*1108 1. Petitioners, owners of an undivided interest in a group of oil and gas leases, assigned their interest for a cash payment and an agreed amount to be paid out of future production, and retained overriding royalties in all but three of the leases and certain other rights in all the leases. Held, the transaction was not a sale within the provisions of section 102, Revenue Act of 1932, which entitled petitioners to the limitation provisions of said section, but was in the nature of a leasing transaction, and petitioners are entitled to depletion deductions on all payments received as a result of the transfer.
2. Petitioners executed certain consents covering the taxable year but attempted to limit the applicability of their first consent to the execution of a closing agreement under section 606, Revenue Act of 1928. No attempt was made to limit a later consent. Held, respondent is not estopped to assert the deficiency herein.
3. Petitioners paid $8,432.37 to various individuals organized to uphold the right to separately report community income, and to prevent the passage of a bill conferring control of the oil industry upon the Secretary of the Interior. Held,*1109 the disbursements were not ordinary and necessary expenses paid or incurred in carrying on a trade or business.
*1054 These consolidated proceedings involve deficiencies in income tax for the calendar years 1932 and 1935 in the following amounts:
| 1932 | 1935 | |
| H. R. Cullen | $101,383.09 | $3,951.90 |
| Lillie Cranz Cullen | 101,383.09 | 3,951.90 |
The issues for 1932 are (1) whether the transfer of an undivided interest in certain oil and gas leases for $3,000,000, a $17,000,000 oil payment, and the retention of certain overriding royalties in some but not all of the leases and certain rights in all the leases constituted a sale subject to the surtax limitation provisions of section 102 of the Revenue Act of 1932; (2) the amount of depletion to which petitioners are entitled; (3) whether the cash consideration should be reduced by the cost of leases and depreciated cost of equipment and oil wells in determining income derived from *1055 the transaction; and (4) whether investment in equipment became merged with leasehold cost returnable*1110 through depletion, or should be returned by depreciation allowances.
By an amended answer respondent affirmatively alleged that if the Board upholds the allocation of the cash payment claimed by the West Production Co. in Docket No. 88997, a companion case hereto, the same allocation should apply to these petitioners, since the same transaction is involved, and asks this Board to increase the deficiencies for 1932 accordingly.
The taxable year 1935 involves petitioners' right to deduct certain alleged legal expenses amounting to $8,432.37.
The parties stipulated many of the facts necessary for a determination of the issues and supplemented their stipulations with documentary evidence and oral testimony. We incorporate the stipulated facts in our findings by reference and hereinafter set forth the portions thereof requisite to a determination of the questions presented.
FINDINGS OF FACT.
The petitioners are citizens of Houston, Texas. They were married in Texas in 1903 and have continuously maintained their marriage status as citizens of Texas since 1911. They filed their income tax returns for 1932 and 1935 on the community basis with the collector of internal revenue*1111 at Austin, Texas. All of their income is community income, and all the deductions here involved are community deductions. The returns were filed on an accrual basis.
On March 10, 1932, the petitioners and the West Production Co., a private corporation, and the Gulf Production Co., a private corporation, owned certain mineral leases on which were ten oil wells on lands situated in Fort Bend County, Texas, an undivided one-half interest therein being owned by the Gulf Production Co., an undivided one-fourth interest being owned by the West Production Co., and the remaining undivided one-fourth interest being owned equally by the petitioners. Some of the said leases were subject to outstanding overriding royalties, as hereinafter more fully mentioned. As of March 10, 1932, but under actual date of March 23, 1932, the petitioner, H. R. Cullen, acting in behalf of petitioners, joined by the West Production Co., executed and delivered two instruments to the Humble Oil & Refining Co., a private corporation, affecting said properties, the first instrument being recorded in Fort Bend County.
The first of said instruments is a standard form of assignment, with the customary warranties. *1112 After reciting the receipt of $1,000 and other valuable considerations from the Humble Oil & Refining *1056 Co., sometimes hereinafter referred to as Humble, it provides that Cullen and the West Production Co. "do hereby GRANT, BARGAIN, SELL and CONVEY" unto Humble:
* * * all of our one-half (1/2) undivided interest, * * * in and to the oil and gas mineral leases mentioned below, and each of them, together with our one-half (1/2) undivided interest in all leasehold rights and other rights, titles and interests vested in the lessee by virtue of said leases, and each of them, and all of our one-half (1/2) undivided interest in and to all rights, titles and interests purported to be created by said leases, and each of them, in so far as said leases cover and include oil, gas and other minerals * * * [with exceptions not here material].
* * *
This assignment does not fully express the understanding between the assignors herein and the assignee herein with respect to the consideration, terms and stipulations under which the property above described has been transferred, assigned and conveyed to Humble Oil & Refining Company. The parties hereto have executed in triplicate*1113 originals a supplemental agreement bearing even date herewith, with respect to said properties, in which is set out in detail the consideration, terms and stipulations of the parties with respect to the property hereby assigned. Reference is here made, for all purposes, to said supplemental contract.
The second of the two instruments executed on March 23, 1932, contains the special provisions under which the trade was consummated. After reciting that Cullen and the West Production Co. by an assignment of even date herewith "did bargain, sell and convey" unto Humble, "all of their interest in and to those certain oil and gas mineral leases covering lands situated in Fort Bend County, Texas," which leases are therein described, it provides in part as follows:
I.The consideration for the assignment of said properties is the sum of Twenty Million ($20,000,000,00) Dollars, of which amount Three Million Dollars ($3,000,000.00) has been paid in cash by Assignee, simultaneously with the execution and delivery of such assignment and of this instrument to Assignee, one-half of which has been paid to H. R. Cullen and the remaining one-half to West Production Company, and the remaining*1114 consideration of Seventeen Million ($17,000,000.00) Dollars the Assignee agrees to pay monthly to the said H. R. Cullen and West Production Company, the Assignors, in equal portions, from production, after deducting royalties, and outstanding overriding royalties and the overriding royalties hereinafter provided for, as follows: (a) The market value as run to the pipe line or storage of one-fourth (1/4) of the amount of all oil produced and saved under said leases from the lands covered by the lease contracts hereinbefore described, [plus fractional portions of gas and other minerals produced and saved] * * * until the aggregate sum of Five Million ($5,000,000.00) Dollars, exclusive of the Three Million ($3,000,000.00) Dollar cash payment, shall have been so paid; and thereafter (b) The market value as run to pipe line or storage of one-eighth (1/8) of the amount of all oil produced and saved under said leases from the lands covered by the lease contracts hereinbefore described, [plus fractional portions of gas and other minerals produced and saved] * * * until the aggregate sum of Twelve Million Dollars *1057 ($12,000,000.00), exclusive of the Three Million ($3,000,000.00) *1115 Dollar cash payment and exclusive of the five Million ($5,000,000.00) Dollar payments out of production above provided for, shall have been so paid. * * * There shall, under no circumstances, be any obligation or liability to pay said contingent consideration save from the value of oil, gas and other minerals actually produced and saved as above set out. The obligation to pay the value of the specified portion of such oil, gas and other minerals as may be produced and saved or marketed as above set out (being the sole obligation, express or implied, created by this paragraph) shall follow the ownership of the interest herein conveyed, and be dependent upon such ownership; and each successive owner shall pay and be responsible only for payments due on account of oil and gas and other minerals produced and saved by him under said leases and the provisions of this contract.
II.The Assignors shall be entitled to receive the following overriding royalties on all oil, gas, sulphur and other minerals that may be produced, saved or marketed from said lands and premises, covered by the lease contracts hereinbefore described, under the terms and provisions of said leases; except, however, *1116 that the following overriding royalty provisions shall have no application, and shall not relate to production from the said A. P. George, et al, 200-acre lease mentioned above, the said R. A. Wolters, et al 800-acre lease mentioned above, and 3/4 undivided interest in and to the R. A. Wolters, et al, 100-acre lease mentioned above. The overriding royalties herein provided for as to the leases not above excepted from the provisions of this overriding royalty paragraph, being as follows, to-wit: * * *
The omitted paragraphs of the supplemental agreement provide that the assignors shall receive an overriding royalty of an equal 1/48 part of all oil produced and overriding royalties on gas, sulphur, and other minerals in amounts not here material, except as to the three leases mentioned; that the assignee shall be under no implied obligation to preserve said leases or to develop and operate said premises to a greater extent than is required under the provisions of the respective leases and the supplemental agreement; that the assignee agrees to perform the obligations contained in the several lease contracts affected by the assignment and supplemental agreement so long as it retains*1117 said leases; that the assignee may reassign all leases to its assignors and thereupon relieve itself of all liability under the contract; that the assignee may surrender one or more leases or any acreage under conditions not here material; and that the assignee will, within 120 days, so develop and operate the leases that the production therefrom will amount to at least 15,000 barrels of oil per day and will maintain production from the leases to at least 15,000 barrels of oil per day until the assignors have received in full their $17,000,000 out of oil produced, or in lieu of such production, regularly and currently pay to assignors the equivalent of 15,000 barrels of oil per day unless, after reasonable development, production from the leases under efficient operation is less than 15,000 *1058 barrels per day, in which event the assignee will pay on the basis of actual production. Assignors were to have access to the records and books of account relating to production, were to be furnished with logs of the wells drilled or being drilled and samples of cores and cuttings from the wells and to have a representative present at all times to witness gauges of production.
*1118 At the time of transfer the principal value of all of the property covered by the assignment and supplemental agreement had been demonstrated by prospecting, exploration, and discovery work done by the taxpayers.
Under these instruments Humble acquired the full unexpired terms of the original leases. None of the property involved has been reacquired from Humble by the petitioners or the WestProduction Co. All rentals, royalties, or sums of money coming due thereon to the original lessors since the date of said instruments have been paid directly to the original lessors by Humble, or its representatives, and none of said items have been paid by petitioners.
The negotiations preceding the transfer of March 23, 1932, were conducted by Wallace E. Pratt for Humble and J. M. West, Sr., for the West Production Co.West had no authority to represent petitioners, but Pratt understood from West that the Cullens would dispose of their interest for the same consideration as the West Production Co. The moving consideration to Humble was the acquisition of the acreage as a block, which had distinct advantages over the acquisition of an oil field cut up into small competing tracts. In*1119 the negotiations the parties gave no consideration to an allocation of the purchase price between the leases, but dealt solely on the basis of transferring the entire acreage as a producing field. The Humble officials, relying upon their own information and information obtained from the wells drilled on the tract, considered the entire acreage potentially productive. West relied upon an investignation and report made by a geologist and engineer named Cashin, who estimated the 2,010 acres within a radius of one mile from the discovery well were potentially productive. Petitioners relied upon information obtained from the Gulf Production Co. and they considered the entire acreage potentially productive.
The cash consideration of $3,000,000, paid under the above instruments, was received one-half by the West Production Co. and one-half by the petitioners.
The deficiency letters, dated March 5, 1938, treat the assignment of leases in which an overriding royalty interest was retained as a sublease and the cash received therefor as a bonus against which depletion is allowable on the percentage basis. It treats the assignment of the leases in which no overriding royalty interest*1120 was retained *1059 as a sale for cash and the retention of an oil payment. The deficiency letter states that "The cost of lease and of equipment is divided between the interest sold and the interest retained", and that "The cash consideration in excess of the equipment valued at cost less depreciation, has been divided between the sublease and the sale on the basis of relative acreage, and the allocated equipment added to each." Respondent's allocation is as follows:
| Sublease | Sale | ||
| Leases | $2,424,475.29 | $418,880.00 | $2,843,355.29 |
| Equipment | 133,361.57 | 23,283.14 | 156,644.71 |
| Total | 2,557,836.86 | 442,163.14 | 3,000,000.00 |
In computing petitioners' tax liability respondent applied section 102 of the Revenue Act of 1932 to the portion of the leases treated as sold.
Petitioners duly filed separate claims for refund for 1932 as follows: For $64,217.28, filed September 7, 1935; and for $32,565.58, filed November 19, 1938.
The petitioners' claims for refund filed in 1935 were based in part upon the following reasons:
(2) In the so-called partnership return of H. R. Cullen and West Production Company, no depletion was taken upon the consideration*1121 received for the sale to Humble Oil & Refining Company by H. R. Cullen and West Production Company of their respective interests in certain oil leases known as the Rabbs Ridge-Thompson properties in Fort Bend County, Texas. Neither was any depletion taken thereon by deponent or deponent's spouse in their separate returns. Under Section 114(3) of the Revenue Act of 1932 deponent claims to be entitled to an allowance of 27 1/2% depletion upon all of the consideration received from said transaction in the year 1932, because the vendors in said transaction retained an economic interest in the leases sold by reason of overriding royalty provisions and deferred oil payments, which interest entitled them to depletion upon said royalties and oil payments and the full amount of the cash bonus, paid in 1932.
(3) In applying the surtax limitation provided for by Section 102 of the Revenue Act of 1932, this claim for refund is based upon the assumption that the cash bonus was the purchase price of the interests sold in the leases and that the deferred oil payments were mere recovery of the interest retained in the oil in place. Of course, if the deferred oil payments also constituted a part*1122 of the purchase price, then the 16% surtax limitation applicable would be increased and this claim for refund would be correspondingly decreased.
Under date of January 30, 1936, the petitioners were each advised that respondent had accepted the report of his Dallas office, which disclosed a deficiency for 1932 of $32,565.58 each, and had denied their claims for refund of $64,217.27 each. Thereafter, petitioners were notified by letter, dated May 5, 1936, that further action on their 1932 *1060 returns would be held in abeyance pending final adjudication of the case of ; affirmed by the ; and that respondent had not acquiesced in this decision and therefore a closing agreement could not be entered into at this time. Petitioners were also advised that the statutory period within which a deficiency notice could be issued would expire in the near future and that in the absence of an application for the execution of a consent it would be necessary to issue the notice of deficiency within 15 days.
On or about May 14, 1936, petitioners' attorney forwarded consents, but attempted to limit*1123 their scope by the following language:
It is understood, however, that the execution of a closing agreement for the years 1932 and 1933 on the basis heretofore approved by the taxpayers is only to be deferred until it is determined whether the Commissioner will apply for certiorari in the William Fleming case decided by the United States Circuit Court of Appeals for the Fifth Circuit on March 7, 1936 being No. 7899 on the docket of said court, and involving allowance of depletion on oil payments. In the event that no certiorari is applied for by the Commissioner, the closing agreement is then to be promptly executed.
By letter dated May 19, 1936, the petitioners were notified that the consents extending the period of limitation for assessment of income tax for 1932 to June 30, 1937, "have been accepted by the Commissioner."
Under date of April 2, 1937, respondent notified petitioners that final determination of their income tax liability for 1932 had been withheld pending the decision in the J. J. Perkins case (). Upon advice that the statutory period as extended by the consents then on file would probably expire before*1124 decision could be made in the Perkins case, the petitioners executed new consents extending the period of limitation. Receipt of these consents was acknowledged by respondent on April 22, 1937. The statutory notices of deficiency were issued before the latter consents expired.
On their income tax returns for 1935 the petitioners deducted expenses to the extent of $8,432.37, which were disallowed. Included in the items disallowed to each petitioner were the following:
(1) One-half of $500 paid to W. L. Clayton as treasurer of a committee organized to uphold the right of taxpayers to file separate Federal income tax returns of income constituting community income under the laws of Texas.
(2) One-half of $7,932.37 paid respectively to the J. S. Abercrombie Co. ($1,155.37) and to J. M. West, trustee ($6,777), to oppose the passage of the Thomas-Disney bill, introduced for the purpose of conferring upon the Secretary of the Interior the control of the oil industry in Texas and other states.
*1061 During all of the year 1935 petitioners were engaged in the oil business in Texas, and considered these expenditures as ordinary and necessary expenses in the carrying*1125 on of that business.
OPINION.
ARNOLD: These proceedings, like their companion case, West Production Co., Docket No. 88997, require a determination of the tax liability resulting from the transfer of an undivided interest in the so-called Thompson Oil Field to Humble. The surtax rates applicable to individual incomes work to the disadvantage of these taxpayers, as compared with corporate rates, unless they can bring themselves within the provisions of section 102(a) of the Revenue Act of 1932, set forth in the margin. 1 Even with the benefit of the limitation provisions of section 102(a) petitioners' tax rate would be 16 percent, as compared with the corporate rate of 13 3/4 percent.
*1126 Petitioners, therefore, have vigorously contended that the transaction of March 23, 1932, was a bona fide sale of an undivided interest in the leases, wells, and equipment making up the Thompson Oil Field. They point out that the stipulated facts, documentary evidence, testimony, and surrounding circumstances all indicate that West Production Co. and the petitioners sold five-sixths of their undivided interest to Humble. Furthermore, they rely on the language used by the Texas Civil Court of Appeals in , which involved a fee due Cashin for assisting "in making a sale" of these very oil properties. The use of the term "sale" as there used by the court is not controlling here. Whether the transaction was a sale or a sublease did not affect Cashin's right to recover and the court was not called on to determine the nature of the transaction. Petitioners here are in a position similar to that occupied by the taxpayer in , in which the Supreme Court rejected the Government's argument that the transaction was a sale. See also *1127 , and , decided this day.
In the Supreme Court case partnerships in which Palmer was a member conferred upon two separate oil companies the right to take over certain leased property for cash, oil payments, and overriding royalties. The taxpayer claimed depletion based upon discovery value. The Commissioner denied the deduction upon the theory that both transactions were sales and that the only allowable deductions *1062 in calculating the taxable gains were those based upon the cost of the properties, which was materially less than value at the date of discovery of oil. Palmer sued to recover the additional taxes paid as a result of the Commissioner's determination. The lower courts both held the transactions were assignments or sales.The Supreme Court held it was immaterial whether the transactions were sales or subleases, and that the formal attributes of the instruments or the descriptive terminology applied to them by local law was irrelevant. The Court said that for depletion purposes "It is enough if, by virtue of the leasing transaction, he has retained a right*1128 to share in the oil produced. If so he has an economic interest in the oil, in place, which is depleted by production." See also .
The respondent, relying upon the above decision, determined that the present transfer amounted to a sublease as to those leases in which petitioners retained an overriding royalty, coextensive with the lease, and a sale as to those leases in which petitioners retained only an oil payment, citing . Respondent, contending that this transaction contains both the Palmer and the Fleming situations, breaks down the transfer into two separate types of transactions and applies the cited decisions to the respective situations.
We agree with the respondent that the instant transaction was more in the nature of a sublease than a sale, but we can not agree that the transfer is divisible into a sublease as to all but three of the leases and a sale as to those three. The oral testimony and the documentary evidence refute respondent's argument that this transaction was divisible into separate transfers*1129 of one or more leases for varying considerations. Wallace E. Pratt, the Humble representative, testified unequivocally that the moving consideration to Humble was the acquisition of an undivided interest in the oil field as a unit, and that no consideration was given to the value of one lease over another, or with relation to other leases. The documentary evidence shows that the property transferred was an undivided interest in a producing field as a whole and, therefore, we see no justification in the Palmer or Fleming decisions, supra, for breaking down the transfer into arbitrary classifications not contemplated or intended by the contracting parties. See discussion of this point in The transfer was made for a consideration consisting of a cash payment, or bonus, future payments to be made from oil produced, royalties reserved for the life of the leasehold interest transferred, and certain other reserved rights. Depletion, therefore, should be allowed on the bonus payment, *1130 , on the oil payments, , and on the oil royalties,
*1063 Our determination that the transaction can not be considered a sale for income tax purposes disposes of petitioner's contentions regarding the applicability of section 102 and their contentions against the respondent's allocation of the cash payment. All of the cash payment will be subject to percentage depletion, and, as there is no dispute between the parties relative to depletion of the oil payments and oil royalties, the depletion issue can be settled under Rule 50.
The evidence indicates that percentage depletion deductions will exceed petitioners' costs of leaseholds and equipment. Under the doctrine of , petitioners are not limited to recovery of costs, but may recover through percentage depletion deductions much more than their investment. Under this doctrine it is unnecessary to determine whether there is a merger of equipment costs with investment costs, because, in any event, petitioners will more than recoup their total investment*1131 out of the depletion allowances.
In view of the foregoing discussion it is unnecessary to consider the issue raised by respondent's amended answer relative to the allocation urged upon us by the taxpayer in West Production Co., Docket No. 88997.
Petitioners' contention that respondent is estopped to claim an increased deficiency as to 1932 because of the conditions attached to the consents, is not well founded. The conditions relate to the execution of a closing agreement, not to the determination of petitioners' correct tax liability. Furthermore, the correspondence between the parties creates a substantial doubt in our mind that respondent ever accepted the conditions petitioners tried to impose. In any event, whatever binding effect these conditions may have had with respect to the consents executed in 1936 would seem to have expired at the time the deficiency notices were issued, as further consents were executed in 1937.
The disputed expense items in 1935 are not, in our opinion, ordinary and necessary business expenses. *1132 . The $500 payment to Clayton had no relationship to petitioners' oil business. It was purely a personal expense to protect the right of petitioners to file separate income tax returns of one-half of the community income. The payments to the J. S. Abercrombie Co. and to J. M. West, trustee, were for the purpose of opposing enactment of legislation deemed detrimental to petitioners' business and were voluntary rather than obligatory. These disbursements were too remote in their relationship to petitioners' business to be within the scope of the term "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Deputy v. du ; . The disbursements were extraordinary in character and *1064 were for the purpose of influencing legislation, which is outside the normal conduct of a business enterprise. ; *1133 ; .
Decision will be entered under Rule 50.
Footnotes
1. SEC. 102. SALE OF MINES AND OIL OR GAS WELLS.
(a) In the case of a bona fide sale of mines, oil or gas wells, or any interest therein, where the principal value of the property has been demonstrated by prospecting or exploration and discovery work done by the taxpayer, the portion of the tax imposed by section 12 of this title attributable to such sale shall not exceed 16 percentum of the selling price of such property or interest. ↩