114 T.C. No. 15
UNITED STATES TAX COURT
CHARLES E. AND SHERRIE R. STRANGE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8602-98. Filed March 29, 2000.
Ps paid State nonresident income tax to nine
States on net royalty income derived from their
interests in oil and gas wells located within those
States. Ps reported all their royalty income on
Schedules E, Supplemental Income and Loss, which they
attached to their Federal income tax returns. In
calculating their total net royalty income, petitioners
deducted the State income taxes they paid.
Consequently, petitioners deducted the State
nonresident income taxes in computing their adjusted
gross income for the years at issue.
Held, the addition of sec. 164(a)(3), I.R.C., by
the Revenue Act of 1964, Pub. L. 88-272, sec. 207(a),
78 Stat. 19, 40, did not change the existing law with
respect to the deduction of State income taxes.
Held, further, State nonresident income taxes are
not "attributable" to property held for the production
of royalties and, therefore, are not deductible under
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sec. 62(a)(4), I.R.C., in computing Ps' adjusted gross
income.
Held, further, State nonresident income taxes are
not deductible as a trade or business expense under
sec. 62(a)(1), I.R.C. Tanner v. Commissioner, 45 T.C.
145 (1965), affd. per curiam 363 F.2d 36 (4th Cir.
1966), followed.
L. Robert LeGoy, Jr. and Kurt O. Hunsberger, for
petitioners.
Paul L. Dixon, for respondent.
OPINION
PARR, Judge: Respondent determined deficiencies of $3,955,
$5,379, and $3,983 in petitioners' Federal income taxes for the
taxable years 1993, 1994, and 1995, respectively. The sole issue
for decision is whether State nonresident income taxes paid on
net royalty income are deductible for purposes of determining
adjusted gross income. We hold they are not.
Background
This case was submitted fully stipulated under Rule 122.1
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. Petitioners resided in
1
Unless otherwise indicated, all Rule references are to the
Tax Court Rules of Practice and Procedure, and all section
references are to the Internal Revenue Code in effect for the
taxable years at issue.
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Las Vegas, Nevada, at the time they filed their petition in this
case.
During the years at issue, petitioners owned interests in
oil and gas wells (the properties) located in the States of
Alabama, California, Colorado, Louisiana, Michigan, Mississippi,
New Mexico, Oklahoma, and Utah (the nine States).
Each of the nine States imposed an income tax on
nonresidents who derived income from an income-producing activity
within that State. Petitioners received royalties from the
properties and paid a nonresident income tax to each State on the
net royalty income (gross royalty income minus production taxes,
overhead and operating expenses, and allowances for depletion)
derived from the properties located only within that State.
Petitioners reported all their royalty income on Schedule E,
Supplemental Income and Loss, which they attached to their
Federal income tax returns. In calculating their total net
royalty income, petitioners deducted the State income taxes they
paid in addition to the expenses that they deducted in
calculating their State nonresident incomes. Consequently,
petitioners deducted the State nonresident income taxes in
computing their adjusted gross income for the years at issue. In
computing their taxable income, petitioners elected to take the
standard deduction allowed by section 63 instead of itemizing
their deductions.
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Discussion
Section 164(a)(3) provides inter alia that State income
taxes are allowed as a deduction for the taxable year within
which they are paid or accrued. This section was added to the
Code by the Revenue Act of 1964 (the Act), Pub. L. 88-272, sec.
207(a), 78 Stat. 19, 40. Before the Act, the Code did not
specifically list the deductible taxes. Thus, according to
petitioners, the preexisting law was changed by the Act to
provide "unequivocally" for the deduction of the State income
taxes for the purpose of calculating adjusted gross income, and,
when read together, sections 62(a)(4) and 164(a)(3) "specifically
provide that state [sic] income taxes attributable to property
held for the production of royalties are deductible from an
individual's gross income to compute the individual's adjusted
gross income." We disagree.
The general rule under the law before the Act was that State
and local income taxes paid or accrued by an individual were
deductible as itemized deductions for Federal income tax
purposes. See H. Rept. 749, 88th Cong., 1st Sess. (1963), 1964-1
C.B. (Part 2) 125, 171-172. The Act specifically provides for
the continued deductibility of State and local income taxes in
this manner, while, in the interest of tax equity and ease of
compliance, denying the deduction of certain other taxes,
devoting any revenue gain from the denial of those other
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deductions to further tax rate reductions. See id., 1964-1 C.B.
(Part 2) at 173-174. Accordingly, the Act did not change the
existing law with respect to the deduction of State income taxes.
Section 62(a)(4) provides that, in the case of an
individual, the term "adjusted gross income" means gross income
minus, inter alia, the deductions allowed by part VI (section 161
and following), which are attributable to property held for the
production of rents or royalties. See also sec. 1.62-1T(c)(5),
Temporary Income Tax Regs., 53 Fed. Reg. 9873 (Mar. 28, 1988)
(same); sec. 1.62-1T(d), Temporary Income Tax Regs., 53 Fed. Reg.
9874 (Mar. 28, 1988) (taxes are deductible in arriving at
adjusted gross income only if they constitute expenditures
directly attributable to a trade or business or to property from
which rents or royalties are derived). Petitioners contend that
the State nonresident income taxes they paid were "attributable
to" property held for the production of royalties and are,
therefore, deductible in computing adjusted gross income. We
disagree.
The concept of adjusted gross income was first incorporated
by Congress into the 1939 Code by adding subsection (n) to
section 22, I.R.C. 1939, in the Individual Income Tax Act of
1944, ch. 210, sec. 8(a), 58 Stat. 231, 235.2 See S. Rept. 885,
2
Par. (4) of sec. 22(n), I.R.C. 1939, provided that the term
"adjusted gross income" means gross income minus the deductions
(continued...)
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78th Cong., 2d Sess. 24-25 (1944), 1944 C.B. 858, 877. The
legislative history to section 22(n), I.R.C. 1939, states:
The proposed section 22(n) of the Code provides that
the term "adjusted gross income" shall mean the gross
income computed under section 22 less the sum of the
following deductions: (1) Deductions allowed by
section 23 of the Code, which are attributable to a
trade or business carried on by the taxpayer not
consisting of services performed as an employee; * * *
(4) deductions allowed by section 23 which are
attributable to rents and royalties; * * *
* * * * * * *
The deductions described in clause (1) above are
limited to those which fall within the category of
expenses directly incurred in the carrying on of a
trade or business. The connection contemplated by the
statute is a direct one rather than a remote one. For
example, property taxes paid or incurred on real
property used in the trade or business will be
deductible, whereas State income taxes, incurred on
business profits, would clearly not be deductible for
the purpose of computing adjusted gross income.
Similarly, with respect to the deductions described in
clause (4), the term "attributable" shall be taken in
its restricted sense; only such deductions as are, in
the accounting sense, deemed to be expenses directly
incurred in the rental of property or in the production
of royalties. * * * [S. Rept. 885, supra, 1944 C.B.
at 877-878; emphasis added.]
See also H. Rept. 1365, 78th Cong., 2d Sess. (1944), 1944 C.B.
821, 839.
The State nonresident income taxes were imposed upon
2
(...continued)
(other than those provided in pars. (1) for trade and business
deductions, (5) for certain deductions of life tenants and income
beneficiaries of property, or (6) for losses from sales or
exchange of property) allowed by sec. 23 which are attributable
to property held for the production of rents or royalties.
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petitioners' net royalty income, not upon property held for the
production of royalties. Moreover, as the State income taxes
were imposed on petitioners' net royalty income, the State income
taxes were not an expense directly incurred in the production of
that income. See, e.g., Bulloch, Accountants' Cost Handbook 1.9
(3d ed. 1983) (expenses are expired costs that were used to
produce revenue). Accordingly, we find that the State
nonresident income taxes paid by petitioners are not attributable
to property held for the production of royalties.
Furthermore, we find that the taxes are not otherwise
deductible as a trade or business expense in computing
petitioners' adjusted gross income. Section 1.62-1T(d),
Temporary Income Tax Regs., supra, provides that to be deductible
for the purposes of determining adjusted gross income, expenses
must be those directly, and not those merely remotely, connected
with the conduct of a trade or business.
For example, taxes are deductible in arriving at
adjusted gross income only if they constitute
expenditures directly attributable to a trade or
business or to property from which rents or royalties
are derived. Thus, property taxes paid or incurred on
real property used in a trade or business are
deductible, but state taxes on net income are not
deductible even though the taxpayer's income is derived
from the conduct of a trade or business. [Id.]
The committee reports and the regulations specifically state
that State taxes on net income are not deductible for the purpose
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of computing adjusted gross income.3 Finally, in Tanner v.
Commissioner, 45 T.C. 145 (1965), affd. per curiam 363 F.2d 36
(4th Cir. 1966), we held that a taxpayer is not entitled to
deduct, in computing his adjusted gross income, the State income
tax he paid on income he received as his share of the net
business income derived from certain partnerships.4 See also
Lutts v. United States, 15 AFTR 2d 702, 65-1 USTC par. 9313
(S.D. Cal. 1965).
In the instant case, petitioners paid State nonresident
income taxes on their net royalty income, which derived from
their interests in oil and gas wells; the State income taxes were
not expenses attributable to property held for the production of
royalties or expenses directly incurred in the production of
royalties. Accordingly, we hold that the State nonresident
income taxes paid by petitioners are not deductible for the
3
Following the enactment of sec. 22(n), I.R.C. 1939, the
Commissioner amended Regulations 111 by adding sec. 29.22(n)-1,
which provided that State income taxes were not deductible in
determining adjusted gross income, even though the taxpayer's
income was derived from the conduct of a trade or business. See
T.D. 5425, 1945 C.B. 10, 16.
4
In Tanner v. Commissioner, 45 T.C. 145 (1965), affd. per
curiam 363 F.2d 36 (4th Cir. 1966), the issue was decided
pursuant to the provisions of sec. 62(1), I.R.C. 1954 (as
amended). The provisions of sec. 62 of the 1954 Code are
substantially the same as the provisions of sec. 22(n) of the
1939 Code. See id. at 147. Furthermore, sec. 62(a)(4), which is
in effect for the taxable years at issue, is the same as sec.
62(5), I.R.C. 1954 (as amended).
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purpose of computing adjusted gross income.5
In reaching our holdings herein, we have considered each
argument made by the parties and, to the extent not discussed
above, find those arguments to be irrelevant or without merit.
To reflect the foregoing,
Decision will be entered for
respondent.
5
In this case, if petitioners had not elected to take the
standard deduction, the State income taxes that petitioners paid
would be deductible from their adjusted gross income as an
itemized deduction, see secs. 63, 161, subject to the limitation
imposed by sec. 68.