*227 Decisions will be entered under Rule 50.
Petitioners were the owners of a certain oil and gas lease in Texas on which had been developed 19 producing oil wells and one gas well. In 1942, petitioners assigned their interests in the property to another for a cash consideration and, in addition thereto, an overriding royalty of 3/32nds of all oil and gas produced on the lease and a contingent oil payment of $ 112,500 out of oil to be produced on the lease. Of the cash consideration received, $ 95,000 was allocated to the sale price of the physical equipment on the lease and is not in controversy. The Commissioner in his determination of the deficiencies has determined that $ 16,387.10, commission and other expenses, incurred by petitioners in the assignment of the lease in 1942 was a capital expenditure and must be recovered through depletion and cannot be deducted as business expenses in the year when incurred. Held, the amount in question was a capital expenditure and must be recovered through depletion and is not deductible as ordinary and necessary business expense.
*775 These proceedings involve deficiencies in income tax against the petitioners in the amounts and for the years as set forth hereunder:
| Docket No. | 1943 | 1944 | |
| Dorothy Cockburn | 27421 | $ 49,544.23 | $ 5,373.06 |
| H. C. Cockburn | 27422 | 49,539.54 | 5,138.06 |
The cases have been consolidated.
All issues except one have been disposed of by agreement. The details concerning the disposition of the various issues which were settled and the facts pertaining to the remaining issue are incorporated in a stipulation filed at the time of the hearing. The year 1942 is involved because of the Current Tax Payment Act.
The sole question left in issue is whether petitioners are entitled to deduct as an "expense of sale" in the year 1942 the amount of $ 16,387.10 which consists of engineering fees $ 400, revenue stamps $ 424.60, and commission $ 15,562.50. The Commissioner's determination with respect to the $ 16,387.10 in question is explained in the deficiency notice in connection with adjustment (c) and is as follows:
(c) It is held that the transaction whereby you assigned the Burkitt Lease for a cash consideration of $ 386,250.00 and retained an oil payment and an overriding*229 *776 royalty was in the nature of a sublease of the oil rights and a sale of the equipment.
The amount of $ 291,250.00, which is the portion of the $ 386,250.00 cash consideration applicable to the assignment of the oil rights, is held to be ordinary income in the nature of a bonus. Depletion of 27 1/2% thereof, or $ 80,093.75 is allowed. Since you reported this transaction as a sale of the oil rights resulting in long-term capital gain, the amount $ 137,431.45 included by you in taxable income because of the transfer of the oil rights is eliminated from taxable income. The commission, fees and stamps aggregating $ 16,387.10 deducted by you in arriving at the amount of long-term capital gain reported are capital items and are not allowed as deductions.
| Bonus applicable to oil rights | $ 291,250.00 |
| Depletion, 27 1/2% allowable | 80,093.75 |
| Adjustment | 211,156.25 |
The petitioners now no longer contest the correctness of the Commissioner's adjustment (c), except that part of it which says:
* * * The commission, fees, and stamps aggregating $ 16,387.10 deducted by you in arriving at the amount of long-term capital gain reported are capital items and are not allowed as deductions.
*230 By appropriate assignments of error petitioners contest the correctness of the Commissioner's determination with respect to how the $ 16,387.10 should be treated.
FINDINGS OF FACT.
The facts have been stipulated and are adopted as our findings of fact. We state below such of these facts as we deem necessary to an understanding of the issue to be decided.
Petitioners are husband and wife and all income involved is that of the community. Petitioner H. C. Cockburn will sometimes hereafter be referred to as petitioner. The returns for the periods involved were filed with the collector of internal revenue at Austin, Texas.
In 1938 an oil and gas lease referred to as the Burkitt lease was executed with H. C. Cockburn, one of the petitioners herein, being the lessee. On or about October 25, 1940, H. C. Cockburn assigned to John H. Crowell an undivided one-fourth interest in the said Burkitt lease. At or about the time of the assignment of the undivided one-fourth interest, H. C. Cockburn and John H. Crowell entered into an agreement for development and operation of the Burkitt lease under which, in substance, each party agreed to pay his prorata share of the development and operating*231 expenses. After the Burkitt lease was acquired by H. C. Cockburn in 1938, there were 19 oil wells and one gas well drilled on the lease. All such wells were completed prior to April 1, 1942, and were producing at a horizon above 4,200 feet. Such part of the intangible expenses *777 of drilling these 20 wells which was paid by H. C. Cockburn was deducted by him on his income tax returns as operating expenses, rather than being capitalized.
On or about April 8, 1942, H. C. Cockburn and Frank J. Gravis entered into a written agreement regarding the interest of H. C. Cockburn in the Burkitt lease. Pertinent parts of this agreement are as follows:
THIS AGREEMENT by and between H. C. COCKBURN of Harris County, Texas, hereinafter referred to as "OWNER", and FRANK J. GRAVIS of Bexar County, Texas, hereinafter referred to as "PURCHASER",
WITNESSETH:
1.
OWNER agrees to sell the PURCHASER, and PURCHASER agrees to buy, an undivided three-fourths (3/4th) interest in a certain oil, gas and mineral lease, nineteen (19) producing oil wells, and one (1) gas well, together with all of OWNER'S interest in the personal property on said lease now used in the actual production of oil and gas*232 from said wells on said lease, but not to include the personal property, pipe or equipment on said lease and not now actually used from the wells producing from said lease, but shall include Dodge pick-up truck and portable pump unit of the OWNER, the leasehold interest being described as follows, * * *
* * * *
2.
OWNER agrees to accept, and PURCHASER agrees to pay, for said three-fourths interest in said oil, gas and mineral lease, the producing wells aforesaid, and the personal property thereon situated and used in connection therewith, the following:
(a) THREE HUNDRED EIGHTY SIX THOUSAND TWO HUNDRED FIFTY ($ 386,250.00) DOLLARS, payable in cash, upon examination and approval of title, within the time herein stipulated, said cash payments to be allocated as hereinafter provided;
(b) OWNER retains for himself, his heirs and assigns, and there will be excepted from the grant, and the PURCHASER agrees for him to retain and except from the grant, three-fourths (3/4ths) of one-eight (1/8th), three thirty-seconds (3/32ds) of all the oil, gas and other minerals produced on said land, the same to be a perpetual overriding royalty;
(c) In addition to the cash payment and overriding royalty*233 aforesaid, it is agreed that additional payments, as royalty, out of production of oil, shall be made to the OWNER upon the following basis, to-wit:
THE OWNER shall be paid currently, as produced, the market value at posted field prices, as run into the pipe line or storage, three-fourths (3/4th) of one sixty-fourth (1/64th), three two-hundred-fifty-sixths (3/256ths) of all the oil and gas produced, free of cost, from each well, or wells, producing from a depth below forty two hundred (4200) feet, until the value of the oil produced from such well or wells shall amount to ONE HUNDRED TWELVE THOUSAND FIVE HUNDRED ($ 112,500.00) DOLLARS. After said production shall have amounted to, in cash, the sum of ONE HUNDRED TWELVE THOUSAND FIVE HUNDRED ($ 112,500.00) DOLLARS, no additional payments shall be made out *778 of the production of oil from such wells below the depth of forty two hundred (4200) feet, except as to such well or wells the OWNER shall be entitled to receive his aforesaid overriding royalty of three-thirty-seconds (3/32ds), as provided for in paragraph two (2) hereof.
There shall, however, be no obligation on the part of the PURCHASER to pay said contingent consideration*234 SAVE FROM THE VALUE OF THE OIL ACTUALLY PRODUCED BELOW THE DEPTH OF FORTY TWO HUNDRED (4200) FEET. However, it is specifically agreed and understood that the OWNER, for himself, his heirs and assigns, retains and excepts from this grant an equal three two-hundred-fifty-sixths (3/256ths) of all the oil produced and saved, or to be produced and saved, from the wells drilled or to be drilled, below the depth of forty-two hundred (4200) feet, until the amount so produced and saved shall have, in dollars, estimated on the current posted field price, as run to the pipe line and storage, amounted to ONE HUNDRED TWELVE THOUSAND FIVE HUNDRED ($ 112,500.00) DOLLARS. The obligation to pay the value of the aforesaid specified portion of the oil, as the same is produced, as above set forth, is a covenant running with the lease assignment, and shall follow the ownership of said lease, and each successive owner, if any, shall be responsible for the oil produced by him.
* * * *
6.
The total cash consideration for the sale of the property above described is THREE HUNDRED EIGHTY SIX THOUSAND TWO HUNDRED FIFTY ($ 386,250.00) DOLLARS, of which said consideration the sum of NINETY FIVE THOUSAND ($ 95,000.00) *235 DOLLARS is represented, and shall be applied to the purchase of the personal property, and the nineteen (19) producing oil wells and one (1) gas well, which said personal property shall include all of the equipment in and on the wells now producing, and all the personal property such as pipe, tubing, pumps, connections, etc., used in connection with the wells now producing on the lease aforesaid, and the remaining part of the purchase price represents the sales price of the leasehold interest.
It is agreed by and between the parties, after due consideration, that the allotments of the aforesaid amounts, in the manner provided represents a fair, in their opinion, just and equal apportionment to the payment of them separately at this time, and that in all negotiations leading up to the execution of this agreement these items were considered separately, and that the sum of NINETY FIVE THOUSAND ($ 95,000.00) DOLLARS is believed to be a reasonable price for the personal property and wells aforesaid, and that the remainder is just and reasonable for the leasehold interest, taking into consideration the overriding royalty reservation and the exceptions from the grant, and the oil payment.
*236 7.
The PURCHASER agrees, in the acceptance of the assignment, that he will not only develop and operate the premises in accordance with the provisions of the original lease and the assignment, but likewise he will carry out the terms and provisions of the operating agreement between H. C. COCKBURN and JOHN H. CROWELL, dated November 12, 1940, and as to which operating agreement the OWNER agrees to procure from the said JOHN H. CROWELL an agreement substituting the PURCHASER as OPERATOR in lieu of H. C. COCKBURN, the OWNER, as OPERATOR, and the PURCHASER agrees to accept the substitution.
*779 In May 1942, the aforesaid agreement was carried out by H. C. Cockburn and Frank J. Gravis to the extent that H. C. Cockburn executed an "assignment of oil and gas lease" to Gravis covering the Burkitt lease. The assignment of oil and gas lease contained the provisions which had been agreed upon between Cockburn and Gravis.
In reporting the $ 386,250 received from Gravis in connection with the said "assignment of oil and gas lease" and "agreement," the petitioners stated on their income tax returns that of the total consideration received, $ 95,000 was received in payment of tangible equipment*237 which had a depreciated cost of $ 86,323.21. Also allocated to this particular part of the transaction was a salesman's commission of $ 5,000 which, when added to the depreciated cost of $ 86,323.21, made a total of $ 91,323.21. This sum was subtracted from $ 95,000 with the result that petitioners reported a net profit of $ 3,676.79 from the sale of tangible equipment. The Commissioner in his determination of the deficiencies made no change in this method of reporting the gain from the sale of the tangible equipment.
Petitioners also reported on their returns for the year 1942 the receipt of $ 291,250 ($ 386,250 minus $ 95,000) as being income from "sale price of lease" and reduced this figure by claimed "expense of sale" represented by engineering fees, $ 400, revenue stamps, $ 424.60, and commission, $ 15,562.50, making a total of $ 16,387.10 expenses which, when subtracted from $ 291,250, left $ 274,862.90 which petitioners reported as gain on the sale of a capital asset. The Commissioner in his determination of the deficiencies made the changes in petitioners' method of reporting the gain from this part of the transaction which have been detailed in our preliminary statement.
*238 Petitioners received income from the Burkitt lease subsequent to executing the agreement with Gravis and the assignment of oil and gas lease to him, and prior to the year 1944 when they sold their interest in the Burkitt lease for $ 150,000. In their income tax returns for the year 1944, petitioners reported the $ 150,000 received for the said sale as long term capital gain and respondent made no adjustment with respect thereto.
OPINION.
The stipulated facts show, among other things, that petitioners reported on their returns for the year 1942 the receipt of $ 291,250 ($ 386,250 minus $ 95,000) as being income from "sale price of lease" and reduced this figure by claimed expenses of sale aggregating $ 16,387.10. After deducting this $ 16,387.10 as expenses of sale, petitioner reported $ 274,862.90 as long term capital gain from this part of the transaction. Petitioners now abandon their contention that the $ 274,862.90 was capital gain.
*780 This abandonment by petitioners of their former position in this respect is in conformance with the Supreme Court's decisions in , and .*239 Petitioners have not, however, abandoned their contention that the $ 16,387.10 expenses incurred in the assignment of the lease to Gravis is allowable as a deductible business expense. Petitioners' primary contention is that these expenses aggregating $ 16,387.10 were expenses incurred in the disposition of property and are, therefore, deductible. Of course, if it could be held that the assignment of the lease by Cockburn to Gravis was a sale, the $ 400 engineering fees, $ 424.60 revenue stamps and $ 15,562.50 commission, all aggregating $ 16,387.10, would be deductible as expenses of the sale because there can be no question but that petitioner was in the business of dealing in oil wells and oil leases. The Commissioner does not contend otherwise. However, it cannot be held that the assignment from Cockburn to Gravis was a sale, except as to the tangible equipment which was sold for $ 95,000. That $ 95,000 is not in controversy. The balance of the consideration which petitioner received was for a sublease. .
The Commissioner has determined that the $ 16,387.10 in question represents capital expenditures by petitioner*240 in the acquiring of the rights which he obtained under the contract with Gravis and must be recovered through depletion and cannot be deducted as business expenses. Among other cases relied upon by respondent to sustain his determination, he cites , affirmed on this point, , and . While the facts in the Bonwit Teller case and in the L. S. Munger case are not the same as here, nevertheless, we think they support in principle the determination which respondent has made.
Since the petitioners received depletion allowances of $ 80,093.75 in the year 1942, and unspecified amounts in the years 1943 and 1944, they have fully recovered any outlay they may have had in connection with the execution of the sublease with Gravis. Petitioners lay much stress in their briefs on the fact that in reserving to themselves three thirty-seconds of the oil and gas to be produced by Gravis as an overriding royalty, they acquired nothing which they did not already own. Petitioners in arguing this point in their brief say:
* * * In *241 the instant case, the Taxpayers' overriding royalty was in no manner a factor that could have been attributed to any act of the negotiating broker because at the time of the sale or the disposition of the lease, the Taxpayers had their three thirty-seconds (3/32) and withheld it. It was a producing royalty flowing from twenty wells that had been discovered by the Taxpayers and which the Taxpayers' capital had developed. Neither the broker nor Gravis added anything to the Taxpayers' assets which the Taxpayers did not theretofore enjoy.
*781 We think the above quotation from petitioners' brief does not tell the whole story. In addition to the overriding royalty of three thirty-seconds of all the oil, gas, and other minerals reserved by petitioner in the sublease with Gravis, there was also provided an oil payment of $ 112,500 which is described in the assignment to Gravis as follows:
There is reserved as royalty to H. C. Cockburn, assignor herein, his heirs and assigns, on all oil and gas which may be produced from wells located on said premises and which well or wells are then produced from a depth below forty two hundred (4200) feet in addition to the above overriding royalty, *242 an undivided three two-fifty-sixths (3/256ths) of all the oil and gas produced from each such well or wells producing below said depth of forty two hundred (4200) feet, to be delivered free of cost, to the said H. C. Cockburn, assignor herein, when, as, and if produced, in like manner as the landowner's royalty provided in the original lease, until the proceeds derived from said proportion of such production on the basis of the then market value at posted prices shall aggregate the sum of One Hundred Twelve Thousand Five Hundred $ 112,500.00) Dollars, subject to further terms and conditions hereof, and provided further that this provision shall be a covenant running with the lease assignment and shall follow the ownership of said lease and each successive owner, of all or any part of the land covered by this assignment.
Whatever amounts petitioners should receive from this contingent oil payment of $ 112,500 would be ordinary income to petitioners, subject to depletion; but they must also look to depletion for the recovery of their cost or other basis of this contingent oil payment. , affd., .*243
We think that the Commissioner's determination that the $ 16,387.10 in question cannot be deducted as a business expense but represents capital expenditures in obtaining certain benefits under an oil and gas sublease and must be recovered by way of depletion should be sustained. We so hold.
Decisions will be entered under Rule 50.