Walls v. Commissioner

W. L. WALLS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Walls v. Commissioner Docket No. 25297. United States Board of Tax Appeals 21 B.T.A. 1417; 1931 BTA LEXIS 2190; January 30, 1931, Promulgated *2190 Petitioner received as compensation for personal services an undivided one-eighth interest in a certain oil and gas working agreement. The respondent determined that such one-eighth interest had a market value of $16,500 and included that amount in petitioner's gross income for the year in which the interest was received. Held, that the petitioner has not overcome the prima facie correctness of the respondent's determination. Held, further, that the $16,500 value of petitioner's interest in the working agreement should be exhausted ratably over the life of the interest. Charles P. Swindler, Esq., for the petitioner. P. A. Bayer, Esq., for the respondent. SMITH *1417 This proceeding is for the redetermination of an alleged deficiency in income tax for the calendar year 1923 amounting to $3,082.91, and an alleged penalty of $770.73 for failure to file a return for that year. The petitioner alleges that the respondent erred in computing his income tax liability for 1923 by including in taxable income $16,500 on account of the alleged value of a certain interest acquired by the petitioner in 1923 in a certain oil and gas working*2191 agreement. The respondent alleges in his answer that he has understated the petitioner's taxable income for 1923 by the amount of $163.18 and moves that the deficiency be increased accordingly. FINDINGS OF FACT. The petitioner is an attorney residing in Cheyenne, Wyo. He had as one of his clients T. J. Cahill, who had become involved in litigation with the Midwest Refining Co. and the State of Wyoming regarding certain oil leases. In 1923 the Midwest Refining Co. and Cahill entered into an agreement by which it was provided that if the Midwest Refining Co. got the leases which Cahill was claiming the Refining Co. would give Cahill a contract entitling him to a share of the profits from operations thereunder. Pursuant to the agreement the litigation was terminated, and the Midwest Refining Co. received a lease from the State of Wyoming for the operation of the properties. The agreement recites in part as follows: THIS AGREEMENT, made this 19th day of April, A.D. 1923, by and between THE MIDWEST REFINING COMPANY, a Maine corporation, party of the first part, and T. JOE CAHILL, of Cheyenne, Wyoming, party of the second part, WITNESSETH: *2192 WHEREAS, the parties hereto have become involved in controversy and litigation with each other and with the State Board of Land Commissioners of the *1418 State of Wyoming relative to the right to operate for oil and gas production purposes the North Half of the Southeast Quarter (N 1//4) of Section Nineteen (19), Township Forty-six (46) North, Range Ninety-eight (98) West of the Sixth Principal Meridian, in Hot Springs, Wyoming, which is land owned by the State of Wyoming; and whereas, the parties hereto desire to settle all such controversies and avoid further litigation, and do propose, with the knowledge and assent of the said State Board of Land Commissioners, that said party of the first part shall apply for a five year oil and gas lease upon said premises to be effective as of March 1, 1923, and upon the granting of said lease shall agree to the rescission of a certain operating agreement dated May 25, 1921, between the State of Wyoming and the party of the first part relative to said premises and shall further recognize an interest of the party of the second part in the net profits of operations under said lease as hereinafter set forth; NOW, THEREFORE, *2193 THIS AGREEMENT WITNESSETH: That for and in consideration of the premises and of the withdrawal by the said party of the second part of his application for a lease upon the said premises and of his application for an oil and gas lease upon the North Half of the Northeast Quarter (N 1//4) of said Section Nineteen (19), the said party of the first part does covenant and agree that if the said State Board of Land Commissioners of the State of Wyoming shall execute and deliver unto the said party of the first part an oil and gas lease upon the North Half of the Southeast Quarter (N 1//4) of said Section Nineteen (19) and an oil and gas lease upon the North Half of the Northeast Quarter (N 1//4) of said Section Nineteen (19), each of said leases being effective as of March 1, 1923, for the term of five years from said date, at a royalty of Forty (40%) per cent upon the gas and upon the oil of gravity exceeding Thirty-six (36) degrees Baume, and a royalty of One-eighth (1/8) upon the oil of gravity of Thirty-six (36) degrees Baume and less, the said party of the first part will pay unto the said party of the second part, his personal*2194 representatives and assigns, One-third (1/3) of the net profits resulting from operations under the said lease upon the North Half of the Southeast Quarter (N 1//4) of said Section Nineteen (19), effective March 1, 1923, the said interest to be determined and payment on account thereof to be made under the following conditions: * * * 6. This agreement shall be binding upon the parties hereto, their respective successors, personal representatives and assigns and shall affect not only the said lease but any subsequent lease issued upon the said premises or any part thereof by the State of Wyoming to either of the parties hereto or their assigns; provided, however, that in the event upon the expiration of the said lease or any subsequent lease upon the said premises the State of Wyoming shall sell a lease upon the said premises at public auction either of the parties hereto shall have the right to bid at such auction and if awarded the lease the successful party shall be under no obligation whatever unto the other party with respect to the operations under such lease. Thereupon and during the month of April, 1923, Cahill assigned to the petitioner an undivided*2195 one-eighth interest in and to and under and by virtue of its agreement with the Midwest Refining Co. "for a good and valuable consideration to-wit: professional services rendered." The Midwest Refining Co. accounted to the petitioner for all income due in 1923 on account of his one-eighth interest as follows: January $179.17 February 256.78 March 563.54 April 562.10 May 573.78 June $398.62 July 509.07 August 504.00 September 410.43 October 256.44 November $157.43 December 99.51 Total 4,470.87 *1419 The land described in the working agreement constituted what was known as the Grass Creek Field. This field was a proven field and operations thereon were controlled by the Midwest Refining Co. Prices of oil produced from this field varied during the years 1923 to 1927 from 95 cents per barrel low on November 9, 1923, to $2.40 per barrel high on May 17, 1926. During the month of April, 1923, the price was approximately $2 per barrel. Production in barrels of oil from the premises described in the working agreement was as follows: — 1916 — 62,597 — 1917 — 350,399 — 1918 — 190,451 — 1919 — 120,399 — 1920 — 106,249 — 1921 — 240,720 — 1922 — 225,928 — 1923 — 146,330 — 1924 — 85,473 — 1925 — 84,857 — 1926 — 76,745 — 1927 — 58,023 — 1928 — 50,399 *2196 The Midwest Refining Co. purchased five of the outstanding one-eighth interests similar to the interest held by the petitioner at $16,500 each. It desired to purchase all of the outstanding interests at the same rate. Its standing offer for each one-eighth interest was $16,500. The petitioner did not choose to sell his interest. He preferred to hold it and take his proportion of the net profits of operation under the lease over a period of five years, the term for which the lease ran. The interest had additional value in its renewal features which the petitioner knew would be foreclosed to him if he sold in 1923. The petitioner did not file an income tax return for 1923, and the return for him for that year was prepared by the respondent. This return showed total income, including $16,500 as the value of the Grass Creek contract, $32,943.31, from which the Commissioner deducted for taxes and contributions $201.80, leaving a net taxable income of $32,741.51. The Commissioner added to the deficiency in tax found to be due, amounting to $3,082.91, a 25 per cent penalty for delinquency in filing the return, amounting to $770.73. OPINION. SMITH: The principal question*2197 presented by this proceeding is whether the petitioner is liable to income tax in respect of the fair market value of the petitioner's interest in the Cahill contract with the Midwest Refining Co., which was assigned to him by Cahill as compensation for legal services rendered. The petitioner was of the opinion that he received no income upon the assignment from Cahill. He was of the opinion that he was required to return as taxable *1420 income only the amounts of cash which might be paid to him by the Midwest Refining Co. under the contract. He returned the amounts thus received in the years 1924 to 1928, inclusive. The respondent, on the other hand, contends that the petitioner realized taxable income in 1923 to the amount of the fair market value of the interest in the Cahill contract received by him in that year, and to the extent of the distributions made to him by the Midwest Refining Co. under the contract in 1923. Section 213 of the Revenue Act of 1921 provides in part as follows: That for the purposes of this title (except as otherwise provided in section 233) the term "gross income" - (a) Includes gains, profits, and income derived from salaries, wages, *2198 or compensation for personal service * * * of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, * * * or gains or profits and income derived from any source whatever. * * * The record shows that the petitioner received the assignment of the interest in question "for a good and valuable consideration to-wit: professional services rendered." We interpret this statement of fact contained in the petition and admitted in the answer to mean that Cahill discharged his obligation to the petitioner for services rendered by assigning to him an interest in the working agreement and that the petitioner received the assignment in payment for such services. No contention is made to the contrary. We apprehend that the situation might be different if the evidence showed that the petitioner did not receive the assignment in payment of his claim against Cahill. In , it was said, after referring to : What is there said of unpaid services applies with equal force to unpaid purchase money. If a seller accepts the notes of third*2199 persons in absolute payment, the rule would be different. But where the effect of the transaction is a mere promise to pay, and not an actual payment, it can not be said to be income, until it has been actually received, and is not subject to be taxed as such until its actual receipt. The interest assigned was a property right, a chose in action, and had a market value to the petitioner of $16,500 at the date of assignment and throughout the year 1923. The vice president of the Midwest Refining Co. deposed that the Midwest Refining Co. was willing and ready to purchase all of the outstanding one-eighth interests under the Cahill contract at a uniform price of $16,500 each, less any distributions which might have been made on the interest. In other words, the Midwest Refining Co. was not willing to pay more than a total of $16,500 for each one-eighth interest. The petitioner was well aware of the fact that the Midwest Refining Co. was willing and ready to purchase his interest in 1923 at a price of $16,500. In a letter addressed to the Income Tax Unit, relative *1421 to the deficiency which had been determined against the petitioner for 1923, the petitioner stated: *2200 This 1/8th of 1/3rd interest had an estimated value of $16,500 and I have no doubt of my being able to sell it for such sum but I do not choose to sell my interest I prefer to hold it and take my proportion of the net results of the operating under the lease over the period of five years, the time for which the lease runs. * * * This interest has additional value in its renewal features which would be foreclosed to me if I sold in 1923. The renewal values are of course speculative, as was the earning capacity of the interest in the first instance. Article 33 of Regulations 62, promulgated pursuant to the provisions of the Revenue Act of 1921, provides in part as follows: Where services are paid for with something other than money, the fair market value, if readily realizable, of the thing taken in payment is the amount to be included as income. If the services were rendered at a stipulated price, in the absence of evidence to the contrary such price will be presumed to be the fair value of the compensation received. Compensation paid an employee of a corporation in its stock is to be treated as if the corporation sold the stock for its market value and paid the employee*2201 in cash. * * * It can not be doubted that if the compensation paid to the petitioner had been in the form of cash or of real estate or of shares of stock of a corporation or other personal property, the amount of the cash received or the cash value of the other property received would have constituted taxable income. In , we said: It is well settled that capital stock of a corporation received by an individual as compensation for services rendered is taxable as income only to the extent of its fair market value at the time received. See also ; James R. Lister, 3. B.T.A. 475; ; . The assigned interest in the Cahill contract received by the petitioner was property. Cf. , affirmed in . It was certainly something of exchangeable value received by the petitioner. We can see no valid reason for differentiating property of the kind received by the petitioner from shares of stock which*2202 might have been received by him as compensation for services rendered. In either case the petitioner would have actually realized a gain or profit in 1923 equal to the amount of cash which could have been received for it had he chosen to sell it in 1923. The Commissioner's determination that the petitioner received taxable income of $16,500 upon the receipt of the assigned interest is sustained. At the hearing of this proceeding the petition was amended so as to raise an alternative issue relating to an amortization or depletion allowance in the event that we approved the respondent's action in giving to the assigned interest a value for income tax purposes and including that value in petitioner's taxable income for 1923. *1422 So far as the record discloses the petitioner had no property right in the lease given by the State of Wyoming to the Midwest Refining Co. He was not a party to the lease. He had, however, an interest in a working agreement between the Midwest Refining Co. and T. J. Cahill. A witness for the Government, the vice president of the Midwest Refining Co., was asked to state the distinction or difference between a royalty interest in a lease and*2203 a working interest of the character involved in this proceeding. He replied: A royalty interest represents a percentage of the gross income of the lease; a working interest represents a percentage of the net income of the lease. He further stated that a royalty interest was less speculative than a working interest, for the reason that the holder of a royalty interest would have income if any oil or other mineral subject to the royalty payment was produced; but that a holder of a working interest would not have any income unless the operations resulted profitably. Since the petitioner had no royalty interest in the lease given by the State to the Midwest Refining Co., we are of the opinion that he had no depletable interest in that lease. The assigned interest in the working agreement, which was received by the petitioner, did, however, at the date of receipt have a fair market value of $16,500. With the lapse of time this interest would be exhausted. Its definite or certain life was only five years. The petitioner received certain profits from the assigned interest, and these profits constituted a part of the petitioner's gross income for income tax purposes. The question*2204 for our immediate consideration is whether petitioner's interest in the working agreement is subject to any exhaustion allowance. Section 214(a) of the Revenue Act of 1921 provides in part: That in computing net income there shall be allowed as deductions: * * * (8) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. * * * The Commissioner provided, in article 163 of Regulations 62, that: Intangibles, the use of which in the trade or business is definitely limited in duration, may be the subject of a depreciation allowance. Examples are patents and copyrights, licenses, and franchises. * * * The interest of the petitioner in the working agreement was a property right and is comprehended by the all-inclusive term "property," used in section 214(a)(8) of the taxing statute. But was it property "used in the trade or business" within the meaning of the statute? We are of the opinion that it was. It was used in a trade or business to the same extent that an office building which is owned by a professional man and from which he receives the rents is used in the trade or*2205 business. We think no question could arise but that in such a situation the recipient of the rents is entitled to *1423 deduct from gross income received a reasonable amount for the depreciation of the office building, and we have held in , that an individual owning a patent, from which he derives taxable royalties, is entitled to deduct from his gross income a reasonable amount for the exhaustion of the patent from which he derives his income. The same principle is applicable here. In the circumstances of the instant proceeding we are of the opinion that the exhaustion deduction for 1923 is a pro rata part of $16,500, the cash value of the assigned interest to the petitioner in 1923, exhausted over the five-year period, the definite life of the interest. The final point for our consideration is whether the petitioner is liable to a 25 per cent penalty for delinquency in filing his return for 1923. Section 3176, Revised Statutes, as amended, provides for the assessment and collection of such a penalty where a return is filed delinquently and no reasonable excuse is given for such delinquency, or where the return is*2206 made up for him by the proper officer of the Government. The evidence of record shows that the petitioner had a taxable income of approximately $16,000 for the year 1923 without any reference to any income from the receipt of the assigned interest as such. No reasonable ground has been shown for failure to file a return. The respondent's action in imposing a penalty for failure to file the return is sustained. Reviewed by the Board. Judgment will be entered under Rule 50.