Wegener v. Commissioner

H. H. WEGENER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Wegener v. Commissioner Docket No. 92333. United States Board of Tax Appeals 41 B.T.A. 857; 1940 BTA LEXIS 1135; April 16, 1940, Promulgated *1135 Petitioner and two associates owned undivided one-third interests in certain oil leases which were developed and operated as a joint venture, and financed from borrowed money obtained on the joint and several credit of the joint venturers. Petitioner, a driller, entered into a contract to drill the oil wells on the property at an agreed price per foot. In the taxable year he was paid $130,594.50 for footage drilled at the agreed price. Held, that the entire profit computed as the difference between the amount received and the cost of drilling is taxable income to petitioner. Charles H. Garnett, Esq., and C. F. Miller, C.P.A., for the petitioner. John E. Marshall, Esq., for the respondent. KERN *857 The respondent determined a deficiency in petitioner's income tax for the year ended December 31, 1935, in the amount of $13,347.99. *858 The petitioner alleges that the respondent erred (a) in including in income the amount of $23,592.08 as "additional income from drilling", and (b) in understating allowable depletion on certain oil and gas leases in the amount of $2,040.05. This assignment of error was, however, abandoned at*1136 the hearing. The case was submitted on oral testimony and documentary evidence. FINDINGS OF FACT. The petitioner is an individual, residing at Dallas, Texas. His principal place of business for the taxable year 1935 was Oklahoma City, Oklahoma. By written agreement dated February 23, 1932, Walter H. Gant and Knox L. Garvin acquired from the Reliance Oil & Royalty Corporation et al., an interest in certain oil and gas leases covering acreage in Rusk County, Texas, for certain oil considerations. Under the terms of the agreement the assignees were obligated to begin drilling operations at once and to develop the acreage in order to prevent drainage of the field. The petitioner was engaged, among other things, in the business of drilling oil wells and owned drilling machinery and equipment. It was agreed, in February or March 1932, between Gant and Garvin and petitioner that petitioner would take a one-third interest in the Rusk County leases and would drill wells on the property at an agreed price. During the negotiations petitioner expressed himself as being unwilling to enter into a partnership deal and no partnership agreement was entered into between the parties. *1137 By written agreement dated October 31, 1932, which is included herein by reference, Gant and Garvin assigned to him an undivided one-third of the interest acquired by them in the Rusk County leases, all personal property used or obtained in connection therewith, and all rights, options, and privileges granted under the agreement of February 23, 1932, and the supplemental modification dated July 7, 1932, subject to the terms and conditions thereof. According to the terms of the assignment petitioner assumed one-third of all the duties, obligations, and liabilities imposed upon Gant and Garvin by their agreement with their assignors, and the undivided one-third interest assigned to him was chargeable with one-third of all oil considerations payable by them under the terms of that agreement. It was further specifically provided that, in so far as the Reliance Oil & Royalty Corporation, et al., were concerned, petitioner "shall be liable jointly and severally with the said Walter H. Gant and Knox L. Garvin for the full performance of all the duties, obligations, and liabilities imposed" upon Gant and Garvin by the original contract and modifying agreement, and the one-third *859 *1138 interest assigned to him "shall be and remain jointly and severally liable with the 2/3 interest" for the payment of all oil and money considerations payable to the Reliance Oil & Royalty Corporation, et al. Gant, Garvin, and Wegener developed the leases. Drilling operations were started by petitioner in March 1932 and continued thereafter. In order to finance the development and operation of the leases it was necessary to borrow money from time to time and oil runs were pledged to repay the loans. In October 1932 a loan of $80,000 was obtained from the First National Bank & Trust Co. of Oklahoma City and a deed of trust was executed by petitioner and Gant and Garvin, "as individuals and as partners", conveying the Rusk County leases to A. J. Peters, as trustee, to secure the loan. A separate bank account was opened at the First National Bank & Trust Co. of Oklahoma City by Gant, Garvin & Wegener, and checks were issued on this account. According to the terms of the trust instrument, checks in payment of oil runs were sent direct to the bank until the loan was liquidated. Such checks were made out to the individual owner of an interest in the lease and not to Gant, Garvin*1139 & Wegener. Petitioner made financial statements to the Liberty National Bank, Oklahoma City, Oklahoma, at the close of the years 1932, 1933, and 1934. In answer to the question, "Have you any partners in your business?", he said: "No - Rusk County, Texas, operations are a joint venture." Petitioner's books were kept in the office of his attorneys, Miller & Homan. They kept books on an accrual basis. For the first wells drilled on the Rusk County leases, he charged Gant and Garvin with two-thirds of the price and his own capital account with one-third. In the latter part of 1932, books in the name of Gant, Garvin & Wegener, were set up for the joint enterprise. Thereafter petitioner charged Gant, Garvin & Wegener with the entire amount due him for drilling done on the leases at the agreed price. It was understood that he would receive the full amount of the footage rate for drilling wells, which, including the agreed rental for tools, was $130,594.50 in the taxable year. He billed Gant, Garvin & Wegener with this amount and received payment in full from them. Letterheads bearing the name "Gant, Garvin & Wegener", were printed and used after the fall of 1932. Petitioner, *1140 Gant, and Garvin shared equally in the profits and losses from the enterprise. In 1935 Gant, Garvin, and Wegener, as a copartnership and as individuals, secured loans from the National Bank of Tulsa, Tulsa, Oklahoma, in the amount of $300,000, and assigned to F. M. Sowle, as trustee, the Rusk County leases as security for the loan. Other loans *860 were made during the year. The money in payment of the oil runs went to the bank to liquidate the loans and the bank turned over to the joint account enough money to pay the current operating expenses. Petitioner was paid for drilling from the money borrowed from time to time. It was understood that he would receive the full amount of the footage rate for drilling wells. Partnership returns on form 1065 were filed by Gant, Garvin & Wegener, on the advice of tax counsel (who thought the revenue law required such a return), for the taxable years 1932, 1933, 1934, and 1935. These returns showed a loss of $4,449.74 for 1932 and net income of $6,445.63 for 1933, $15,635.84 for 1934, and $55,680.67 for 1935. The gross profits from operations in 1935 were $174,609.15. These returns stated that Gant, Garvin & Wegener is a partnership*1141 organized in 1932 and engaged in the oil and gas business. No deduction was taken on these returns for the cost of drilling oil wells, or for any amount paid out for such drilling. In his individual income tax return for 1935 petitioner reported, as income from Gant, Garvin & Wegener, his pro rata share of the net income shown on the partnership return, or $18,560.22. He also reported net income from drilling and rental of tools, "Gant, Garvin & Wegener", $47,184.15. The latter amount represented two-thirds of the net profit from the drilling operations in 1935 and was computed by petitioner as follows: Amount received from drilling, rental tools $130,594.50 Drilling expense 59,818.27 Net profit $70,776.23 1/3 Net profit allocated to petitioner's interest 23,592.08 2/3 Net profit allocated to Gant & Garvin $47,184.15 The "drilling expense" included the following items: Contract drilling $600.00 $6Labor 28,633.00 Blacksmith shop work 563.59 Teaming and trucking??h6,247.83 Fuel and water 245.98 Supplies 16,274.07 Auto expense 117.40 Compensation insurance 6,029.12 Miscellaneous 1,107.28 Total 59,818.27 In computing the*1142 deficiency here in question the respondent added to petitioner's income the amount of $23,592.08, as additional profit from drilling oil wells. *861 OPINION. KERN: The only issue before us is whether the respondent erred in including in petitioner's income for 1935 the amount of $23,592.08 as additional income from drilling operations on the Rusk County, Texas, oil leases. In computing petitioner's income tax liability the respondent considered Gant, Garvin & Wegener to be a partnership for income tax purposes and petitioner a partner. He considered that petitioner, as an individual contractor, drilled oil wells on the leased property at an agreed price, and determined that in the taxable year petitioner realized from such drilling operations a taxable net profit of $70,776.23, and had failed to include $23,592.08 of that amount in income. The petitioner contends that Gant, Garvin & Wegener is not a partnership, and that the $23,592.08 was not taxable income to him. It appears from the record that petitioner became associated with Gant and Garvin in the development of the Rusk County oil and gas leases early in 1932. No partnership agreement was entered into*1143 at that time, and it is obvious from the record that the parties did not intend to form a general partnership. It was a joint enterprise in which Gant, Garvin, and Wegener, and their individual interests in the Rusk County, Texas, oil and gas leases were jointly and severally liable for full performance of all obligations imposed upon Gant and Garvin under the original agreement and the supplement thereto. In order to borrow money they jointly and severally (as a partnership and as individuals) assigned their interests in the oil leases in trust as security for loans and provided for the payment of the loans from the joint income from the sale of oil and gas. These loans were repaid from oil and gas produced by the joint operation of the leases. In financial statements the petitioner stated that the Rusk County, Texas, operations were a joint venture and not a partnership. A joint bank account was opened in 1932. Letter-heads bearing the name of Gant, Garvin & Wegener were printed and used in the business. Late in 1932 books of account were set up in the name of Gant, Garvin & Wegener, and thereafter billings were made to and accounts paid by the firm. The enterprise was conducted*1144 by Gant, Garvin, and Wegener, who consulted with each other concerning the business and shares equally in the profits and losses. From the facts in the record we conclude that the development and operation of the Rusk County, Texas, oil and gas leases by petitioner and Walter H. Gant and Knox L. Garvin was a joint venture conducted under the name of Gant, Garvin & Wegener. As such it was properly treated as a partnership by the respondent for income tax purposes under section 801(a)(3) of the Revenue Act of 1934, and *862 petitioner properly returned his proportionate share of the net income from such venture. . But the fact that Gant, Garvin & Wegener is considered a partnership for the purpose of computing its net income and the members of the firm are considered partners for the purpose of reporting their distributable shares of its taxable net income under the Federal revenue laws, does not necessarily mean that it is a general partnership and the members of the firm are partners for all purposes in the conduct of its business. Cf. *1145 ; . It remains a joint venture, and such cases as ; ; and (cited by petitioner), which deal with partnerships, are not controlling. Petitioner argues that, regardless of whether Gant, Garvin & Wegener is a partnership, he is not subject to tax on one-third of the profit received from drilling because as to him it was a distribution of a part of his capital investment. This argument, while ingenious, is not in accordance with the facts. Gant, Garvin & Wegener, as coadventurers, were engaged in the business of developing and operating the leasehold. They jointly borrowed money for this purpose and entered into an agreement under which petitioner, who was a driller, undertook to drill the oil wells at an agreed price per foot. In the taxable year they paid petitioner under this contract $130,594.50 for the footage drilled. This was not a mere paper transaction. It was a transaction in which Gant, Garvin & Wegener paid out cash for oil wells, which*1146 became capital assets of the joint venture in which petitioner had the same individual interest as his coadventurers. The $130,594.50 which was paid to petitioner by Gant, Garvin & Wegener was merely changed from capital assets in cash to capital assets consisting of oil wells, in which petitioner retained the same undivided interest he had in the cash. He can not, therefore, be said to have subtracted from the newly acquired assets a part of his capital investment therein and at the same time continue to hold an equal interest with his coadventurers in the property. He can not retain his capital in the joint venture and withdraw it too. 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. Petitioner argues in effect that in the taxable year he was engaged in drilling oil wells on his undivided one-third interest in the leased property at his own expense and without profit, and at the same *863 *1147 time he was drilling oil wells on the undivided two-thirds interest of Gant and Garvin at a profit under a contract with them. We do not think the facts in the record add up to this construction. It was necessary for the owners of the leases to borrow money to develop the property. Early in 1932 and before a loan was secured from the bank, each of the parties necessarily contributed his proportionate share of the cost of drilling and petitioner billed Gant and Garvin with their share of the cost. At this time they were associated under an oral agreement and there had been no assignment to petitioner of a one-third interest in the leasehold. In October 1932 petitioner and Gant and Garvin jointly borrowed $80,000, and petitioner acquired a one-third interest in the leasehold by assignment. Thereafter Gant, Garvin & Wegener conducted the business as coadventurers and not as individuals, using their joint capital, their joint credit, and their joint efforts in developing and operating the oil properties. A new agreement for drilling was entered into, which was subsequently changed as to price per foot, but the entire footage drilled at the agreed price was billed by petitioner*1148 to Gant, Garvin & Wegener, paid from the bank account of Gant, Garvin & Wegener, and treated as a capital investment. From the facts in the record and the relation of the parties, we conclude that the development and operation of the property was carried on by the joint venture and that petitioner as an individual drilled the oil wells for Gant, Garvin & Wegener, and not for himself as to his interest, and for Gant and Garvin as to their interest. We do not think that the joint venture was paying petitioner a profit for drilling wells on his hown property. Petitioner received from Gant, Garvin & Wegener the full contract price of $130,594.50 for the oil wells drilled during the taxable year. The cost of the drilling was $59,818.27. Obviously, he realized a profit in the amount of $70,776.23, which is income taxable to him. The determination of the respondent is affirmed. Decision will be entered under Rule 50.