Pettit v. Commissioner

CHARLES PETTIT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. BERTIE PETTIT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Pettit v. Commissioner Docket Nos. 94292, 94293, 94799, 94800. United States Board of Tax Appeals 41 B.T.A. 264; 1940 BTA LEXIS 1206; February 6, 1940, Promulgated *1206 Petitioners prior to the taxable years in question acquired by investment certain oil payment contracts which by assignments and conveyances contained in such contracts entitled them to certain fractional interests in the the first oil if, as, and when produced and saved from certain leases until either a certain number of barrels of oil or a certain number of dollars had been received. It was estimated that it would take from three to thirty years to realize all the oil or dollars to which petitioners were so entitled. During the taxable years in question, petitioners by virtue of their contracts and the production of oil on the leases in which they owned an interest, received certain sums of money which the respondent in his determinations has treated as gross income from the properties offset by deductions for depletion based upon cost or percentage depletion, whichever was greater. Held, that the respondent's treatment of the matter was proper, and that petitioners are not entitled to the benefit of the capital gains provisions of the applicable statutes since they did not sell or exchange any of the oil interests which they held during the taxable years involved. *1207 W. B. Harrell, Esq., Russell Allen, Esq., and Albert G. Moss, C.P.A., for the petitioners. James H. Yeatman, Esq., M. L. R. Wade, Esq., and James L. Backstrom, Esq., for the respondent. BLACK *265 The respondent has determined deficiencies in income tax against petitioners for the years 1934, 1935, and 1936, as follows: Petitioner Docket No. Year Deficiency Charles Pettit 94292 [1934] $4,552.98 Do 94292 [1935] 2,316.07 Do 94799 [1936] 5,523.44 Bertie Pettit 94293 [1934] 4,552.98 Do 94293 [1935] 2,316.07 Do 94800 [1936] 5,523.44 During the taxable years in question petitioners received certain sums of money from 31 oil payment contracts, against which sums the respondent has allowed deductions for depletion and has determined that the balance is taxable as ordinary income. Petitioners accept and claim the depletion allowances but assign as error the failure of the respondent to apply section 117 of the Revenue Acts of 1934 and 1936, respectively, relating to capital gains and losses, which application petitioners allege will result in refunds instead of deficiencies, as follows: Petitioner Docket No. Year Alleged Refund Charles Pettit 94292 [1934] $1,445.18 Do 94292 [1935] 545.37 Do 94799 [1936] 473.54 Bertie Pettit 94293 [1934] 1,445.18 Do 94293 [1935] 545.37 Do 94800 [1936] 473.54 *1208 The respondent contends that if the Board should hold that the proceeds received by petitioners under the various oil payment contracts represent gains from the sale or exchange of capital assets, then in that event only a proportionate part of the cost of the contracts may be deducted from the amounts received in arriving at the net *266 income subject to tax, and that petitioners are not entitled to deduct depletion. Petitioners assigned another error, (h), in Docket Nos. 94292 and 94293, which the parties have stipulated "may be disregarded by the Board." On motion, the proceedings were consolidated. FINDINGS OF FACT. During the years involved petitioners were husband and wife, domiciled at Dallas in the State of Texas, and filed separate income tax returns with the collector for the second district of Texas. They kept their books and rendered their returns on the basis of cash receipts and disbursements, and all of their income and all of their allowable deductions for the years in controversy are community income and deductions, respectively. Petitioners have at divers times entered into written agreements or contracts with various persons involving oil*1209 and gas leases. Copies of the contracts involved have been filed as exhibits 1 to 31, inclusive. Some of these contracts are sometimes referred to as "barrel" contracts and others as "dollar" contracts. Under the socalled barrel contracts (exhibits 1 to 9, inclusive), the sellers in exhibits 1 to 8, inclusive, granted, conveyed, and sold to petitioners, and agreed to deliver to them if, as, and when produced, a definite number of barrels of merchantable pipeline crude oil from a fractional part of the total production from the particular leased premises. Exhibit 9 was a sale by petitioners in 1931 of their interests in an oil lease for $5,000 and a reservation of 210,000 barrels of oil in place. Under the so-called dollar contracts, nine (exhibits 16, 23, 24, and 26 to 31, inclusive) were acquired direct from the owners of the working interests in the leases, and by them the sellers conveyed and sold to petitioners the proceeds of the sale of certain fractional parts of all the oil and gas in and under, and that which might be produced, saved, and sold from the wells on the leases, until petitioners had received a certain fixed sum of money from the sale of the oil. In eleven*1210 of the so-called dollar contracts (exhibits 11 to 15, inclusive, 17, 19 to 22, inclusive, and 25), petitioners purchased or otherwise acquired from others their interests, or a portion of their interests, in and to various and sundry oil payments. In two of the dollar contracts (exhibits 10 and 18), petitioners had been the owners or part owners of the leases and they had assigned them to other parties, retaining the right to receive a certain sum of money payable out of a fraction of the oil produced and saved from the leases. All of the contracts are alike in that there is no personal obligation on the part of the assignors to pay petitioners the specified number of barrels of oil *267 or amounts of money out of oil, and petitioners must look to the oil, and to the oil only, for the return of their capital investment. If there were no production, no right to any payment would arise. If there were production, the right to payment would be limited to the fraction of the oil out of which the barrels of oil or sums of money were to be delivered or paid. Petitioners' exhibit No. 1 is an agreement made and entered into by and between Inland Oil Co., of Dallas, Texas, and Charles*1211 Pettit of Dallas, Texas, whereby Inland Oil Co. "For and in consideration of the sum of ten dollars ($10.00) and other good and valuable consideration * * * granted, sold, conveyed and hereby agrees to deliver unto Buyer, if, as and when produced and saved from the aforesaid tracts of land two hundred twenty thousand (220,000) barrels of merchantable pipe line crude oil, of forty-two (42) gallons each, out of seven-sixteenths (7/16) of the total production of oil from said lands." Said written agreement and contract contained the following paragraph: This conveyance is intended to have all of the effect of a deed to the said oil hereby conveyed to the buyer out of seven-sixteenths (7/16) of all of the oil produced and saved from the aforesaid leases herein provided, and any pipe line company or other purchasers of oil from said tract shall so treat this agreement, and it shall not be necessary for the Seller to execute to the buyer any further conveyances or other instruments to enable the Buyer to receive full performance hereof. A similar clause of conveyance is contained in the other 30 oil payment contracts, hereinbefore referred to, whether "barrel" contracts or "dollar" *1212 contracts, though not stated in all contracts, in the identical language above quoted. Neither party contends that there are any differences in substance in this respect, in the several contracts and conveyances involved in these proceedings. It is, therefore, deemed unnecessary to further set forth the language of the several contracts. There is included in the record as a part of a stipulation of facts a tabulation, which is incorporated herein by reference, listing the 31 contracts, the date of their acquisition by petitioners, the name of the lease upon which the contracts are respectively applicable, the number of barrels to be received under the barrel contracts and the amount in dollars to be received under the dollar contracts, the original cost of each contract, the amount of cost unrecovered at December 31, 1933, the proceeds received by petitioners from the sale of oil under each contract for the years 1934, 1935, and 1936, the amount of cost or percentage depletion allowed by the respondent in determining the deficiencies, the net income as determined by the respondent, and the amounts of the net income which petitioners contend is taxable under section 117 of the*1213 Revenue Acts of 1934 and 1936. in some instances the tabulation varies from the contracts in *268 the matter of the number of barrels purchased or dollars to be recovered. The variances came about because, in certain instances, Charles Pettit took title in his own name to the whole amount of the barrels or dollars shown on the face of the contract, when in fact other persons were interested with him. He immediately assigned such persons their interests, and the amounts shown in the tabulation to belong to petitioners are, in fact, the amounts which petitioners acquired. A condensed summary of the tabulation is as follows: Contracts Total collections Deduction for cost or percentage depletion (whichever greater) Net income as determined by respondent 9 Barrel $84,457.58 $23,225.83 $61,231.75 22 Dollar 72,460.19 25,427.70 47,032.49 Total 31 156,917.77 48,653.53 108,264.24 9 Barrel $71,694.58 $19,716.01 $51,978.57 22 Dollar 27,279.39 10,863.48 16,415.91 Total 31 98,973.97 30,579.49 68,394.48 9 Barrel $80,166.28 $24,970.07 $55,196.21 22 Dollar 35,155.32 14,910.12 20,245.20 Total 31 115,321.60 39,880.19 75,441.41 *1214 Prior to the acquisition of the contracts, except the contracts evidenced by exhibits 9, 10, and 18, petitioners had no interest either in the properties to which the contracts were applicable or in the oil and gas leases on the properties. The leasehold estates to which the contracts were applicable were developed by the lessees or persons other than petitioners, without cost to petitioners, and petitioners had nothing whatever to do with, and paid no part of, the cost of the drilling of the wells on the leasehold estates or the production of oil therefrom. The operators of the leasehold estates to which the contracts were applicable arranged with pipeline companies to purchase and run the oil produced from the wells thereon, and in each instance petitioners executed what is known in the oil industry as a "division order" to the oil company purchasing and running the oil from the wells. There is inserted in the record as a part of a stipulation of facts, as exhibit B, a copy of a division order executed to the Magnolia Petroleum Co. on the Pinkston lease, and this division order is typical *269 of the division orders executed by petitioners in the case of the other*1215 leases with respect to which they held contracts. In their returns for the years in controversy, petitioners treated the proceeds from the sales of oil under the contracts as proceeds from the sale or exchange of capital assets. For the years 1934 and 1935 petitioners deducted from the amounts received from the sales of oil a proportionate part of the cost of each contract and reported a percentage of the balance, the percentage depending on the length of time the contract had been in force. For the year 1936 petitioners deducted from the amounts received in each instance a proportionate part of the cost of the contract or percentage depletion, whichever was greater, and reported a percentage of the balance in gross income, the percentage depending on the length of time the contracts had been held. The respondent has included in income the entire amount received under the various contracts and has allowed as deductions against such amount cost or percentage depletion, whichever is greater. The parties have stipulated in part that: If the Board should hold that the proceeds aforesaid received by Petitioners under the various "dollar" and "barrel" contracts represent gains*1216 from the sale or exchange of capital assets, Respondent contends that only a proportionate part of the cost of the contracts may be deducted from the amounts received in arriving at the net income subject to tax, and that Petitioners are not entitled to deduct cost or percentage depletion, whichever is higher. There is attached hereto and made a part hereof as Exhibit "C" a tabulation showing the amount of cost which will be deductible from the amounts received in the cases of each contract for each year if the Board decides that said proceeds received under the contracts represent gain from the sale or exchange of capital assets and that the Petitioners are entitled to deduct only a proportionate part of the cost of the contracts from the amounts received in arriving at net income, as contended by the Respondent. We deem it unnecessary to incorporate this exhibit as a part of these findings of fact. It is incorporated herein by reference. Under present restrictions, it will require from three to thirty years for petitioners to receive the number of barrels of oil or the number of dollars payable out of or under their contracts. The wells out of which petitioners' oil is produced*1217 are permitted to produce oil five days a week, with a maximum production of twenty-two and a fraction barrels a day. The oil that is produced from the wells is accumulated on the leases in storage tanks. At irregular intervals, depending upon the amount of storge, the oil is run from the storage tanks into the pipelines belonging to the companies that purchase it. Pettit has nothing to do with the running of this oil. The pipeline companies purchasing the oil pay him once a month for the amount he is entitled to receive under the contracts. *270 The petitions in Docket Nos. 94292 and 94293 were filed on June 9, 1938, wherein each petitioner prayed for a refund of $1,445.18 for the year 1934 and for a refund of $545.37 for the year 1935. A claim for refund for the year 1934 was filed by petitioners on February 28, 1938. Amendments to the petitions in Docket Nos. 94799 and 94800 were filed on January 30, 1939, wherein each petitioner prayed for a refund of $473.54 for the year 1936. There have been previously assessed against and paid in quarterly installments by each of the petitioners the following taxes as shown by Joint Exhibit A-1: Year Assessed Paid [1934] $7,451.19 $7,451.19 [1935] 2,913.12 2,913.12 [1936] 10,500.15 10,500.15 *1218 OPINION. BLACK: The material provisions of section 117 of the Revenue Acts of 1934 and 1936 are identical and are set out in the margin. 1 Petitioners contend that the rights and estates held by them by virtue of the 31 oil payment contracts are "capital assets" as that term is defined in section 117(b); that the profits resulting from the sales of oil in connection with these contracts should be taken into account in computing net income at the percentages mentioned in section 117(a), depending upon the length of time the contracts have been held; and that in computing the profits resulting from the sales of oil, petitioners are entitled to have the gross proceeds received by them reduced by cost or percentage depletion, whichever is greater. The respondent, in determining the deficiencies, has reduced the gross proceeds received by petitioners by cost or percentage depletion, whichever is greater. He contends that petitioners have not sold or exchanged capital assets and are not, therefore, entitled to the benefits of section 117, and that his determinations of *271 the deficiencies are correct. He further contends as an alternative, that if the Board should hold*1219 that petitioners are entitled to the benefits of section 117, then the gross proceeds received should only be reduced by a proportionate part of the cost of the contracts, and that the deductions for depletion which he has allowed should be disallowed. The parties are in agreement as to the amount of taxable net income from the sales of oil in connection with the 31 oil paymemt contracts for each of the taxable years involved under either the petitioners' contention or the respondent's alternative contention, which taxable net income, compared with the respondent's determination, is as follows: Year Respondent's determination Petitioners' contention Respondent's alternative [1934] $108,264.24 $69,778.06 $80,883.79 [1935] 68,394.48 42,998.92 51,547.89 [1936] 75,441.41 44,349.58 52,766.57 *1220 The term "capital assets" is defined by section 117(b) to mean "property held by the taxpayer" exclusive of three classifications of property, namely, (1) stock in trade, (2) property of a kind which would properly be included in the inventory, and (3) property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business. The respondent does not seriously contend that the "property held by the taxpayer" falls within any of the three classifications specifically excluded, and, under the view which we take, it will not become necessary to decide whether the "property held by the taxpayer" does or does not fall within any of the three classifications specifically excluded from the term capital assets. The respondent contends that the "property held by the taxpayer" consisted of the 31 oil payment contracts, vesting in petitioners an economic interest in a certain amount of oil in the ground, and that no part of this property, as such, was either sold or exchanged by petitioners during the taxable years in question. If any "property" were sold, the property sold was the oil itself, rather than the economic interest in the oil, and although some of*1221 the oil was run into storage tanks prior to its sale, it is not petitioners' contention that any of the oil sold had been held in the storage tanks for more than one year prior to its sale. But as will be explained later in this opinion, we think the proceeds received by petitioners should be classed as "income * * * growing out of the ownership or use of or interest in * * * property" rather than "gains" from the sales of property. (Words within quotation marks are taken from section 22(a), Revenue Acts of 1934 and 1936.) *272 The respondent says in his brief, "If petitioners had sold their contracts outright, we would then agree that they were entitled to the benefit of the capital gain provisions * * *." Such a situation would be controlled by , reversing . But petitioners did not sell their economic interests in the oil in place. They retained those interests, diminished, of course, from time to time by depletion, and merely enjoyed the income which those interests produced. This, we think, is the deciding factor in the case. We do not think there is any difference in substance*1222 between the proceeds which petitioners received by virtue of their ownership of the several economic interests, and the bonus payments which Harmel received in . In that case Harmel was the owner in fee of Texas oil lands. He executed oil and gas leases of the lands for a stated period in return for bonus payments, aggregating $57,000 in cash, and stipulated royalties, measured by the production of oil and gas by the lessee. The question there was whether under the Revenue Act of 1924, the bonus payments of $57,000 were "gain from the sale or exchange of capital assets." The Supreme Court was of the opinion that the payments (both bonus and royalties) by the lessee to the lessor were not a conversion of capital, as upon a sale of capital assets, but were income to the lessor, like payments of rent. It did not think that the treatment of the payments as income produced the kind of hardship aimed at by the capital gains provision of the taxing act, as the abstraction of the oil from the soil was a time-consuming operation and the payments made to the lessor did not normally become payable as the result of a single transaction within*1223 the taxable year, as in the case of a sale of property. It said that the statute speaks of a "sale" and that the leases there in question would not generally be described as a "sale" of the mineral content of the soil, using the term in its technical sense or as it is commonly understood. Finally, the Supreme Court noted that the court below thought that the bonus payments, as distinguished from the royalties, should be treated as capital gain, apparently because it assumed that the statute authorized a depletion allowance upon the royalties alone, an assumption which later proved to be incorrect. Cf. . It said it could see no basis for such a distinction, and that: Bonus and royalties are both consideration for the lease, and are income of the lessor. We cannot say that such payments by the lessee to the lessor, to be retained by him regardless of the production of any oil or gas, are any more to be taxed as capital gains than royalties which are measured by the actual production. Although the Harmel case was decided under the Revenue Act of 1924, there are no provisions in the Revenue Acts of 1934 and 1936 *273 *1224 which would require any different holding on the same set of facts as were there involved. In the instant proceedings, the proceeds received and to be received by petitioners are as much of a time-consuming operation as was the receipt of income by Harmel from his leases. Pettit testified that it would take from three to thirty years to realize all that he hoped to realize from his contracts. Furthermore, there can be no question as to petitioners' rights to depletion deductions against the gross proceeds received by them. By virtue of their 31 oil payment contracts, they acquired for a capital outlay such an economic interest in the oil as under , and , entitles them to the statutory depletion allowance. The respondent in his determinations has granted them this allowance and in his brief states, "if income is subject to depletion it cannot be classed as capital gain." There is merit in this statement, we think. Cf. . In his determination of the deficiencies in these proceedings, respondent has included the entire amount received*1225 under the various contracts in gross income and has allowed, as deductions against such gross income, cost or percentage depletion, whichever is the greater. This is the same method that we directed should be used as to receipts from the Fox lease oil payment contract involved in Depletion is a deduction from gross income. The latter term includes "gains" from the sales of property and also "income * * * growing out of the ownership or use of or interest in * * * property." See sections 22(a) and 23(m) of the Revenue Acts of 1934 and 1936. The amount of the "gain" from the sale of property is determined under section 111(a) of the Revenue Acts of 1934 and 1936 and "shall be the excess of the amount realized therefrom over the adjusted basis provided in section 113(b) * * *." Congress certainly did not intend to reduce the "amount realized" on a sale by the "adjusted basis" and then, on top of that, allow the taxpayer a deduction for depletion. Cf. . So, if it is clearly established, as it has been in these proceedings, that petitioners are entitled to deductions for depletion, then it*1226 is our opinion that the proceeds received by petitioners must be classed as "income * * * growing out of the ownership or use of or interest in * * * property" rather than "gains" from the sales of property. The Circuit Court of Appeals for the Fifth Circuit, in the case of , affirming , held that an oil well driller who was paid for his services by an assignment of an interest in the oil in place, until he received the amounts of the payments in the contracts, obtains an economic interest in the oil in place and can not deduct the costs of drilling from the payments received by him under his *274 drilling contracts, but he must recover his costs through depletion deductions. The court said the production of oil under the contract is not a sale of the partnership interest in the oil in place, but is an enjoyment of that interest. Its interest in the oil reserve, like the fee owner's, is not thereby sold, but only depleted. Neither of them can deduct cost in dealing with the income so received, but each may reduce his income by depletion. The statute, of*1227 course, provides that a taxpayer who is entitled to deduct depletion may either deduct percentage depletion or depletion based on cost, whichever is the greater. Counsel for petitioners cite , and , and in their briefs say, "We think it unquestionable that under the rulings in these cases, the money received by the Pettits under their contracts is taxable under the capital gains provisions of the Revenue Acts of 1934 and 1936." The Carroll case held that, where a partnership engaged in the manufacture and sale of lumber at wholesale was the owner of extensive tracts of standing timber and sold a part of the timber to another company under an agreement that the purchaser cut and pay for the same as cut, such timber, having been held by the taxpayer for more than two years prior to sale, was a capital asset and the gain thereon was a capital gain, under the capital gains provisions of the applicable statutes. We do not think this case throws any particular light on the questions involved in the instant proceedings, as the law relating to timber is quite different from*1228 that relating to oil and gas. The Boeing case is also a timber case and was reversed by the Circuit Court of Appeals for the Ninth Circuit at 106 Fed.(2d) 305; certiorari denied, December 11, 1939. It is our opinion that the instant proceedings are controlled by , as we can not say that the proceeds received by petitioners are any more to be taxed as capital gains than were the bonus payments which were involved in that case. The respondent's determination on this issue is sustained. Decisions will be entered under Rule 50. Footnotes 1. SEC. 117. CAPITAL GAINS AND LOSSES. (a) GENERAL RULE. - In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net income: 100 per centum if the capital asset has been held for not more than 1 year; 80 per centum if the capital asset has been held for more than 1 year but not for more than 2 years; 60 per centum if the capital asset has been held for more than 2 years but not for more than 5 years; 40 percentum if the capital asset has been held for more than 5 years but not for more than 10 years; 30 per centum if the capital asset has been held for more than 10 years. (b) DEFINITION OF CAPITAL ASSETS. - For the purposes of this title, "capital assets" means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. ↩