Merle-Smith v. Commissioner

KATE FOWLER MERLE-SMITH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Merle-Smith v. Commissioner Docket Nos. 4584, 7957, 18564. United States Board of Tax Appeals 11 B.T.A. 254; 1928 BTA LEXIS 3842; March 27, 1928, Promulgated *3842 Petitioner, a beneficiary under a testamentary trust, held not entitled to deductions for depletion on account of the removal of ore from property forming a part of the corpus of the trust. Fleming v. Commissioner,6 B.T.A. 900, followed. Talbert W. Sprague, Esq., for the petitioner. Granville S. Borden, Esq., for the respondent. ARUNDELL *254 These are proceedings for the redetermination of income taxes as follows: Docket No. Calendar year Amount [1917] $48,195.64 - Overassessment. [1918] $28,523.12 - Deficiency. [1919] $27,187.47 - Deficiency. [1920] $18,856.44 - Deficiency. 18564 [1921] $13,288.62 - Deficiency. At the hearing the parties agreed upon the issues and stipulated that the petitions and answers be amended to conform thereto. The issues agreed upon are as follows: 1. The Commissioner in his answer contends that he erred in allowing to the petitioner the benefit of any depletion in respect of the mines referred to in the findings of fact. The petitioner denies this contention and contends that petitioner was entitled to the benefit of depletion in respect of*3843 such mines. 2. The petitioner contends that in the determination of deficiencies from which these appeals are taken, the Commissioner used too *255 high a rate of discount in computing the value as of March 1, 1913, of the expected royalties under the consolidated lease, and thereby underestimated the value as of March 1, 1913, of said expected royalties which resulted in an inadequate allowance for depletion in each of the years covered by these appeals. The Commissioner denies this contention. 3. The petitioner contends that no higher rate of discount should be used in determining the value as of March 1, 1913, of the expected royalties from the consolidated lease than - (a) Five per cent compound interest applied to the entire expected royalties; (b) Four and one-half per cent compound interest applied to the royalties from 1,000,000 tons of first grade ore each year with the Hoskold formula with 6 per cent interest rate and a 4 per cent capital redemption rate applied to the balance of the estimated royalties; or (c) A 5 per cent compound interest rate applied to the known ore as of March 1, 1913, with the Hoskold formula with 6 per cent interest and a 4 per*3844 cent capital redemption rate applied to the estimated probable ore. The Commissioner denies this contention. 4. The petitioner contends that in no event should the depletion allowed in respect of the consolidated lease in any year be less than the value as of March 1, 1913, of the royalties accrued for the year in question discounted at a 5 per cent compound interest rate. The Commissioner denies this contention. 5. The petitioner contends that she has such an interest in the mining properties constituting the corpus of the so-called Kate Fowler Mining Trust as to entitle her to depletion upon the entire interest of said trust in the mining properties, and that the Commissioner erred in allowing the petitioner the benefit of only 75 per cent of such depletion. The Commissioner denies this contention. The overassessment for the year 1917 results, as shown by the notice upon which the petition is based, from the partial rejection of a claim in abatement. FINDINGS OF FACT. The petitioner, Kate Fowler Merle-Smith, is a daughter of Eldridge M. Fowler, who died on November 7, 1904, a resident of the State of California, leaving a last will and testament which was duly*3845 probated both in the State of California and in the State of Minnesota. The petitioner, Kate Fowler Merle-Smith was born on the 27th day of December, 1888, and is the person named in the last will and testament of Eldridge M. Fowler as "my daughter Kate." Marjorie Fleming Lloyd-Smith is the person designated in the last will and testament of said Eldridge M. Fowler as "my granddaughter Marjorie Fleming" and was born on October 14, 1894. *256 By the terms of his said will said Eldridge M. Fowler created two trusts, designated herein for convenience as the Kate Fowler Mining Trust and the Marjorie Fleming Mining Trust. The material portions of the will relating to the Kate Fowler Mining Trust are set forth in Paragraph XIII of said will and are as follows: I give, devise and bequeath one-half of all my real estate and interest in real estate situate in the Counties of Cook, Lake, St. Louis and Itasca, in the State of Minnesota, and one-half of all my mineral rights, rights in minerals, ores and fossils, mineral reservations and surface rights in said Counties of Cook, Lake, St. Louis and Itasca, in said State of Minnesota, and one-half of all my stock in corporations*3846 owning mines, mineral lands or mineral rights in said State of Minnesota and in mining corporations and corporations engaged in mining in said State; excepting, however, my real estate situate in the City of Duluth in said State, to my daughter Kate when she shall arrive at the age of forty-five years if she shall live so long, with the power to dispose thereof by will at any time before she shall arrive at the age of forty-five years; and if she shall die intestate as to such property before arriving at the age of forty-five years, then to her child or children, and to the issue of any deceased child or children, her surviving, such issue of any deceased child or children to take parent's share by right of representation; and if she shall leave no child or children, nor issue of any deceased child or children, her surviving, then the one-half thereof to my wife, Margaret B. Fowler, if she shall survive my daughter Kate, when my granddaughter Marjorie Fleming shall arrive at the age of forty years, and if my said granddaughter Marjorie Fleming shall die before arriving at the age of forty years, then on the death of my said granddaughter; and the remaining one-half thereof to my granddaughter*3847 Marjorie Fleming, when she shall arrive at the age of forty years, if she shall live so long; and if my said granddaughter, Majorie Fleming, shall die before arriving at the age of forty years, then such remaining one-half thereof to the child or children and to the issue of any deceased child or children of my said granddaughter, if she shall leave any her surviving, such issue of any deceased child or children to take the parent's share by right of representation; and if my said wife shall not survive my daughter Kate, then the whole thereof to my granddaughter Marjorie Fleming when she shall arrive at the age of forth years, if she shall live so long; and if she shall die before arriving at the age of forty years, then to the child or children and to the issue of any deceased child or children of my said granddaughter Marjorie Fleming, if she shall leave any her surviving, such issue of any deceased child or children to take the parent's share by right of representation; and if my said granddaughter Marjorie Fleming shall leave no child or children, nor issue of any deceased child or children her surviving, then to my heirs forever: Subject, however, to the following trust viz: *3848 My wife Margaret B. Fowler, my son-in-law Arthur H. Fleming, my daughter Clara H. Fleming, my daughter Kate Fowler, provided she has attained her majority at the time of my decease, and if not, then when she attains her majority, and my nephew Harold F. McCormick, and their successors in trust, shall, until it shall be ascertained in whom the absolute title to said property so devised and bequeathed is vested, hold in trust said property so devised and bequeathed for the purposes herein expressed. 1 - They shall have full charge, possession and control of said property so devised and bequeathed; they may make mining or other leases and change *257 leases in existence at the time of my decease, as they may deem best; they shall collect all royalties, dividends, rents and income from said property and do all things necessary to preserve the same; they shall take especial care to see that all taxes are paid on all lands and property they may deem valuable for any purpose whatever; they are not to engage in mining operations upon said lands or any part thereof, except so far as is necessary to determine if any portion of said land is of sufficient value to warrant payment of*3849 taxes. 2 - If the income from said property is not sufficient to pay the taxes and the expenses of this trust, they are authorized to borrow money to pay such taxes and expenses, and to secure the payment of the money borrowed they may mortgage or encumber said land and property, but they shall not encumber said land or property for any other purpose. 3 - They are authorized to sell and to execute and deliver deeds to effect the sale of any lands and property upon which no mineral or ore has been discovered prior to such sale, provided that all the trustees concur in such sale. All monies received on the sale of said lands and property, or any part thereof, under this clause, shall be invested and from time to time reinvested and kept invested in interest bearing securities during the continuance of this trust, and the income received therefrom shall be disposed of in the same manner and at the same times as is provided for other income received from said trust property. 4 - Out of the dividends, rents, royalties and income, and the interest from such investments, said trustees shall pay: First: Taxes and expenses of testing land, as above provided, and of caring for said*3850 property, including the expenses of this trust and such compensation as any of said trustees may be entitled to for services therein. Second: To my son-in-law Arthur H. Fleming, annually during the continuance of this trust, if he shall live so long, and if not, then until his decease, eight per cent of the net annual income received from said lands and property after the payment of taxes and expenses. Third: To my wife Margaret B. Fowler, quarter-yearly during the continuance of this trust, if she shall live so long, and if not, then until her decease seventeen per cent of said net annual income. Fourth: The remainder of said net income shall be retained by said trustees and invested and reinvested until my daughter Kate reaches her majority, if she shall live so long, at which time said trustees shall pay to her said accumulated income, and thereafter shall pay to her quarter-yearly said remainder of said net income until she arrives at the age of forty-five years, if she shall live so long. Fifth: If my daughter Kate shall die intestate as to said property before arriving at the age of forty-five years, and shall leave no child or children, nor issue of any deceased*3851 child or children, her surviving, then said trustees shall until my granddaughter, Marjorie Fleming, arrives at the age of forty years, if she shall live so long, pay quarter-yearly one-half of the remainder of said net income to my granddaughter Marjorie Fleming, and the other one-half of the remainder of said net income, to my wife, Margaret B. Fowler, if she shall live so long, and if not, then to my said granddaughter, Marjorie Fleming. The property embraced in the Marjorie Fleming Mining Trust consisted of the remaining one-half of that described in Paragraph XIII of the will. The material portions of the will relating to the *258 Marjorie Fleming Mining Trust are contained in Paragraph XIV thereof and are as follows: I give, devise and bequeath one-half of all my real estate and interest in real estate situate in the counties of Cook, Lake, St. Louis and Itasca, in the State of Minnesota, and one-half of all my mineral rights, rights in minerals, ores and fossils, mineral reservations and surface rights in said Counties of Cook, Lake, St. Louis and Itasca, in said State of Minnesota, and one-half of all my stock in corporations owning mines, mineral lands or mineral*3852 rights in said State of Minnesota and in mining corporations and corporations engaged in mining in said State; excepting, however, my real estate situate in the City cf Duluth in said State, to my granddaughter Marjorie Fleming, when she shall arrive at the age of forty years, if she shall live so long, with the power to dispose thereof by will at any time before she shall arrive at the age of forty years; and if she shall die intestate as to such property before arriving at the age of forty years, then to her child or children, and to the issue of any deceased child or children her surviving, such issue of any deceased child or children to take the parent's share by right of representation; and if she shall leave no child or children, nor issue of any deceased child or children, her surviving, then to my daughter Kate, when Kate shall arrive at the age of forty-five years, if she shall live so long, and if she shall die before arriving at the age of forty-five years, then to the child or children and to the issue of any deceased child or children of my said daughter Kate, if she shall leave any her surviving, such issue of any deceased child or children to take the parent's share*3853 by right of representation; and if my said daughter Kate shall leave no child or children nor issue of any deceased child or children her surviving, then to my heirs forever. Subject, however, to the following trust, viz: My wife Margaret B. Fowler, my son-in-law Arthur H. Fleming, my daughter Clara H. Fleming, my daughter Kate Fowler, provided she has attained her majority at the time of my decease, and if not, then when she attains her majority, and my nephew Harold F. McCormick, and their successors in trust, shall, until it shall be ascertained in whom the absolute title to said property so devised and bequeathed is vested. hold in trust said property so devised and bequeathed for the purposes herein expressed. 1 - They shall have full charge, possession and control of said property so devised and bequeathed; they may make mining or other leases and change leases in existence at the time of my decease, as they deem best; they shall collect all royalties, dividends, rents and income from said property and do all things necessary to preserve the same; they shall take especial care to see that all taxes are paid on all lands and property they may deem valuable for any purpose*3854 whatever; they are not to engage in mining operations upon said lands or any part thereof, except so far as is necessary to determine if any portion of said land is of sufficient value to warrant payment of taxes. 2 - If the income from said property is not sufficient to pay the taxes and the expenses of this trust, they are authorized to borrow money to pay such taxes and expenses, and to secure the payment of the money borrowed they may mortgage or encumber said land and property, but they shall not encumber said land or property for any other purpose. 3 - They are authorized to sell and to execute and deliver deeds to effect the sale of any lands and property upon which no mineral or ore has been discovered prior to such sale, provided that all the trustees concur in such sale. All monies received on the sale of said lands and property, or any part thereof, *259 under this clause, shall be invested and from time to time reinvested and kept invested in interest bearing securities during the continuance of this trust, and the income received therefrom shall be disposed of in the same manner and at the same times as is provided for other income received from said trust*3855 property. 4 - Out of the dividends, rents, royalties, and income, and the interest from such investments, said trustees shall pay: First: Taxes and expenses of testing land, as above provided, and of caring for said property, including the expenses of this trust and such compensation as any of said trustees may be entitled to for services therein. Second: To my son-in-law Arthur H. Fleming, annually during the continuance of this trust, if he shall live so long, and if not, then until his decease eight per cent of the net annual income received from said lands and property after the payment of taxes and expenses. Third: To my wife, Margaret B. Fowler, quarter-yearly during the continuance of this trust, if she shall live so long, and if not, then until her decease seventeen per cent of said net annual income. Fourth: The remainder of said net income shall be paid quarter-yearly by said trustees to my daughter Clara during the continuance of this trust, if she shall live so long, and if not, and my said granddaughter Marjorie Fleming shall not have arrived at her majority, then the remainder of said net income shall be retained by my said trustees and invested and reinvested*3856 until my said granddaughter, Marjorie Fleming, attains her majority, if she shall live so long, at which time said trustees shall pay to her said accumulated income and thereafter shall pay to her quarter-yearly said remainder of said net income until she arrives at the age of forty years, if she shall live so long. Fifth: If my said granddaughter Marjorie Fleming shall die intestate as to said property before arriving at the age of forty years, and shall leave no child or children nor issue of any deceased child or children, her surviving, then said trustees shall pay said net income quarter-yearly to my said daughter Kate until she arrives at the age of forty-five years, if she shall live so long. Pursuant to the provisions of the will for the distribution of the income of said trusts, the income thereof after payment of taxes and expenses was distributed in the following proportions: Beneficiaries Kate Marjorie Fowler Fleming mining mining trust trust Per cent Per cent Kate Fowler Merle-Smith (this petitioner and daughter of deceased) [75] Margaret B. Fowler (wife) [17] Arthur H. Fleming (son-in-law) [8] Marjorie Fleming Lloyd-Smith (granddaughter) [75] *3857 At the time of the death of the testator certain of the mining properties in which he had an interest, namely those known as Fayal No. 2, Fayal No. 3, Adams, Spruce, and Cloquet, were under lease to the Minnesota Iron Co., a corporation, for a period of 50 years from January 1, 1902. These properties, hereinafter called the consolidated properties, had previously been leased to various parties, the previous leases being acquired by the Minnesota Iron Co. The lease *260 to the Minnesota Iron Co. will hereinafter be designated the consolidated lease. The consolidated lease provided that the ore mined and shipped by the lessee should be graded into first and second grades, with royalties per ton on the first grade ore as follows: Cents. First 13 years (Jan. 1, 1902-Dec. 31, 1914) [30] Next 7 years (Jan. 1, 1915-Dec. 31, 1921) [37] Next 5 years (Jan. 1, 1922-Dec. 31, 1926) [42] Balance of term (Jan. 1, 1927-Dec. 31, 1951) [45] Royalties on second grade ore were fixed by the lease at 15 cents per ton less than those on the first grade and the amount to be considered second grade was fixed at certain percentages of the total output. Said Eldridge M. Fowler*3858 at the time of his death owned an undivided one-half interest in the fee of the properties covered by the consolidated lease. Subsequent to the death of the testator the trustees of the Fleming and Fowler Mining Trusts gave leases under various dates on three other pieces of property in Minnesota forming a part of the corpus of the trust. The properties leased under the consolidated lease consisted of five parcels containing iron ore and located on what is known as the Mesaba Range, near Eveleth, Minn. Of these properties three are mined by the open pit method and two by underground mines. At March 1, 1913, about 35 per cent of the ore was available by open pit mining and it was known then that the stripping area would be greatly extended. About 60 per cent of the available ore will eventually be recovered by open pit mining. The mines are located on land that is from 100 to 200 feet above the general level of the surrounding country and there was no danger in 1913 of the mines being flooded. There was no fire hazard in the open pit mines and little if any in the underground mines, as the air in them was moist, which made the timbers noninflammable. There was no danger*3859 from gas, fire damp, or underground explosions in any of the mines operated under the consolidated lease, nor was there any danger of cave-ins, due to careful methods of operation. The ore in the consolidated properties was close to the surface and easily mined. The mining operations have been so conducted as to take out some of both the high grade and the low grade ores. The produce has been exceedingly uniform, varying only from a low of about 59.71 per cent to a high of 60.23 per cent. The lessee, the Minnesota Iron Co., is a subsidiary of the United *261 standpoint of the payment of royalties being assured during the life of the lease. In 1913 royalty rates for bodies of ore inferior in quantity and quality to those of the consolidate properties ranged from 60 cents to $1 per ton. Reasonable estimates, as of March 1, 1913, of the ore reserves of the consolidated properties, the rates of mining and the expected royalties, are as follows: Total ore in mines - first and second grade Second-grade ore in mines Rate of mining per year for 22 years - first and second grade Rate of mining per year for 22 years - second-grade ore Expected gross royalties Less*3860 3 per cent for expenses Net expected royalties tons 53,455,468 do 7,107,078 tons 2,429,794 do 323,049 $20,899,276.06 626,978.29 20,272,297.77 By applying to the net expected royalties of $20,272,297.77 under the consolidated lease, the Hoskold formula factors of 6 per cent interest rate and 4 per cent capital redemption rate, the Commissioner determined the fair market value as of March 1, 1913, of the ore reserve in the consolidated properties, for depletion purposes, to be $10,287,970.24. Reasonable estimates as of March 1, 1913, of the ore reserves, the life of the mines, and the expected royalties from the other properties of the mining trusts are as follows: Mine Mar. 1, 1913, Life of Gross expected Expenses Net expected ore reserves mine royalties royalties Tons Years Per cent Fayal No. 1 2,783,691 [22] $1,251,139.90 [3] $1,213,605.76 Park Lot No. 1 53,152 [5] 31,891.20 [3] 30,934.40 Park Lot No. 2 132,600 [3] 132,600.00 [3] 128,622.00 Cloquet No. 2 212,500 [5] 85,000.00 [3] 82,450.00 Meadow Mine 153,933 [7] 46,179.90 [3] 44,794.50 By applying to the net expected*3861 royalties from these properties the Hoskold formula factors of 6 per cent interest rate and 4 per cent capital redemption rate, the Commissioner determined the fair market value as of March 1, 1913, of the ore reserves for depletion purposes, to be as follows: Fayal No. 1 $618,437.69 Park Lot No. 1 25,291.09 Park Lot No. 2 94,644.30 Cloquet No. 2 67,408.65 Meadow Mine 34,291.98 The rate of interest on commercial investments on March 1, 1913, was about 4 1/2 per cent. *262 Having by the use of the Hoskold formula with a 6 per cent interest rate and a 4 per cent capital redemption rate estimated the value as of March 1, 1913, of the royalties to be expected under the consolidated lease at $10,287,970.24, the Commissioner divided said sum by the estimated tonnage of $53,455,468 tons, which resulted in a unit of $19.246 cents per ton. The Commissioner in computing his allowance for lessor's depletion in respect of the consolidated lease, applied said unit of 19.246 cents per ton to the actual tons of ore paid for by the lessees in each respective year, and allocated one-quarter of the amount in each respective year to the Kate Fowler Mining Trust*3862 and one-quarter to the Marjorie Fleming Mining Trust. In his determination of the deficiencies from which these appeals are taken, the Commissioner in each year prorated the depletion allocated as aforesaid to the Kate Fowler Mining Trust and the Marjorie Fleming Mining Trust, respectively, among the respective recipients of income therefrom in accordance with the amount of income accruing to each, to wit: As to Kate Fowler mining trust 75% to Kate Fowler Merle-Smith. 17% to Margaret B. Fowler. 8% to Arthur H. Fleming. As to Marjorie Fleming mining trust 75% to Marjorie Fleming Lloyd-Smith. 17% to Margaret B. Fowler. 8% to Arthur Fleming. The estimate of $20,272,297.77 as the total net expected royalties under the consolidated lease is based on estimated royalty receipts after March 1, 1913, as follows: Total net return Yearly net return First year $660,066.42 $660.066.42 Next 7 years 5,775,346.05 825,049.44 Next 5 years 4,714,472.23 942,894.45 Next 9 years 9,122,413.07 1,013,601.45 Total 20,272,297.77 The reasonable estimate of 53,455,468 tons of ore in the consolidated mines as of March 1, 1913, is based on*3863 an estimate as of that time of 45,342,271 tons of known ore and 8,113,197 tons of probable ore. With respect to the effect of the Hoskold formula on the determination of present values - (a) With the interest rate on the investment remaining constant, the present value decreases when the interest rate allowed on the *263 redemption fund is decreased. For example, a Hoskold formula with a 6 per cent interest rate and a 4 per cent capital redemption rate results in a lower present value than a Hoskold formula with a 6 per cent interest rate and a 4 per cent redemption rate. (b) With the interest rate on the redemption fund remaining constant, the present value decreases when the interest rate allowed on the investment is increased. For example, a Hoskold formula with a 6 per cent interest rate and a 4 per cent capital redemption rate results in a lower present value than a Hoskold formula with a 5 per cent interest rate and a 4 per cent capital redemption rate. (c) Where the interest rate and the capital redemption rate are the same, the Hoskold formula resolves itself into the ordinary compound interest and discount tables. In ordinary compound interest tables*3864 the present value increases as the interest rate decreases. For example, a 6 per cent compound interest table gives a lower present value than a 5 per cent compound interest table. In determining the deficiencies involved in these appeals, the Commissioner allowed to the petitioners deductions for depletion of the mines based on the March 1, 1913, value of the interests of the trusts therein computed by the application of Hoskold formula with a 6 per cent interest rate and a 4 per cent capital redemption rate as hereinbefore set forth. In the answers to the petitions, the Commissioner avers that he erred in allowing any deduction for depletion. The shipments of ore from the consolidated mines and the aggregate gross royalties therefrom for the years covered by these appeals were as follows: Tons paid for Royalty receipts [1917] 3,078,679 $1,095,141.43 [1818] 2,908,558 1,031,779.92 [1919] 2,554,211 905,525.45 [1920] 2,411,558 853,299.99 [1921] 1,154,680 404,029.60 OPINION. ARUNDELL: We have adopted as our findings of fact all of the agreed statement of facts submitted by the parties except two paragraphs thereof which incorporated by reference*3865 the will of Eldridge M. Fowler in its entirety and the lease to the Minnesota Iron Co., which is referred to in the findings of fact as the consolidated lease. The pertinent parts of the Fowler will are set forth and the provisions of the lease are sufficiently described so that we do not deem it necessary to set out the documents in full. *264 By the terms of the will of Eldridge M. Fowler two trusts were created, the corpus in each case being one-half of Fowler's interest in certain mining properties. This petitioner was the principal beneficiary under one of the trusts (the Kate Fowler Mining Trust), her interest therein being the same as that of Marjorie Fleming Lloyd-Smith in the Marjorie Fleming Mining Trust. The same issues as are here involved were before us in regard to the income of Marjorie Fleming Lloyd-Smith from the trust under which she was a beneficiary, in the case of . In that case, after reviewing at some length decisions of the Board and of various courts, we concluded that the Commissioner had erred in allowing depletion deductions in respect of the income from the trust. The present petitioner, *3866 however, apparently feels that we overlooked some of the language used in . All that the Gavit case decided was that the amount paid to the taxpayer from a trust fund was income to him, and taxable, and not an exempt bequest. That case does not purport to decide what deductions may be taken in determining the amount of taxable income. The Court of Claims in the recent case of ; 6 Am.Fed.Tax.Rep. 7093, has taken the same position that we took in the Fleming case, supra, and cases therein cited. There the taxpayer was a life beneficiary under a testamentary trust with remainder over, and claimed deductions for depreciation of the real estate embraced in the corpus of the trust. The court, after quoting the definition of allowable depreciation from , observes: But if this depreciation be paid over to the beneficiary for life, and the amount of it be deducted from her taxable income, of what possible benefit has it been to the estate or to those ultimately succeeding to the capital*3867 or corpus of the estate? The year 1921 is governed by the Revenue Act of 1921, which provides in section 219(d) for the inclusion in the income of a beneficiary such as we have here of "that part of the income of the estate or trust * * * which, pursuant to the instrument or order governing the distribution is distributable to such beneficiary * * *." Under this provision there can be no question that the deductions claimed are not allowable. We accordingly hold that the respondent erred in allowing deductions for depletion. Holding as we do on the issue raised by the respondent's answer, the issues as to the method of computation of depletion and the amount allowable therefor do not require decision. Judgment will be entered on 15 days' notice, under Rule 50.