any *568 other coowner's share of the production nor did any coowner actually sell another's share. Subject to a termination at the will of each coowner, the Company received bills for the expenses incurred in the operation and development of the Puig Lease, and at the end of each*139 month billed the other coowners for their respective parts for such expense and thereupon was reimbursed. Petitioner kept its own books on the income and expenses involved. A partnership return of income for the year 1937 was filed with the respondent on Form 1065 in the name of Benedum-Trees Oil Company, Duval County, Texas (Puig Operations). In that return it is stated that the nature of the organization is a "joint venture." Also, in that return, a gross profit of $ 70,548.76 was reported and deductions of $ 131,243.41 were claimed. Among the deductions taken were the following: Accrued interest $ 2,781.30 Depreciation 2,385.19 Depletion 3,143.13 Drilling expenses (intangible drilling and development) 122,581.93 The net loss thus reported was $ 60,694.65. This loss was distributable to the members of the joint venture in proportion to their respective interests. This partnership return for the year 1937 was not examined by the respondent or his agents. A partnership return of income (Form 1065) for the year 1938 in the name of Benedum-Trees Oil Company, for the Puig Lease Operations, was filed with the respondent. In that return it was stated that the nature*140 of the organization was a "joint venture." In the return for 1938 a gross profit of $ 272,551.56 was reported. Among the deductions taken on the return were the following: Interest on indebtedness $ 1,254.80 Taxes 5,336.58 Accrued interest 13,453.25 Depreciation 7,911.14 Depletion 77,862.76 Drilling expense 191,676.39 The return showed a loss of $ 25,096.72 which was distributed to the partners as shown in Schedule J thereof. A similar return was filed with the respondent for the year 1939 for the Puig Lease Operations. Again, in this return, it was stated that the nature of the organization was a "joint venture" and a gross profit of $ 242,518.76 was reported. Among deductions claimed therein were the following: Interest on indebtedness $ 6,938.08 Taxes 17,495.84 Loss on sale of capital assets 38.67 Depreciation 16,981.85 Depletion 70,294.10 Drilling expenses 32,259.51 *569 The return showed ordinary net income of $ 99,098.92 distributable to the partners as shown in Schedule J thereof. The foregoing partnership returns were filed on the Puig Lease Operations upon the advice of counsel that the then rulings of the respondent required such filing*141 and treatment. These rulings were later modified. The partnership returns for the years 1938 and 1939 were examined by respondent's agents, and the intangible drilling and development expenses claimed as deductions in the returns were, at first, disallowed. At a later date, after protest of the petitioner and the Company, this action was reversed by respondent and the deductions so claimed for intangible drilling and development costs were allowed in determining the distributable income or loss of the coowners. One-fourth of the intangible drilling and development costs of the Puig Lease Operations (petitioner's share) for the years 1937, 1938, and 1939 was $ 30,645.47, $ 43,342.04, and $ 7,974.08, respectively. The petitioner, in a protest dated September 8, 1942, contested the disallowance by the respondent of the intangible drilling and development costs of Hiawatha Oil and Gas Company Joint Venture; Benedum-Trees Troy Field Joint Venture; Benedum-Trees Puig Lease Joint Venture for the years 1938 and 1939; and Plymouth Oil Company Joint Venture for the years 1938 and 1939. Benedum-Trees Oil Company, one of the parties in Benedum-Trees Oil Company (Puig Lease Operations) in an*142 amendment to protest dated June 1, 1942, referred to Benedum-Trees Oil Company (Puig Lease Operations) as a partnership and stated: The partnership entered into certain drilling contracts with Henderson Coquat for the drilling of a number of wells on land held under lease by the partnership on what is known as the Puig Lease, Duval County, Texas. These contracts were similar to those considered in the Revenue Agent's Office in the Hiawatha Oil and Gas Company, Duval County, Texas, Joint Venture. The controversy that subsequently developed between the petitioner and respondent and between the Company and the respondent, as to whether the intangible drilling and development costs of Hiawatha Oil and Gas Company Joint Venture, Benedum-Trees Troy Field Joint Venture, Benedum-Trees Puig Lease Joint Venture, and Plymouth Oil and Gas Company Joint Ventures were allowable as deductions in arriving at the distributable income or loss of the several ventures, was settled on the basis that the first three ventures named were partnerships and that their intangible drilling and development expenses were to be allowed as deductions. The intangible *570 drilling costs of Plymouth Oil and *143 Gas Company venture were to be capitalized. There was no formal compromise or closing agreement executed with respect to the foregoing settlement. The petitioner filed corporation income and excess profits tax returns for the years 1942, 1943, 1944, and 1945. In the return for 1942 the excess profits tax was computed on the invested capital credit method. Such tax, in the returns for 1943, 1944, and 1945, was computed on the income credit method. In his notice of deficiency, respondent computed the excess profits tax on the invested capital credit method inasmuch as such method allowed petitioner a larger excess profits credit. The organization known as the Puig Lease Operations was a joint venture or partnership. OPINION. The ultimate question for decision is whether the petitioner, in computing its excess profits credit for the years 1944 and 1945, was entitled to capitalize its proportionate share, one-fourth, of the intangible drilling and development costs of the Puig Lease Operations for the years 1938 and 1939. The petitioner elected to capitalize intangible drilling and development expenses on its 1936 income tax return pursuant to the option granted in Regulations 94, *144 article 23 (m)-16. 1 In 1938 and 1939, however, the petitioner in conjunction *571 with other coowners of the Puig Lease Operations, undertook to expense and deduct such costs in arriving at the proportionate share of profits or losses of the respective coowners. The 1938 and 1939 income tax returns were examined by respondent's agent and these deductions were disallowed. The petitioner contested this determination and argued that the Puig Lease Operations constituted a partnership and possessed the right to elect to deduct such intangible drilling and development costs. The controversy was settled in an informal compromise by which the intangible drilling and development costs of the Puig Lease Operations were allowed as deductions. The petitioner now contends that it acted erroneously in 1938 and that the intangible costs should be capitalized. The respondent urges that this contention constitutes an inconsistent position from that taken in the earlier controversy. The petitioner admits the inconsistency and the propriety of the adjustments claimed by respondent as to 1938 and 1939 if the petitioner's present position be sustained. *145 Petitioner makes two contentions, the first, and principal one, being that Puig Lease Operations was not a partnership or joint venture and therefore had no right to exercise an option in 1937, 1938, and 1939, and second, assuming it be held to be a partnership or joint venture under the statute, as such it was not a "taxpayer" and consequently had no right to an option under the regulations. On the facts set out in our Findings of Fact we entertain no doubt as to the answer to the petitioner's first contention and accordingly hold that in the years in question the Puig Lease Operations was a joint venture or partnership within the broad definition of that term in section 3797, Internal Revenue Code. Directing our attention to the second question, i. e., the right to an election, we find that Regulations 94, article 23 (m)-16 provided that "All expenditures for wages, fuel, repairs, hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas, may, at the option of the taxpayer, be deducted from gross income as an expense or charged to capital account." A further provision is that "Any election so made is*146 binding for all subsequent years." It will be noted that this regulation grants the election to the taxpayer. Petitioner calls attention to the provision of section 181, Internal Revenue Code, that "Individuals carrying on business in partnership shall be liable for income tax only in their individual capacity"; that consequently a partnership is not a taxpayer. From this it is argued that its action in 1937, 1938, and 1939 in deducting the intangible drilling costs as expense was without legislative sanction and that it was bound by the election exercised by it in 1936 to capitalize such expenses. When the practical application of the statute is considered and the possible impact of petitioner's argument on the income-computing *572 responsibility of the partnership is appreciated, it appears clear that the regulations, construed as petitioner asks, would lead to results not contemplated by the Congress. Such is the case where two members of a partnership having equal investments and being entitled to equal shares in the profits have previously made opposing elections, one to charge such costs to expense, the other to capitalize them. How could such a partnership determine*147 its capital account, the amount of its expenses, its income, and distributions, and what justification could be advanced for distributing to the partners the differing amounts that would result therefrom? The term "taxpayer" in the pertinent regulations had its genesis in the office of the Commissioner, not in the authorizing statute. If it be held to exclude a partnership from the election granted to other income-computing agencies, the regulation works an unnecessary hardship and is plainly unreasonable and unworkable. We are inclined to the view that the word "taxpayer" was used in the broad sense of any "person," as defined in section 3797, Internal Revenue Code, which term "shall be construed to mean and include an individual, a trust, estate, partnership, company or corporation." Any narrower interpretation would effectively so hamper the partnership in its computation of income as to make impossible a true and fair accounting to the partners and the Government. See article by Valentine Brookes, Esq., 5 Tax L. Rev. 35, 39. The only direct reference we have found to the question in issue is in H. H. Wegener, 41 B. T. A. 857,*148 affirmed 119 F. 2d 49, where this Court said: "It is true that the joint venture had a right to elect to treat 'intangible' development costs as ordinary and necessary expenditures in its income tax return, Regulations 86, art. 23 (m)-16, but it did not do this. Obviously it elected to capitalize the entire development cost, and we see no reason for treating it otherwise." The organization of the joint venture known as the Puig Lease Operations brought into being a new entity, which, while not a taxpayer, had a very important role as an income-producing and computing agency. See John G. Scherf, Jr., 20 T. C. 346, where we said "* * * in computing its net income under the revenue laws, it is generally the partnership, not the individual partner, that exercises the various options open to taxpayers in computing net income under the Code." The rationale on which this statement is based is applicable in solving our present difficulty. We hold that the petitioner's contention is untenable with the consequence that respondent's action is affirmed. Decision will*149 be entered under Rule 50. Footnotes 1. Regulations 94. Art. 23 (m)-16. Charges to capital and to expense in the case of oil and gas wells. -- (a) Items chargeable to capital or to expense at taxpayer's option: (1) Option with respect to intangible drilling and development costs in general: All expenditures for wages, fuel, repairs, hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas, may, at the option of the taxpayer, be deducted from gross income as an expense or charged to capital account. Such expenditures have for convenience been termed intangible drilling and development costs. * * * * * * * (d) This article does not grant a new option or election. Any taxpayer who made an election or elections under article 223 of Regulations 69 or under article 243 of Regulations 74 or under article 236 of Regulations 77 or under article 23 (m)-16 of Regulations 86 is, by such election or elections, bound with respect to all optional expenditures whether made before January 1, 1936, or after December 31, 1935, in connection with oil and gas wells. Any taxpayer who has never made expenditures for drilling oil or gas wells prior to the first taxable year beginning after December 31, 1935, must make an election as to intangible drilling and development costs in general in the return for the first taxable year in which the taxpayer makes such expenditures, and a taxpayer who has never made expenditures for a nonproductive well prior to the first taxable year beginning after December 31, 1935, must make an election as to the cost of such wells in the return for the first taxable year in which the taxpayer completes such a well. Any election so made is binding for all subsequent years. A taxpayer is considered to have made an election in accordance with the manner in which the respective types of optional items are treated (1) in his return for the first taxable year ending after December 31, 1924, in which optional expenditures of the respective types are or were made, or (2) in an amended return filed between June 18, 1927, and December 18, 1927, in accordance with Treasury Decision 4025↩. Any taxpayer who has made expenditures for optional drilling and development costs must attach to his return for the first taxable year beginning after December 31, 1935, and for each year thereafter a clear statement of his election under each of the options, together with a statement of the time at which, and the manner in which, such election was made.