1946 U.S. Tax Ct. LEXIS 87">*87 Decision will be entered under Rule 50.
1. Prior to the taxable year, certain land owners entered into oil and gas leases with various oil companies, reserving to themselves a one-eighth royalty interest in the oil produced. Subsequently a pooling agreement was devised whereby, in 1933, one-half of the royalty interest of each land owner was transferred to the petitioner in exchange for shares of stock in a number based on the number of acres pooled. In addition, the promoters of the pool received 25 per cent of the petitioner's stock. Under the pooling agreement, the royalties paid on the interests thus pooled were to be collected by the petitioner and distributed monthly to the stockholders on the basis of their stockholdings. Thereafter, certain of the landowners instituted proceedings to have the pooling agreement canceled, alleging fraud and a violation of the blue sky laws of Michigan in the sale of petitioner's stock. The litigation lasted eight years, during which time the oil royalties were impounded by the oil companies. In 1941 the Supreme Court of Michigan decreed that there was no fraud; that the sale of stock did not violate the blue sky laws; that the petitioner1946 U.S. Tax Ct. LEXIS 87">*88 was the owner of the pooled royalty interests and entitled to the royalty payments. Pursuant to such decree, the oil companies in 1941 paid over the impounded royalties and subsequent royalties to the petitioner. Held, such royalties constitute taxable income to the petitioner.
2. Held, attorneys' fees and legal expenses paid in connection with the litigation in the Michigan courts are capital expenditures and not deductible from gross income as ordinary and necessary business expenses.
7 T.C. 685">*686 The respondent determined deficiencies in income tax for the years 1940 and 1941 and a deficiency in excess profits tax for the year 1941 against Porter Royalty Pool, Inc., as follows:
| Year | Income tax | Excess profits |
| tax | ||
| 1940 | $ 70.81 | |
| 1941 | 45,975.12 | $ 3,461.60 |
The petitioner claims an overpayment in income tax for the year 1941 in the amount of $ 128,021.98 and an overpayment in excess profits tax for the same year in the amount of $ 9,338.63.
It is stipulated that there is no deficiency due in excess profits tax; that the petitioner has overpaid its excess profits tax and is entitled to relief under section 722 of the Internal Revenue Code. The parties agree that the amount of such overpayment can be determined in the recomputation under Rule 50.
The issues in controversy are: (1) whether royalties paid to the petitioner in 1940 and 1941 constitute taxable income to it; and (2) if the first issue is answered adversely to the petitioner, whether1946 U.S. Tax Ct. LEXIS 87">*90 amounts representing legal expenses and attorneys' fees incurred and paid by the petitioner in 1940 and 1941 are properly deductible from gross income for those years as expenses under section 23 (a) of the Internal Revenue Code.
7 T.C. 685">*687 FINDINGS OF FACT.
The facts are all contained in a stipulation, together with exhibits attached thereto. The facts essential to a proper presentation of the issues may be summarized as follows:
The petitioner is a corporation, organized and existing under the laws of Michigan, with principal office at Breckenridge, Michigan. The returns for the years in controversy were filed with the collector of internal revenue at Detroit, Michigan.
At various dates prior to December 31, 1933, certain fee owners of land located in the Township of Porter, County of Midland, State of Michigan, each executed an oil and gas lease as lessor, with certain persons or corporations as lessee. Under such lease, the lessor conveyed to the lessee for a term of years, and for so long thereafter as operated for oil and gas, all the oil and gas in and under the described land, as well as certain surface rights incident to the oil and gas operations, in consideration of the1946 U.S. Tax Ct. LEXIS 87">*91 lessee agreeing to drill and sell within a stipulated period of time, and "to deliver to first party [lessor] in the pipe line with which it may connect the well or wells, the one-eighth part of the oil produced and saved from said premises" and for other considerations. The leases were recorded by the register of deeds of the County of Midland, State of Michigan.
At various dates prior to December 1, 1933, each of the fee owner-lessors entered into a so-called pooling agreement with certain promoters and trustees whereby they assigned to the trustees certain royalty interests derived from the property or properties subject to the leases. These contracts provided in pertinent part as follows:
Whereas, The parties of the first part [fee owner-lessor] are now the owners of a royalty interest in and to all the oil and/or gas produced from or contained in the following real estate in the township of Porter, county of Midland and state of Michigan, described as follows: to-wit:
[Here followed a description of the property so owned.]
Whereas, the first parties desire to enter into a pool or combination with certain other owners of land in the township of Porter, Midland county, 1946 U.S. Tax Ct. LEXIS 87">*92 Michigan, providing for an assignment of one-half of each of their royalties of oil and/or gas to second parties, and to be by the said second parties [trustees] later assigned to a corporation to be formed, each owner of land to own a number of shares in said corporation equal to the number of acres owned by him and placed in said pool, so as to insure to each stockholder of said corporation a certain participation in the revenue to be derived from the production of oil and/or gas in said territory, irrespective of whether or not oil and/or gas is produced on his land; and
Whereas, The said first parties desire to assign a one-half of their royalty interest in and to all oil and/or gas produced from the lands aforesaid to a corporation to be formed of all owners of oil and/or gas royalties who enter into similar contracts hereto with second parties; and
7 T.C. 685">*688 Whereas, The third parties [promoters] intend to do all the work necessary to be done in getting the owners of royalty interests to join in such pool, and become stockholders in the corporation provided for herein, for the mutual profit, advantage and protection of said parties, and as a consideration for such services, 1946 U.S. Tax Ct. LEXIS 87">*93 the said third parties are to receive a share in the capital stock of said corporation as hereinafter provided; and
Whereas, Said third parties intend to pay all charges and expenses of second parties, and all costs, charges and expenses of drafting this contract, and all costs, charges and expenses of forming this pool and incorporating said corporation; and
Whereas, The said first parties desire to appoint the second parties as trustees for the uses and purposes hereinafter set forth; and
Whereas, The second parties desire to act as said trustees:
Now, Therefore, In consideration of the premises and the mutual contracts of other owners of royalty interests as enter into similar contracts hereto with second and third parties, and the sum of one dollar mutually paid, it is hereby agreed as follows:
1. The first parties hereby irrevocably appoint the second parties as their trustees upon the trusts and for the purposes hereinafter set forth, and the second parties do hereby accept and agree to perform said trusts and conditions and to look to, and settle with, said third parties for their, and each of their, remuneration.
2. The first parties do hereby transfer, assign and set over 1946 U.S. Tax Ct. LEXIS 87">*94 to the said second parties, as trustees, all the right, title, interest, claim or demand of the first parties in and to all royalty interest in oil and/or gas now or hereafter discovered and/or produced from the real estate hereinbefore described, to the extent, however, of a one-half of the royalty interest of the first parties only, that is to say, to the extent of an undivided one-sixteenth interest in and to all the oil and/or gas produced from the aforesaid lands, to be held by said trustees until a corporation is organized as hereinafter set forth or for a period of five years from the date hereof, when said trustees are to transfer this contract, and all other such contracts as herein provided for, to such corporation, and in the event a corporation is not so organized within said five year period said trustees agree to cancel, surrender and deliver over this contract to first parties. First parties also agree to convey a good merchantable title to said oil and gas.
3. In the event that oil and/or gas is discovered and/or produced in commercial quantities upon any of the lands affected by this agreement, including similar agreements executed by other owners of oil and gas lands, 1946 U.S. Tax Ct. LEXIS 87">*95 in the territory hereinbefore mentioned, the said second parties shall forthwith after such discovery and/or production, and within at least ninety days thereafter, draft articles of incorporation for the signature of first parties and such others as are hereinbefore mentioned, and upon obtaining such signatures, or sufficient signatures as will comply with the laws of the state of Michigan, and present such articles of incorporation to the Secretary of State of the State of Michigan for the organization and incorporation of a Michigan corporation to be known as Porter Royalty Pool, Inc., or such other name as may be hereafter be agreed upon.
4. The corporation to be formed as aforesaid shall have a capital stock of no par value common shares only and each share shall have equal voting and participating rights and be non-assessable. The amount of capital stock to be issued and outstanding, and the manner of its issue, shall be determined as follows: If there be six hundred acres of land represented in this agreement and similar agreements executed by other owners as a part of the plan herein contemplated, 7 T.C. 685">*689 then there shall be issued eight hundred shares of capital common1946 U.S. Tax Ct. LEXIS 87">*96 no par value stock, or, if there are twenty-four hundred acres of land, then there shall be issued thirty-two hundred shares of stock, and so on and in such proportion, and there shall be issued to the first parties, and to each of the other owners that have entered into similar agreements, as aforesaid, one share of said capital common no par value stock for each acre of land represented by this agreement and similar agreements as aforesaid, providing the royalty interest hereby assigned is a one-sixteenth part of all the oil and/or gas produced, but if such royalty interest is less than a sixteenth interest, say a thirty-second interest, then there shall be issued a one-half share of stock for each acre, and so on in the same ratio as the royalty interest decreases, i. e. if the first parties hereto contribute sixty acres of land, the capital stock authorized, so far as they are concerned, shall be eighty shares, of which they shall receive sixty shares, but if first parties hereto contribute sixty acres of land bearing a royalty interest of only a thirty-second, the capital stock authorized, so far as they are concerned, shall be forty shares, of which they shall receive thirty1946 U.S. Tax Ct. LEXIS 87">*97 shares. The remaining shares of the capital common no par value stock shall be issued to Clarence H. Bangs and David S. McCutcheon [promoters] jointly, or their assigns, in consideration of their services heretofore and hereafter to be performed in connection with the organization of the plan herein set forth and hereby contemplated and the procuring of this and similar agreements for the mutual benefit, profit, advantage and protection of the first parties and the other owners named in similar agreements.
5. On the completion of the organization of such corporation and upon the execution of good and sufficient assignments by the second parties hereto to such corporation of all the royalty interests acquired by them as trustees under this and similar agreements above mentioned, the said second parties, as such trustees, shall be considered to have performed and completed their trust and this contract and shall be discharged.
Under the contracts the promoters agreed to pay all the expenses of forming the pool and the corporation.
The trustees were not to be liable to see to the recording of any instrument nor to take any action to protect the interest in the lands and property. They1946 U.S. Tax Ct. LEXIS 87">*98 had no responsibility as to the validity of the instrument or of any agreement for royalty in or to oil and/or gas produced in the lands, nor as to the execution or acknowledgment of such agreement, nor as to the title of the assignors of such oil and gas leases. The trustees were absolved from all duty to pay or to keep themselves informed as to the payment of taxes or assessments upon the property and were absolved from the obligation to take any action toward the execution or enforcement of the trust which might involve them in any expense or liability.
In accordance with the terms of the pooling agreements, Porter Royalty Pool, Inc., petitioner herein, was duly incorporated under the laws of Michigan on May 22, 1933. The purpose clause of the petitioner's articles of incorporation recited as follows:
Article II.
The purpose or purposes of this corporation are as follows: The purpose of this corporation is to own royalty in oil and gas lands and leases; to pay mortgages, 7 T.C. 685">*690 notes, taxes, assessments and other charges that are or may become a lien or charge against any lands or leases in which this company may have a royalty interest. (In general to carry on any business1946 U.S. Tax Ct. LEXIS 87">*99 in connection therewith and incident thereto not forbidden by the laws of the State of Michigan and with all the powers conferred upon corporations by the laws of the State of Michigan).
Article 14 of the bylaws of the petitioner provided for the issuance of stock certificates. It was provided therein that a transfer fee of 25 cents per transfer, plus transfer tax, should be paid by any person desiring the transfer on the books of the petitioner of any stock. It was further provided that the stock certificates were issued subject to the following rights and provisions which were required to be written or printed plainly on the face of each certificate:
1. This corporation hereby reserves the right to apply all dividends that may be declared, applicable to this stock certificate upon any debt due or owing by the record holder thereof to this corporation.
2. The consideration for the issuance of this stock certificate is the assignment or conveyance of a interest in the oil and/or gas royalties upon the following described premises, to-wit: (Here insert in each stock certificate the description of the land upon which said assignment has been given), and in which said assignment1946 U.S. Tax Ct. LEXIS 87">*100 it is agreed that a good merchantable title to said oil and/or gas royalties is to be conveyed and assigned.
3. Now, therefore, if for any reason said title so conveyed as aforesaid is not a good merchantable title, and this corporation by reason of the existence of any incumbrance or lien having priority to the rights of this corporation which shall be allowed to become past due and unpaid, either in principal or interest, or if any action shall be commenced or threatened, which, if successful, might extinguish the title of this corporation to said oil and/or gas royalties so assigned, then in that case, this corporation hereby reserves the right to apply all dividends applicable to this certificate of stock, to the payment of any such incumbrance or lien, or to the expense of protecting the title to said oil and/or gas so assigned as aforesaid, and if for any such reason this corporation loses its interest in said oil and/or gas royalty so conveyed and assigned as aforesaid, then thereafter no further dividends shall be declared or paid on this certificate of stock, and the holder thereof shall lose the right to, and be debarred from voting this certificate, and from all further1946 U.S. Tax Ct. LEXIS 87">*101 participation in the affairs of this corporation by reason of the holding of this certificate.
4. If the owner, or the grantee of the owner, of the land upon which the said oil and/or gas royalties have been conveyed to this corporation, or if this corporation shall pay all or any part of any encumbrance upon said land, then and in that case, all stock issued in consideration of said oil and/or gas royalty assignment shall be effected equally by said payment.
Paragraph 17 of the bylaws provided as follows:
17. Profits.
After the payment of all current expenses of the corporation, there shall be set aside a sufficient amount of money each month to amortize taxes, franchise fees and other necessary expenses that are not required to be paid monthly, and all the balance thereof shall be voted and paid to the stockholders at the end of each fiscal month, providing however, that at least Two Hundred Dollars shall be retained in the treasury after each declaration of dividends.
7 T.C. 685">*691 It was further provided in the bylaws that the annual management and operating expenses of the petitioner should not exceed $ 1,500 per annum, except for litigation or legal fees.
On June 16, 1933, the trustees1946 U.S. Tax Ct. LEXIS 87">*102 under the pooling agreements assigned to the petitioner all the royalty interests which they had acquired as trustees. Thereafter the petitioner issued its stock certificates to the persons enitled thereto under its articles of incorporation and its bylaws.
Subsequently certain of the fee owner-lessors who had signed the pooling agreements declined to accept their stock in the petitioner and refused to sign the division orders which would permit the proceeds of the oil produced from their lands to be paid directly to the petitioner and otherwise declined to carry out the terms of the pooling agreements which they had signed.
The petitioner thereupon instituted an action in the Midland County Circuit Court against certain of the recalcitrant individual fee owner-lessors who had signed the pooling agreements, for the enforcement of the terms of the pooling agreements and for an accounting. No final decree was entered in this proceeding.
Thereafter Glenn R. Hathaway and Mildred J. Hathaway, who had executed one of the pooling agreements, filed a bill of complaint in the Midland County Circuit Court, alleging fraud and misrepresentation in the organization of the pool and a violation1946 U.S. Tax Ct. LEXIS 87">*103 of the Blue Sky Law in the organization of the petitioner. Such suit prayed for a rescission of the pooling agreement and for an accounting. The pipe line companies purchasing the oil produced under the various leases were made parties defendant. Subsequently, other fee owner-lessors who had signed the pooling agreements joined as plaintiffs and the petitioner filed a cross-bill. The circuit court entered its decision adverse to the petitioner and ordered the cancellation of the pooling agreements then in controversy before the court.
The petitioner appealed from this decision to the Michigan Supreme Court, which rendered its original opinion on January 6, 1941, (296 Mich. 90">296 Mich. 90) and filed an amendatory opinion on July 30, 1941, (296 Mich. 733">296 Mich. 733). In its opinion, which reversed the decision of the circuit court, so far as is here pertinent, the Michigan Supreme Court held that the pooling agreement "was an agreement for a joint adventure; that the formation of the corporation pursuant to the agreement in no way changed the relationship of joint adventure between the parties; that the agreement for the use of the corporate medium1946 U.S. Tax Ct. LEXIS 87">*104 was only a convenient method of carrying into effect the joint adventure, and was not a contract within the prohibition of the blue sky law; that the issuance of stock by the corporation to the pool members was not the sale of securities within the intendment of the statute."
7 T.C. 685">*692 On April 24, 1941, the Michigan Supreme Court issued its original decree in accordance with its decision of January 6, 1941. On October 31, 1941, it issued its amended final decree, which was in accordance with its amended opinion of July 30, 1941. Such amended decree provided, in part, as follows:
(e) * * * that the purpose of the organization of the Porter Royalty Pool, Inc., was to create a legal entity under the corporate laws of this state which would serve as a convenient medium to carry out the joint adventure contract with power and authority, through its board of directors, among other things, to protect and preserve the subject matter of the joint adventure enterprise; to collect and distribute (subject to the payment of all expenses and obligations properly deductible therefrom) pooled oil royalties or the proceeds thereof; to enforce and require the performance of all of the joint adventure1946 U.S. Tax Ct. LEXIS 87">*105 agreements in all their terms; to institute or defend legal proceedings with relation thereto and to employ legal counsel in connection therewith and otherwise to do all things within the powers of a corporation organized under said Act 327 necessary or incidental to the management, direction, control and operation of the joint adventure enterprise and not expressly prohibited by the terms of the joint adventure agreement, the articles of association or the corporate by-laws.
(f) That the oil royalty rights transferred and assigned by the terms of the royalty pool agreements to the Trustees named therein were properly transferred and assigned by said Trustees to the Porter Royalty Pool, Inc., a Michigan corporation, subsequent to the organization of said corporation, pursuant to the terms of the royalty pool agreements and by such transfer and assignment, all the title to and ownership of said royalty rights which were originally transferred to said Trustees by the parties to said royalty pool agreements, became and at the date hereof remain vested in said Porter Royalty Pool, Inc., a Michigan corporation. That said Porter Royalty Pool, Inc., a Michigan corporation, is the sole and1946 U.S. Tax Ct. LEXIS 87">*106 only owner of all of said royalty rights transferred by said royalty pool agreements and of all royalty oil (or the proceeds of the sale thereof) realized from said pooled royalty rights out of oil produced from any of the premises described in said royalty pool agreements.
* * * *
(h) That the said Porter Royalty Pool, Inc., a Michigan corporation, having been duly organized pursuant to the terms of the royalty pool agreement as aforesaid and having acquired all the right, title, interest, claim and demand of the joint adventurers originally transferred by them by the royalty pool agreements to the Trustees named therein, and said corporation being at the date hereof the sole and only owner of all of said royalty rights and the said joint adventurers having agreed by the terms of the royalty pool agreements to accept the status of stockholders in such corporation and having agreed that such joint adventure enterprise be governed and administered by a corporation pursuant to the laws relating to corporations, the said joint adventurers who executed the original royalty pool agreements, their heirs, executors, administrators, successors and assigns, have no right, title, interest, 1946 U.S. Tax Ct. LEXIS 87">*107 claim or demand in or to any of the oil royalties transferred by the original royalty pool agreements and now vested in Porter Royalty Pool, Inc., a Michigan corporation, or in or to the proceeds of the sale thereof, save only in their capacity as stockholders in the Porter Royalty Pool, Inc., in accordance with the laws relating to corporations, all pursuant to the terms of the royalty pool agreement.
During the pendency of the litigation in the Midland County Circuit Court in Chancery and the Supreme Court of the State of Michigan, 7 T.C. 685">*693 the oil or pipe line companies, under and in pursuance of the order of the court, accumulated and impounded that portion of the purchase price of the oil produced which the pooling agreements provided should be paid to the petitioner. The years in which the moneys were so impounded (being the years in which the oil was produced and sold), the names of the oil or pipe line companies which purchased the oil and with whom the funds were so impounded, and the amounts so impounded with each company, were as follows:
| Simrall Corporation (Formerly Simrall Pipe Line Co.) | |||
| Year | Gross amount | Severance tax | Net amount |
| 1933 | $ 803.57 | $ 16.07 | $ 787.50 |
| 1934 | 48,010.80 | 960.22 | 47,050.58 |
| 1935 | 34,317.63 | 686.35 | 33,631.28 |
| 1936 | 16,871.35 | 337.43 | 16,533.92 |
| 1937 | 10,892.72 | 217.85 | 10,674.87 |
| 1938 | 6,035.23 | 120.70 | 5,914.53 |
| 1939 | 2,693.22 | 53.86 | 2,639.36 |
| 1940 | 2,104.45 | 42.09 | 2,062.36 |
| 1-1-41 to 7-31-41 | 1,332.41 | 26.65 | 1,305.76 |
| Total | 123,061.38 | 2,461.22 | 120,600.16 |
| Pure Oil Co. and/or Pure Transportation Co. (Formerly Pure Oil | |||
| Pipe Line Co.) | |||
| Year | Gross amount | Severance tax | Net amount |
| 1933 | $ 33,033.26 | $ 660.67 | $ 32,372.59 |
| 1934 | 130,333.52 | 2,606.67 | 127,726.85 |
| 1935 | 162,109.64 | 3,242.19 | 158,867.45 |
| 1936 | 132,140.48 | 2,642.81 | 129,497.67 |
| 1937 | 80,005.35 | 1,600.10 | 78,405.25 |
| 1938 | 42,237.45 | 844.75 | 41,392.70 |
| 1939 | 29,580.15 | 591.60 | 28,988.55 |
| 1940 | 40,044.14 | 800.88 | 39,243.26 |
| 1-1-41 to 7-31-41 | 31,529.91 | 630.60 | 30,899.31 |
| Total | 681,013.90 | 13,620.27 | 667,393.63 |
| Combined totals | 804,075.28 | 16,081.49 | 787,993.79 |
In its amended final decree the Michigan Supreme Court ordered and decreed that Pure Oil Co. should forthwith pay to the petitioner or its assigns the sum of $ 667,393.63 of impounded royalties and that Simrall Corporation (formerly Simrall Pipe Line Co.) should forthwith pay to the petitioner the sum of $ 120,600.16 of impounded royalties. It was further ordered and decreed that both companies pay the proceeds of all pooled royalties coming into their hands and accruing subsequent to July 31, 1941, to the petitioner, in accordance with the usual practice in the petroleum industry.
In addition to1946 U.S. Tax Ct. LEXIS 87">*109 the sums shown as having been impounded by the oil or pipe line companies through July 31, 1941, the oil and/or pipe line companies paid additional sums to the petitioner for the calendar year 1941 in the amount of $ 20,999.93. This additional sum, added to the gross funds impounded up to July 31, 1941, aggregated $ 825,075.21, which amount was reported as royalties received by the petitioner on its tax returns for the calendar year 1941.
7 T.C. 685">*694 In 1933 and 1934 the petitioner expended an aggregate amount of $ 11,700 for expenses and fees in connection with the litigation in the Circuit Court of Midland County, Michigan. These amounts were claimed as deductions by the petitioner on its income tax returns for those years. Upon audit of the petitioner's returns for such years these claimed deductions were disallowed by the respondent. In 1935 and 1936 the petitioner expended an aggregate amount of $ 8,000 for expenses and attorneys' fees in connection with the litigation in the Circuit Court of Midland County, Michigan. These expenses and fees were not claimed as deductions in the petitioner's income tax returns for those years. The total attorneys' fees and legal expenses 1946 U.S. Tax Ct. LEXIS 87">*110 incurred during the years 1933 to 1936, inclusive, in the aggregate amount of $ 19,700, were claimed as a deduction in the petitioner's income tax return for the calendar year 1941.
On November 5, 1936, the petitioner entered into a contingent fee contract with its counsel, Charles H. Goggin and E. C. Bevan, providing that all moneys heretofore paid to the attorneys should be in full payment of all expenses incurred and paid by them in connection with the litigation and that the attorneys should have as compensation for their services rendered and to be rendered 20 per cent of all pool moneys impounded by the purchasers of royalty oil from pooled lands to January 1, 1938, as, if, and when the same, or any part thereof, should be paid to or received by the pool or its attorneys.
On October 4, 1941, at a special meeting of the petitioner's board of directors, the following resolution was adopted:
That Charles H. Goggin and E. Cyril Bevan, having completed their legal services in connection with the case of Glenn R. Hathaway, et al. vs. Porter Royalty Pool, Inc., et al, and having secured a favorable decision of said appeal to the Supreme Court of Michigan in said case, they are entitled1946 U.S. Tax Ct. LEXIS 87">*111 to receive payment of their compensation for said services forthwith after the entry of final decree in the Supreme Court of Michigan, and Pure Oil Transportation Company, an Ohio corporation, and Simrall Pipe Line Company, a Delaware corporation, are hereby expressly authorized and directed to pay to said Charles H. Goggin and E. Cyril Bevan forthwith after the entry of final decree and service of a certified copy thereof upon said pipe line companies, an amount equal to twenty (20) per cent of all royalties accrued in favor of Porter Royalty Pool, Inc. to and including the 31st day of December, 1937 and impounded with said Pure Oil Transportation Company, and/or said Simrall Pipe Line Company.
Pursuant to the amended final decree of the Michigan Supreme Court, Simrall Corporation, on November 1, 1941, paid to the petitioner the sum of $ 98,864.52. On the same date Simrall Corporation, upon authorization from the petitioner, paid to Charles H. Goggin and E. Cyril Bevan, attorneys for the petitioner, the sum of $ 10,867.82 to each in accordance with the contingent fee contract dated November 5, 1936.
7 T.C. 685">*695 Pursuant to the amended final decree of the Michigan Supreme Court the1946 U.S. Tax Ct. LEXIS 87">*112 Pure Oil Co., on November 3, 1941, paid to the petitioner the sum of $ 561,943.51. On the same date, upon authorization of the petitioner, Pure Oil Co. paid direct to Charles H. Goggin and E. Cyril Bevan the sum of $ 105,450.12 representing the balance of attorneys' fees payable to said attorneys for services rendered in accordance with the contingent fee contract dated November 5, 1936.
During the year 1940 the petitioner paid E. C. Bevan and Inland Press of Detroit, Michigan, the sum of $ 3,586.29, which sum was a part of the legal expenses incurred and paid for prosecuting the appeal from the Midland County Circuit Court to the Supreme Court of Michigan. This amount was claimed as a deduction by the petitioner in its return for that year. During 1941 the petitioner paid the sum of $ 1,250 to Charles H. Goggin and E. C. Bevan for miscellaneous expenses incurred by them in connection with such appeal. On its return for 1941 the petitioner claimed a deduction for legal expenses in the sum of $ 148,659.
During the years 1933 to 1939, inclusive, the petitioner filed only corporation Federal income tax returns. For the years 1940 and 1941 the petitioner filed partnership income 1946 U.S. Tax Ct. LEXIS 87">*113 tax returns on Form 1065. For the year 1941 the petitioner filed also corporation income and excess profits tax returns and paid the tax disclosed thereon. Attached to both the corporation and partnership returns was a letter to the collector of internal revenue signed by the petitioner's president and treasurer, in which appeared the following statement:
The Pool denies that it is taxable as a corporation, but in view of the fact that several years accumulation of income was received in the year 1941 as a result of the foregoing litigation, it would appear to be in the best interests of both the government and taxpayer for taxpayer to file an additional return disclosing what its liability would be were it to be taxed as a corporation and thereby to effect the elections and obtain the benefits under section 721 and other sections to which it would properly be entitled if taxable as a corporation. In view of the substantial tax that would apply on the corporate basis, it is also essential that taxpayer be not subjected to the penalties provided for failure to file a timely return or to timely pay the tax due.
For these reasons, simultaneously with the filing of its proper partnership1946 U.S. Tax Ct. LEXIS 87">*114 return, taxpayer is also filing a corporate return and tendering the full amount of tax as computed in such corporation returns.
On or about July 30, 1942, the petitioner filed claims for refund, Form 843, with the collector of internal revenue at Detroit, Michigan, claiming a refund of all Federal income and excess profits taxes paid for the calendar year 1941.
In his deficiency notice the respondent disallowed the claims for refund in full and determined that the legal and attorneys' fees paid by the petitioner in 1940 and 1941 constituted capital investments and not deductible expenses.
7 T.C. 685">*696 OPINION.
The first issue is whether or not the oil royalties paid to the petitioner in 1941, pursuant to the decree of the Supreme Court of Michigan, constitute taxable income to it. The petitioner contends that the royalty interests reserved by the fee owner-lessors were simply rights to receive income if, as, and when realized; that, under the pooling agreements, they assigned to the petitioner the right to receive a portion of this income; and that the entire transaction thus constituted an anticipatory assignment of future income which, when realized, was taxable to the fee owner-lessors1946 U.S. Tax Ct. LEXIS 87">*115 under the doctrine of Lucas v. Earl, 281 U.S. 111">281 U.S. 111, and related cases, and not to the petitioner.
Whether or not the amounts in question are income taxable to the petitioner depends upon the nature of the rights reserved by the fee owner-lessors and transferred by them to the trustees, who, in turn, assigned them to the petitioner.
Under the terms of the various leases, the fee owner-lessors reserved to themselves a one-eighth royalty interest in the oil and gas produced and saved from the leased premises. It is now firmly established that the owner of a royalty interest in oil lands has an economic interest in the oil in place to the extent of his royalty interest so as to entitle him to a deduction for depletion on royalties and bonuses received. Kirby Petroleum Co. v. Commissioner, 326 U.S. 599">326 U.S. 599. Thus in Palmer v. Bender, 287 U.S. 551">287 U.S. 551, the Supreme Court said:
* * * the lessor's right to a depletion allowance does not depend upon his retention of ownership or any other particular form of legal interest in the mineral content of the land. It is enough if by virtue of the leasing1946 U.S. Tax Ct. LEXIS 87">*116 transaction he has retained a right to share in the oil produced. If so, he has an economic interest in the oil, in place, which is depleted by production. * * *
And in Thomas v. Perkins, 301 U.S. 655">301 U.S. 655, the Court said:
Thus in that case [287 U.S. 551">Palmer v. Bender, supra] we held assignors' mere stipulation for royalty out of oil operated to save to them an economic interest in the oil sufficient to entitle them to deduct from their income derived from the oil an allowance for depletion. If Palmer had retained no interest in the oil, he would have been entitled to no deduction on account of depletion. Ownership was essential. * * * [Italics supplied.]
It is thus manifest that what the fee owner-lessors retained under the leases was an economic interest in the oil in place in the property which produced the royalty income. It was this same economic interest in the oil to the extent of one-half thereof which was transferred to the petitioner under the pooling agreements. The granting clause of these agreements provided, in part, as follows:
The first parties do hereby transfer, assign and set over to the said second1946 U.S. Tax Ct. LEXIS 87">*117 parties, as trustees, all the right, title, interest, claim or demand of the first parties in and to all royalty interest in oil and/or gas now or hereafter discovered 7 T.C. 685">*697 and/or produced from the real estate hereinbefore described to the extent, however, of a one-half of the royalty interest of the first parties only, that is to say, to the extent of an undivided one-sixteenth interest in and to all the oil and/or gas produced from the aforesaid lands * * *.
That the petitioner was the assignee not merely of future income, but of the property which produced the income, is further demonstrated by the decree of the Supreme Court of Michigan, which contained the following provision:
* * * That said Porter Royalty Pool, Inc., a Michigan corporation, is the sole and only owner of all of said royalty rights transferred by said royalty pool agreements and of all royalty oil (or the proceeds of the sale thereof) realized from said pooled royalty rights out of oil produced from any of the premises described in said royalty pool agreements.
From all this we think it abundantly clear that the petitioner, by transfer and assignment, became the owner of one-half of the royalty interests1946 U.S. Tax Ct. LEXIS 87">*118 reserved under the leases, which interests were economic interests in the oil in place and of which the royalty payments here in question constituted the proceeds. Consequently, the petitioner, being the owner of the property which produced the income, it follows that it is taxable on the income arising therefrom. Cf. Helvering v. Horst, 311 U.S. 112">311 U.S. 112. See also Leland J. Allen, 5 T.C. 1232.
As an alternative contention, although it is not so designated on brief, the petitioner contends that the sums in question were not its income, but were the income of its stockholders. It contends that, under its articles of incorporation and bylaws, the petitioner was empowered only to collect the royalties and was required to distribute them monthly to the stockholders after deducting expenses and the sum of $ 200, which was required to be retained in the treasury; that it could use the royalties for no purposes of its own; could not engage in business; and that, therefore, it had no proprietary right, title, or interest to the moneys received, but received them only as trustees or agents for its stockholders.
The petitioner1946 U.S. Tax Ct. LEXIS 87">*119 relies on Moro Realty Holding Corporation, 25 B. T. A. 1135, in support of its contention. In that case a corporation was organized for the sole purpose of holding title to realty for the benefit of members of a certain syndicate. We held that, under the facts there present, the corporation was "a legal shell holding bare record title only," that all beneficial interest in the property was in the syndicate members, and that gain on the sale of the property was taxable to them and not to the corporation.
The Moro case, although of doubtful authority since the decision of the Supreme Court in Moline Properties, Inc.v. Commissioner, infra, is in any event readily distinguishable from the case before us. As we pointed out in our opinion in the Moro case, supra, "The corporation was formed solely for the purpose of holding title, issued no 7 T.C. 685">*698 stock or other evidences of beneficial interest, held no corporate meetings, had no paid-in cash capital, paid no dividends and exercised none of the usual rights or privileges of corporate ownership." Here, on the other hand, the petitioner was regularly created and organized. Its bylaws1946 U.S. Tax Ct. LEXIS 87">*120 provide for the election of officers and directors and the holding of annual meetings. The royalty payments could be distributed only by vote of the board of directors and such distributions were made solely on the basis of stockholdings.
We have examined the other cases cited by the petitioner, but find them to be of no value as precedents. Thus, San Joaquin Valley Poultry Producers' Association v. Commissioner, 136 Fed. (2d) 382, involved the narrow question of whether or not a cooperative marketing association organized to market the produce of its members and to refund all profits to them on a patronage basis, could have any income of its own where this was forbidden by the statutes under which it was organized, its articles of incorporation and its bylaws. United Cooperatives, Inc., 4 T.C. 93, involved the right of a cooperative association to a deduction for patronage dividends paid to its members during the taxable years.
In our opinion this phase of the case is controlled by Moline Properties, Inc. v. Commissioner, 319 U.S. 436">319 U.S. 436. There a corporation was organized by one 1946 U.S. Tax Ct. LEXIS 87">*121 Thompson to be used as a security device in connection with certain realty owned by him. The property was conveyed to the corporation, which assumed the mortgages thereon. Until 1933 the only business done by the corporation was the assumption of an obligation of Thompson to the original creditor, the defense of certain condemnation proceedings, and the institution of a suit to remove certain restrictions from the property. In 1934 a part of the property was leased for use as a parking lot. The property was sold in parcels in 1934, 1935, and 1936 and Thompson sought to include the gain on the 1935 and 1936 sales as his own rather than the corporation's. In holding that the gain was that of the corporation, the Supreme Court said:
The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. 1946 U.S. Tax Ct. LEXIS 87">*122 [Citations.] In Burnet v. Commonwealth Imp. Co., 287 U.S. 415">287 U.S. 415, this Court appraised the relation between a corporation and its sole stockholder and held taxable to the corporation a profit on a sale to its stockholder. This was because the taxpayer had adopted the corporate form for purposes of his own. The choice of the advantage of incorporation to do business, it was held, required the acceptance of the tax disadvantages.
* * * *
7 T.C. 685">*699 Petitioner advances what we think is basically the same argument of identity in a different form. It urges that it is a mere agent for its sole stockholder and "therefore the same tax consequences follow as in the case of any corporate agent or fiduciary." There was no actual contract of agency, nor the usual incidents of an agency relationship. Surely the mere fact of the existence of a corporation with one or several stockholders, regardless of the corporation's business activities, does not make the corporation the agent of its stockholders. Therefore the question of agency or not depends upon the same legal issues as does the question of identity previously discussed. 287 U.S. 415">Burnet v. Commonwealth Imp. Co. supra, 287 U.S. 418">287 U.S. 418, 287 U.S. 418">419, 287 U.S. 418">420.1946 U.S. Tax Ct. LEXIS 87">*123
In the instant case we think the activities of the petitioner were sufficient to constitute the carrying on of business within the rule of 319 U.S. 436">Moline Properies, Inc. v. Commissioner, supra. As in the cited case, there is no evidence of a contract of agency expressed or implied between the petitioner and its stockholders. In point of fact the contrary is true, since the petitioner carried on litigation for eight years in the courts of Michigan, the ultimate effect of which was to establish its absolute title to the royalty interests as against its stockholders. The petitioner's contention must be rejected.
Finally, the petitioner contends that, if the sums in question were its property, they constituted capital to it and not income, upon the theory that they were received in payment for the petitioner's capital stock. This contention is wholly without merit. We shall not discuss it, therefore, except to point out that the record amply demonstrates that the consideration for the stock was, in the case of the fee owner-lessors, the assignment of the royalty interests and, in the case of the promoters, their services in organizing the pool. It is our1946 U.S. Tax Ct. LEXIS 87">*124 conclusion, and we hold, that the royalty payments constituted taxable income to the petitioner.
In view of our decision on the first issue, we must also determine whether or not the petitioner is entitled to a deduction from gross income on account of attorneys' fees and legal expenses incurred and paid in 1940 and 1941 in connection with the litigation in the Michigan courts. On its return for 1941 the petitioner claimed a deduction of $ 148,659 for such fees and expenses. Of this amount, it now claims a deduction of only $ 128,434, the amount actually paid in that year.
The petitioner contends that the expenses so incurred and paid were ordinary and necessary business expenses for which it is entitled to a deduction under section 23 (a) (1) of the code. The respondent has determined and here contends that the expenditures were capital in nature and that no deduction can be allowed therefor.
It is our opinion that the amounts in question constituted capital expenditures and that no deduction may be had therefor by the petitioner. The petitioner contends that the action in the state court involved merely its right to receive the royalty income. We think, 7 T.C. 685">*700 however, that1946 U.S. Tax Ct. LEXIS 87">*125 there was at stake, not only the right to receive the income, but primarily the petitioner's title to the royalty interests themselves. Had the decision been adverse to the petitioner, the pooling agreements would have been canceled and the petitioner would have lost all right, title, and interest in and to the royalty interests and, as a natural consequence, to the royalty payments. The decree of the Michigan Supreme Court firmly established the petitioner's title to such royalty interests, providing that the petitioner was "the sole and only owner of all of said royalty rights" and that the stockholders "have no right, title, interest, claim or demand in or to any of the oil royalties * * * save only in their capacity as stockholders * * *."
Since the litigation involved the defense of the petitioner's title to the royalty rights, no deduction is allowable with respect to the legal expenses and attorneys' fees incident thereto. "The authorities quite generally hold that expenditures made in defense of a title upon which depends the right to receive oil and gas royalty payments are capital expenditures and not deductible as ordinary business expenses." Farmer v. Commissioner, 126 Fed. (2d) 542;1946 U.S. Tax Ct. LEXIS 87">*126 Murphy Oil Co. v. Burnet, 55 Fed. (2d) 17; Bowers v. Lumpkin, 140 Fed. (2d) 927.
Decision will be entered under Rule 50.