*1930 1. Additional compensation of officers and employees for services in prior years held reasonable and proper and deductible from corporation's income year in which paid.
2. Losses claimed by reason of alleged worthlessness of oil and gas lease disallowed for lack of evidence.
3. Held that under the provisions of section 204(c)(2) of the Revenue Act of 1926, the depletion deducted as to oil and gas properties may not be based on the profits received from the sale of the properties themselves.
*55 In this proceeding the petitioner seeks a redetermination of its income-tax liability for the fiscal year ended April 30, 1925, for which year the respondent determined a deficiency in the amount of $17,211.20. The petitioner contends that the respondent made the following errors in computing its taxable income for the fiscal year 1925:
1. In refusing to allow as a deduction from gross income the amount of $20,000 paid during the taxable year to certain officers and employees, as additional compensation for services*1931 performed during that year and two prior years.
2. In refusing to allow as a deduction from gross income as a loss, the cost, $59,959.46, of a certain oil and gas lease, which the petitioner contends was determined to be worthless during the taxable year and abandoned in that year.
3. Section 204(c)(2) of the Revenue Act of 1926, reads: "In the case of oil and gas wells, the allowance for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year." Respondent erred in computing the depletion under the above statute on the gross income from the operation of the wells only, and in not including in such computation the profit from the sale of the wells during the taxable year.
FINDINGS OF FACT.
The petitioner is a joint stock association, which was organized April 10, 1920, with its office and principal place of business in Wichita Falls, Tex. J. F. Shipley organized the petitioner and another association known as the Shipley Trading Company, for the purpose of taking over an oil and gas lease which he had acquired from J. H. White on December 2, 1919, covering 1,535 acres of land in Archer County, Texas. The entire capital stock*1932 of the Shipley Trading Company, $200,000 par value, and $200,000 par value of the capital stock of the petitioner, was given to Shipley as consideration for the assignment of the lease on the 1,535 acres. Shipley sold the stock of Shipley Trading Company at par and gave as a bonus with each share, one share of stock of the petitioner. Under this arrangement more than half of the stock was disposed of and with the proceeds Shipley paid White the contract price for the *56 lease. On October 23, 1923, the Shipley Trading Company was merged with the petitioner. Neither of the companies had any funds with which to develop the property or to pay current expenses. The development work was made either from funds advanced by the stockholders or by the exchange of some of the property in return for development work.
From the date of organization down to the fiscal year here under consideration, the petitioner sustained net losses in each year, but during the fiscal year ending April 30, 1925, in June, 1924, oil was discovered on the property in paying quantities. Certain parts of the acreage proved to be highly productive. No salaries were paid to the officers prior to the year*1933 under consideration, but on October 18, 1924, the following resolutions were adopted by the petitioner's board of directors:
Next in order was the confirming of the action of the Board of Directors in issuing of (50) shares of the Treasury stock to W. H. Godfrey for services rendered and for future service to the company.
A motion duly seconded, was then made that the action of the Board of Directors in issuing the (50) shares of stock to W. H. Godfrey is hereby ratified and approved for services rendered.
* * *
Next in order was compensation of officers and the following resolution was offered:
Resolved that for valuable services rendered to the company during the last two years that there be given to the following named officers fifty (50) shares of the Treasury stock, each, namely, J. F. Shipley, Joe E. Shipley, Thomas A. Ross, and E. W. Gould, and further that E. W. Gould is to receive a monthly salary of $250 per month for his services as secretary and treasurer, said salary to date from September 1, 1924, and that John M. Shipley as field superintendent is to be paid a salary of $250 per month, said salary to date from October 1, 1924, and further that Thomas A. Ross*1934 and Joe E. Shipley as directors are to receive a salary of $125 per month, said salary to begin as of October 1, 1924. The above motion was carried by an affirmative vote, etc.
Thereafter the petitioner issued its stock in the amounts specified in the foregoing resolution and to the parties therein named, and claimed as a deduction from its gross income for the taxable year an amount equal to the par value of the stock.
The respondent refused to allow the deduction of the stock paid to the officers, as well as the value of the stock paid to Thomas H. Ross, who was a director and employed as an engineer. He allowed the deduction as to W. H. Godfrey, geologist, for petitioner.
John F. Shipley, Joe E. Shipley, and E. W. Gould were actively engaged in the conduct of the petitioner's business from the date of its organization in 1920 until the close of the fiscal year here under consideration. Thomas R. Ross, who is a civil engineer with long experience in Africa and China, entered the employ of the petitioner during August, 1922, and was active in its affairs continuously from *57 that date until April 30, 1925. His brother was a large stockholder in the enterprise*1935 and it was chiefly at the instance of his brother that he went with the company to see if he could help develop the property and place it on a paying basis. The four men, to each of whom the petitioner delivered 5,000 shares of its treasury stock, devoted their entire time to the conduct of the petitioner's business until October, 1924, without compensation of any kind. There was no money with which to pay them, prior to that time. As a result of their efforts, the business was so conducted that during the taxable year the petitioner made a large profit from operations, as well as from sale of its property. In March, 1925, the petitioner paid dividends in the amount of $497,200. At the time the treasury stock was delivered to the officers and employees, it had a value of at least par. The recipients of this stock did not own a controlling interest in the petitioner and the payments were not made in proportion to their stock ownership.
Under the original lease from White to Shipley, the acreage was divided into three blocks, designated as Lots 34, 35, and 40. According to the terms of the lease, in order to hold the lease oil had to be discovered on each block within five*1936 years. If oil was discovered in any one of the blocks, the lease was "held" as to that block and no more rental payments had to be made. During the period of the lease many productive oil wells were brought in on Lots 34 and 35, and one well, complying with the terms of the lease, was brought in on Lot 40. The well brought in on Lot 40 began producing two or three barrels per day, which was sufficient to "hold" the lease. Further development on Lot 40 and in its vicinity brought in dry holes, which proved that there was a "dip" in the structure. The development work on Lot 40 was done under contract, which the petitioner had made with an oil prospector, so that the petitioner had no interest in the equipment used in this development.
On February 28 and March 2, 1925, the petitioner sold its holdings in Lots 34 and 35 to the Phillips Petroleum Company for $565,500. The petitioner attempted to have its interest in Lot 40 included in this sale, but the Phillips Petroleum Company refused to buy this part of the lease. The petitioner still held the lease on Lot 40 at the end of the fiscal year, as up to that time it had neither succeeded in disposing of the lease nor had White, *1937 the lessor, taken any steps to recover Lot 40, on which one well was still producing, by pumping, two or three barrels of oil per day.
The petitioner, in its original return, reported the cost of Lot 40 as part of the cost of the portion of the lease sold to the Phillips Petroleum Company. The respondent, in his computation, eliminated the cost of the acreage in Lot 40, which it is agreed amounts *58 to $59,959.46, which amount the petitioner now claims as a loss on account of the lease having been found to be worthless and abandoned during the taxable year.
It has been stipulated that petitioner realized a net profit of $339,025.19 on the sale of its producing oil and gas property to the Phillips Petroleum Company; that the gross income from the operation of its producing oil and gas lease, exclusive of the profits realized on the sale of such leasehold, amounted to $232,952.44; that the net profit from the operation of the petitioner's oil property, exclusive of the profit on the aforesaid sale, and without the deduction of the $20,000 claimed as officers' salaries, and before deducting any depletion sustained within the fiscal year ended April 30, 1925, with respect*1938 to petitioner's producing property, amounted to $189,545.85. That the deduction for depletion allowed by the respondent in the sixty-day letter amounted to $98,374.97 under the provisions of the Revenue Act of 1924, and $68,546.63 under the provisions of the Revenue Act of 1926, and that these amounts are correct, unless the Board should find as a matter of law that the petitioner is entitled to a further deduction for depletion on account of the profit from the sale of the producing oil and gas property to the Phillips Petroleum Company.
OPINION.
BLACK: The first error assigned relates to the disallowance of $20,000 claimed by petitioner as a deduction for salaries paid to officers and employees during the fiscal year under consideration. The facts with reference to this transaction have been fully stated in our findings of fact.
In , the Supreme Court had before it a similar question arising under the corresponding section of the Revenue Act of 1918, which is identical with those here involved and the court there said:
The payments in the present instance were actually made in the year 1920. The expenses*1939 represented by these payments were incurred in that year, for it is undisputed that there was no prior agreement or legal obligation to pay the additional compensation. This compensation for past services, it being admitted that it was reasonable in amount, in view of the large benefits which the corporation had received as the fruits of these services, the corporation had a right to pay, if it saw fit. There is no suggestion of attempted evasion or abuse. The payments were made as a matter of internal policy having appropriate regard to the advantage of recognition of skill and fidelity as a stimulus to continued effort. There was nothing in the income tax law to preclude such action. On the contrary, the payments fell directly within the provision of section 234(a) as a reasonable allowance for compensation for personal services actually rendered. The statute does not require that the services should be actually rendered during the taxable year, but that the payments therefor shall be proper expenses paid or incurred during the taxable year.
*59 On the authority of this opinion, this issue must be decided in favor of the petitioner.
The second issue relates to*1940 the deductibility as a loss incurred in the taxable year of $59,959.46, which is the stipulated cost of Lot 40, in the White lease. Only one producing oil well had been brought in on Lot 40. The surrounding territory was not producing oil and the development work indicated an unsatisfactory structure for the successful production of oil or gas on this particular area. However, the well on Lot 40 was of sufficient production to satisfy the terms of the lease and "hold" it and at the close of the fiscal year the petitioner had not been able to dispose of the lease, nor had White, the lessor, taken any steps to terminate the lease. The petitioner in its books and on its return treated the cost of Lot 40 as part of the cost of the part of the lease sold to the Phillips Petroleum Company. As the development work was done under a contract, the petitioner had no interest in the equipment on the lease.
The pertinent section of the Revenue Acts is 234(a)(4), which reads the same in both the 1924 and the 1926 Acts, and which is as follows:
(a) In computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
* * *
(4) Losses*1941 sustained during the taxable year and not compensated for by insurance or otherwise. * * *
The lease from J. H. White to J. F. Shipley dated December 2, 1919, under which petitioner held, contained a clause reading as follows: "It is agreed that this lease shall remain in force for a term of five years from this date, and as long thereafter as oil or gas, or either of them is produced from said land by the lessee." Petitioner admits that the lease on Lot 40 did not expire on December 2, 1924, five years after the date of the original lease, because there was a well on Lot 40, which was producing about two barrels of oil a day. Petitioner contends, however, that although said lease was "held" by it at the end of the fiscal year, April 30, 1925, nevertheless it was worthless at that time and petitioner had abandoned it. We do not think the evidence sustains this contention. Plainly the two-barrel well on Lot 40 was producing oil long after April 30, 1925.
Evidently the lease was abandoned when it was released back to White, the fee owner of the land and that did not occur until after April 30, 1925. We think the situation we have before us in this proceeding is not substantially*1942 different from that which was *60 before us in , in which case we said:
The petitioner contracted to make the payments necessary to keep all of the leases in existence. These undertakings, particularly the latter, indicate that the parties did not consider the leases to be worthless. It may be that they were regarded as of little value but, if the parties were willing to continue to pay the rents and royalties necessary to keep such leases alive despite two dry holes, they evidenced their opinion of some value. In a case such as this it would be more reasonable to fix the date of worthlessness as being the date when the parties refused to pay further rents and royalties.
In the instant case petitioner did not have to pay any more rental to hold the lease on Lot 40 after the date of bringing in the well, which produced about two barrels of oil daily. Therefore, the date of abandonment of the lease on Lot 40, involved in this proceeding, was when the owners of the two-barrel well ceased pumping it and petitioner released the land back to the fee owner of the land. Up until that date, White, the fee owner of the land, *1943 had no right or authority to lease the land to any one else. This abandonment did not occur until after the taxable year. Petitioner is not entitled to the deduction which it claims on this item. Cf. .
The remaining issue relates to the computation of depletion, and raises the question whether the profit on the sale of leases is a part of the gross income from property within the scope of section 204(c)(2) of the Revenue Act of 1926, which reads as follows:
The basis upon which depletion, exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the same as is provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the sale or other disposition of such property, except that -
* * *
(2) In the case of oil and gas wells the allowance for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance be less than it would be if computed*1944 without reference to this paragraph.
The petitioner's contention is that Congress, under the above section of the Revenue Act of 1926, intended to include as a measure of the allowance for depletion, the profit received from the sale of the property, regardless of the fact that the proceeds of the sale of the property have no relation to the receipts from the operation of the property. The respondent's position is that "gross income from the property" refers to income from operations as distinguished from the gain derived or proceeds from the sale of the property.
In the case of , the District Court for the Western District of Oklahoma*61 had this same question before it and there held that depletion deductions as to oil and gas properties under section 204(c)(2) of the Revenue Act of 1926, providing for a deduction of 27 1/2 per cent of the gross income from the property during the taxable year, may not be based on the amount received from the sale of the properties themselves. The court there said: "This court is of the opinion that a careful reading of the section involved in this case will*1945 show that the construction which has been placed upon it by the Revenue Department is the proper construction, and that gross income from property has a distinct meaning as compared to gross income from the sale of property."
We think the cited case states the law correctly. Accordingly, as to this issue, the determination of the respondent is approved.
Decision will be entered under Rule 50.