Cree v. Commissioner

WILLIAM H. CREE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. RUTH A. CREE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Cree v. Commissioner Docket Nos. 105667, 105835. United States Board of Tax Appeals 47 B.T.A. 868; 1942 BTA LEXIS 633; October 13, 1942, Promulgated *633 The petitioners acquired two oil and gas leases; also, both earlier and later, certain rights of participation in the working interests, each limited to certain wells drilled upon such leases. Held, that each lease, and not each well, is a "property" of the petitioners, within the meaning of section 114(b)(3), Revenue Act of 1938, and the petitioners may deduct depletion upon the gross income received by them from each lease, subject to the limitation to 50 percent of net income from such property. Maurice Levy, Jr., Esq., for the petitioners. Byron M. Coon, Esq., for the respondent. DISNEY *868 These proceedings were consolidated for hearing and report and involve the redetermination of deficiencies in income tax for 1938 in the amount of $262.10 in Docket No. 105667 and $266.12 in Docket No. 105835, all of which is in controversy. The issue common to both *869 proceedings is whether respondent erred in disallowing as a deduction $2,759.78 of the amount of depletion claimed in the return of each petitioner. The stipulation of facts filed by the parties is incorporated herein by reference as part of our findings of fact. Material*634 portions thereof will be set forth in the findings of fact made from other evidence of record. The petitioners filed their income tax returns with the collector of the sixth district of California. FINDINGS OF FACT. During the taxable year petitioners, husband and wife, were sublessees of and operated two oil properties located in the Signal Hill oil field, California, known as the Hall-Webber lease and the Cannon-Jones lease. There were four producing wells on the Hall-Webber lease, known as Hall-Webber wells Nos. 1, 2, 3, and 4, and three producing wells on the Cannon-Jones lease, known as Jones wells Nos. 1, 2, and 3. They also owned, by acquisition prior to, at the time of, and after, the purchase of the leases, various rights to participate in the working interests. The wells on each lease were drilled at different times during the period from 1926 to 1931 in the order in which they were numbered. The cost of drilling the wells was paid from the proceeds of sale of shares in the working interests of the wells at different times to different groups of individuals. Some individuals owned interests in more than one well. Each well was a separate venture. The Hall-Webber*635 wells were subject to landowner's royalty of 33 1/3 percent and the Jones wells were subject to a landowner's royalty of 16 2/3 percent. Prior to November 1937 petitioners held only small interests in the wells. In November 1937 they increased their holdings in each well by purchase of the leases from the lessee. Each assignment of a participating interest in the wells provided for payment to the assignees of a specified percentage "of all proceeds hereafter realized from the sale of the oil and gas produced, saved and sold" from the designated well. The assignments executed in connection with the sale of fractional working interests in Hall-Webber well No. 2 provided that it was the intention to convey a net or working interest in the production of the well, that the owner of each 1 percent of the working interest of 66 2/3 percent was chargeable with his pro rata share of the cost of operating, maintaining, and repairing the well, not exceeding, however, $7 per month per 1 percent, that the 66 2/3 percent of the proceeds of the production should bear the cost of operating, maintaining, and repairing the well, in short, that the 66 2/3 percent of the production should be divided*636 into 100 units, and that each unit should be what is generally termed a 1 percent net or working interest. Similar instruments were executed in connection with the sale of shares in the *870 working interests of the other wells. The assignments of interest in Hall-Webber well No. 3 provided for an arbitrary charge of $7 per month per 1 percent of the working interest. Each assignment provided for the payment by the assignee of a specified share of the cost of operating the well to which the assignment was applicable. During the taxable year the agreements with owners of shares of the working interests in the Jones wells, except No. 2, provided for payment of pro rata proportions of operating costs up to $7.50 per month per 1 percent. The assignment covering interests in Jones well No. 2 provided for payment of operating costs without a limitation. Holders of overriding royalties in the wells were not chargeable with any part of the operating costs of the wells. The charges deducted from the working interests consisted of the cost of pumpers, the cost of dehydrating and cleaning the oil, repairs, mining rights, taxes, and other expenses necessary to incur to keep the*637 wells on production. The same employees operated all of the wells on the leases. One or two wells on another lease were operated by the same crew. Individual tanks were maintained and separate books were kept for each well on the leases. The oil was not commingled. The production of each well was accounted for to the persons entitled thereto. No two wells produced oil from the same sand, and no two wells produced the same gravity of oil. During 1938 Jones well No. 1 and Hall-Webber wells Nos. 1, 2, and 3 had net operating income before deducting depletion, but Jones wells Nos. 2 and 3 and Hall-Webber well No. 4 had net losses before deducting depletion. Holders of royalty interests were charged each month with their proportionate share of the operating cost of the well and any balance in their favor was paid to them. No demand was made upon interest holders and they were not liable for any excess of operating costs over proceeds of production. Such excess was paid by petitioners, the operators of the wells. In the taxable year the petitioners, as operators of the wells, deducted from the amounts payable out of production to themselves, as participants in royalty, *638 the amounts of $467.43 for tax reserve and $4,399.56 for operating charges. These amounts were deducted by the respondent in his computation of gross income for purposes of depletion on the income reported by the petitioners as holders of "royalty" rights. OPINION. DISNEY: The petitioners acquired by assignment two separate oil and gas leases. Both before and after and with such acquisition they *871 also acquired certain fractional interests which the previous lessee had sold. These provided for participation in the working interest, that is, the lessee's interest, after payment of royalties, but each was limited to a particular well. In filing Federal income tax returns, the petitioners reported the income from the participating interests as "royalties" and separately reported the income from leases as income from business or profession. Depletion was claimed as to both classes of interest. The Commissioner in determining deficiencies allowed depletion upon the income from the leases to the petitioners as lessees, and does not now deny such depletion, taking issue only upon the method of computation thereof, i.e., he argues that depletion allowable to petitioners*639 as lessees should be computed upon each lease as a "property" within the meaning of section 114(b)(3), Revenue Act of 1938, while the petitioner urge that each well is a property. With reference to the position of the petitioners as helders of rights to participation, the Commissioner allowed depletion, but only upon the amounts remaining after deduction of certain expenses, this view being based upon the language of the assignments of the rights to participate, which the Commissioner regarded as reducing the petitioners' gross income for depletion purposes to the amounts received by the participant after payment of the expenses provided for. Upon brief, and without any pleadings asking for increased deficiency, the respondent urges that the participants had, under their assignments, only a right to net amounts, not constituting depletable interests. After careful examination of these interesting questions, we are of the opinion that the petitioners are entitled to compute depletion upon the gross amounts received by them from the properties, and that under the circumstances here presented each lease constitutes a property, so that depletion is limited to 50 percent of the net*640 income therefrom, under section 114(b)(3), Revenue Act of 1938, requiring therefore consideration of those wells the operation of which resulted in loss. Though no case is suggested, or found by us, which presents a parallel to the situation here presented, we think it clear from J. T. Sneed, jr.,40 B.T.A. 1136; affd., 119 Fed.(2d) 767; certiorari denied, 314 U.S. 686, and Allie M. Turbeville,31 B.T.A. 283 (292); affd., 84 Fed.(2d) 307, that in general the land covered by an oil and gas lease constitutes a "property" within the statute. The latter case says: "The term 'the property' applies to the particular acreage covered by each of the several leases." In Vinton Petroleum Co. of Texas,28 B.T.A. 549; affd., 71 Fed.(2d) 420; certiorari denied, 293 U.S. 601, the same is held, where eight different but neighboring tracts were involved, and taxpayer sought to consider all as one "property." Though in Helvering v. Jewel Mining Co., 126 Fed.(2d) 1011, the court held that there were two properties where a lessee of coal land *872 subleased*641 a part of the land, this only emphasizes the idea that there was a separation of acreage, and that such is the sound test of what constitutes a property. The court points out that the taxpayer retained its lease on one part of the land, but subleased "anohter part of the land," and that each party operated separately. Herein, the owner of certain rights under the lease purchases the same lease. In Mascot Oil Co.,29 B.T.A. 652, we held that a lessee of oil-producing land did not create a new "property" by granting an exclusive sublease to drill to depths below 1,600 feet. The petitioner cites G.C.M. 22106, C.B. 1941-1, p. 245, wherein it is stated, inter alia, that a single tract or parcel of land may be divided into two or more separate tracts or parcels by means of conveyances or leases "carving up the original 'tract' or 'parcel'," and that a taxpayer with several interests in a tract has several properties therein. But we do not think the idea soundly applied here, where the whole leasehold is acquired by one formerly owning only certain limited rights with respect thereto. We think we are not here faced with the question of depletion by*642 a mere holder of a participating interest in the working interest or leasehold, nor required to base our conclusion upon the form of his instrument of participation, for here the petitioners, in addition to acquiring rights to such participations in the working interests limited to certain wells, have acquired the leaseholds, on each lease. The participating interests were carved out of each leasehold, that is, the lessee (in order to obtain funds for drilling operations) assigned small fractional interests in his working interests, designating them as applying to particular wells. Though so designated and limited, they were obviously interests in the lease, in that they conferred rights growing out of the lease and granted by the holder thereof, even though not applying to all of the production upon the lease. The lease indeed constitutes a mere right to participate in, that is receive, the production from all wells, except in so far as that right is assigned, with the duty of paying expenses. Thus no essential difference is seen between lease and participating interest, and when the petitioners acquired the leaseholds, as well as the fractional interests in rights thereunder*643 sold by the lessee, there was effected a merger of interests, so far as the petitioners were concerned. 21 C.J. 1037. Higgins v. California Petroleum & Asphalt Co.,41 Pac. 1087. The rights to participation were merged with the leasehold in which they participated. We see nothing to prevent such merger, and no reason to view the petitioners in two different stati, that of lessees, and, separately, that of participants in leasehold rights, i.e., in the right to production under the lease (though only from a single well). No intervening estate in law or equity appears to prohibit the merger of the lesser participating right in the larger leasehold estate. It is *873 as if the limited right to participate had been canceled. The leasehold is no longer burdened with it; and the lessee can not logically present a participating right or charge against himself as giving him a different status for purposes of computation of depletion. We need not here decide whether a single tract of land may be the subject of more than one "property" by division of estates or interests therein among different owners, as argued between the parties; for here such different*644 estates or interests, growing out of the same lease, rest in the same person, and are not seen as calling for viewing such party in more than one category. He owns a lease, save only so far as rights have been conveyed to, and remain in, others. We conclude and hold that the petitioners have only one property right in each lease, and that it can not be divided by considering as a unit each well as to which participating rights had been sold, where such rights had returned to the lessee. It follows from this that depletion must be limited to 50 percent of the net income from each of the two leases, each of which we hold to be a "property" of the petitioners; it also follows that depletion should, subject to such limitation, be computed upon the gross income from each lease, received by petitioners both as lessees and as participants, for as lessees the petitioners are entitled to the entire income therefrom, subject only to interests held by the participants-assigness; and that the expenses of operating, maintaining, and repairing the wells may not be deducted before computation of depletion, under section 114(b) Revenue Act of 1938, except of course, as above stated, in calculating*645 the limitation of depletion to 50 percent of net income from each lease. This view renders it unnecessary to consider other issues. Decision will be entered under Rule 50.