*838 1. The petitioners entered into contracts for the drilling of wells under the terms of which the contractor agreed to drill the hole and furnish specified material and equipment and petitioners were in no case to furnish more than water, fuel, tanks, and flow lines and swab the well in and supervise the drilling of the sand area and the running of the casing. Held, following Retsal Drilling Co.,42 B.T.A. 1057">42 B.T.A. 1057, that no part of the amounts paid to the drilling contractors is deductible as intangible drilling and development costs.
2. The petitioners agreed to pay a lump sum for the installation, ready for operation, of oil well pumping equipment. The bid of the contractor for the job listed the price for material and the price for installation. Held, that the work was done under a turnkey contract and that the sum specified by the contractor in its bid as its price for installing the material is not deductible by petitioners as intangible drilling and development costs.
3. Held, that the basis of oil payments acquired in the dissolution of a corporation is recoverable through allowances for depletion and that the tax on receipts may not be deferred*839 until the basis is recovered.
4. The petitioner exchanged in a nontaxable transaction three producing oil leases for four like assets, there being well equipment on each of the seven leases. Held, that respondent committed no error in allocating to the well equipment on each lease acquired in the exchange, as a basis for depreciation purposes, the basis of the well equipment given up, in accordance with their relative values.
5. The petitioners entered into a turnkey contract for the drilling of one or two oil wells for $13,500 each, payable out of seven-eighths of one-fourth or seven-eighths of two-fifths of the production of the wells on the lease, depending upon whether one or two wells were drilled under the contract. The lease had no basis and upon completion each well had a fair market value of $11,000. Held, that there was no sale of an interest in the lease and that the lessees did not derive taxable gain or other income in the transaction.
6. The lessees of property on which there were four producing wells agreed to pay for the drilling of wells Nos. 5 and 6 on the lease the sum of $32,000, payable only out of a specified proportion of the first oil*840 and gas produced, saved and marketed from the wells to be drilled. The contractor was given a first lien upon the production of the wells drilled by him until the consideration was paid. For the purpose of measuring the production of the wells it was agreed that upon the completion of well No. 5 it would be deemed to produce one-fifth of all of the oil on the lease and that when well No. 6 was drilled in, it and well No. 5 would be deemed to produce two-sixths of the oil produced on the lease. No personal liability was assumed by the lessees for the cost of drilling the wells. Held, following Thomas v. Perkins,301 U.S. 655">301 U.S. 655, that no part of the amount paid to the contractor under the oil payments is taxable to the lessees.
7. E. C. Laster, Inc., transferred to the Retsal Drilling Co., both corporations having a single stockholder, without consideration, oil payments payable out of oil produced on leases held by the transferee. Held, that the fair market value of the oil payments at the time of the assignments does not constitute gross income allocable to the transferor under section 45 of the Revenue Act of 1936.
8. Attorney fees accrued by*841 a corporation for general legal services, including legal work in connection with dissolution proceedings, held to be deductible as ordinary and necessary business expenses; held, further, from the facts, that no part of the amount of the fee represented a charge for legal work performed for the sole stockholder of the corporation.
*160 These proceedings were consolidated for hearing and involve the redetermination of the following income and excess profits taxes in the cases indicated:
| Income tax | Excess profits tax | ||||
| Docket No. | 1935 | 1936 | 1937 | 1935 | 1936 |
| 96550 | $851.16 | ||||
| 97442 | 1,111.54 | $4,667.77 | $131.38 | $1,058.12 | |
| 100340 | $1,757.45 | ||||
| 100341 | 1,757.45 |
The remaining proceedings, Docket Nos. 97713, 97714, and 97716, involve transferee liabilities of the petitioners therein for the deficiencies in income and excess profits taxes asserted against E. C. Laster, Inc., for the years 1935 and 1936. Counsel for the petitioners admit that these petitioners are liable as transferees*842 for whatever taxes may be found to be due from E. C. Laster, Inc.
The issues are:
I. Whether certain intangible drilling and development costs are deductible from gross income.*161 II. Whether the portion of the cost of pumping equipment paid to a contractor for installing the equipment is deductible as intangible drilling and development costs.
III. Whether the respondent properly computed the taxable income realized from certain oil payments. IV. The proper basis for computing depreciation on oil well equipment acquired in a nontaxable exchange. V. Whether a gain of $11,000 was reasized by a lessee in connection with the drilling of certain oil wells for oil payments, payable out of all oil produced on the lease. VI. Whether the sum of $2,105.40 representing the proceeds of sale of oil is taxable to petitioner or the holder of the oil payment. VII. Whether income of $6,243.78 was realized upon the assignment of certain oil payments. VIII. Whether attorney fees in the amount of $4,200 are deductible as ordinary and necessary business expenses.FINDINGS OF FACT.
Issue I.
Petitioner E. C. Laster owned all of the stock of E. C. Laster, *843 Inc., and the Retsal Drilling Co., Texas corporations. The petitioners kept their books and filed their income tax returns on the accrual basis of accounting.
On October 22, 1935, the Retsal Drilling Co. entered into a written agreement with the Producers Supply & Tool Co. involving the drilling and equipment of four wells, two of which were to be drilled on a lease known as the Maxwell lease and the other two on a lease known as the Lambert lease. The contractor was to furnish at its expense slush pits, surface pipe, new casing, new tubing, the casinghead hookup and connections, float shoe, upset tubing, casing ring, cement and cementing, and liner, together with all drilling equipment, labor, tools, and supplies incident to the drilling of the wells, and carry workmen's compensation and public liability insurance. The contractor was also to drill the wells in first-class, workmanlike manner and at its expense to set the casing, drill the wells in, and run liner and tubing. The Retsal Drilling Co. agreed to furnish, at the location, water, fuel, tanks and flow lines, swab the wells in after the plug had been drilled, and furnish a man to supervise the drilling of the sand area*844 and the running of the casing. The wells were to be drilled to the Woodbine Sand, found at a depth of from 3,600 to 3,650 feet.
The Retsal Drilling Co. agreed to pay the sum of $11,600 for the drilling and equipping of each well on the Maxwell lease and $10,350 for each well on the Lambert lease. The consideration for the drilling *162 of the wells was payable out of oil produced from the Maxwell, Lambert, and other specified leases and by the Retsal Drilling Co. at the end of two years in the event the consideration was not paid out of production by that time.
Petitioner E. C. Laster owned the Lambert lease and the drilling contract with the Producers Supply & Tool Co. was entered into for his account. During 1935 the Producers Supply & Tool Co. performed its part of the contract respecting the two wells on the Lambert lease, known as Lambert wells Nos. 1 and 2.
In their joint income tax returns for 1935, E. C. Laster and his wife deducted $12,676.05 for intangible drilling and development costs incurred in connection with the drilling of Lambert wells Nos. 1 and 2. The respondent disallowed $11,173.42, representing the portion of the expense paid to the contractor*845 for labor and drilling, upon the ground that the wells were drilled under turnkey contracts.
In 1937 the Producers Contracting Co. performed work for petitioner E. C. Laster in connection with the drilling of an oil well known as F. A. Taylor No. 3. Under the terms of the oral agreement entered into for the work the Producers Contracting Co. was to drill the well to a certain depth, furnish the derrick, etc., pipe, drilling equipment, and tubing and set the pipe. E. C. Laster was to furnish water, fuel, and supervision and swab the well in. Upon the completion of the work the Producers Contracting Co. rendered the following invoice to E. C. Laster:
| Drilling F. A. Taylor #3, 3593' at 85?? per ft | $3,054.05 |
| Derrick | 550.00 |
| Erecting Derrick and furnishing relays and bottom for drilling | 325.00 |
| Cement, cementing service, hauling, and digging slush pit | 450.00 |
| Casing, tubing, hookup, etc. (per itemized list) | 5,575.00 |
| Total | 9,954.05 |
The amount of the invoice, less $100, was paid in cash by E. C. Laster. Of the items of $3,054.05, $325 and $450 charged by the contractor and $400 for cable tool work, $465 for labor, $60 for swabbing, and $80 for trucking, representing*846 amounts paid to others for work done on the well, a total of $4,834.05, Laster charged off $4,813.67 to intangible drilling and development costs. No charge was made by Laster for fuel and water furnished by him in the drilling operations.
Petitioner E. C. Laster owned a one-half interest in a lease known as the J. T. Brown lease. In 1937 the Producers Contracting Co. performed work for the leaseholders in the drilling of a well on the lease known as J. T. Brown No. 6. The Producers Contracting Co. performed the work under an oral agreement the terms of which were the same as those involved in the drilling of the well known as F. A. *163 Taylor No. 3. Upon completion of the work the Producers Contracting Co. rendered the following invoice to the leaseholders:
| Drilling J. T. Brown #6,3723' at 92?? per ft | $3,425.16 |
| Derrick | 600.00 |
| Erecting Derrick and furnishing relays and bottom for drilling | 360.00 |
| Cement, cementing service, hauling, and digging slush pit | 500.00 |
| Casing, tubing, hookup, etc. (per itemized list) | 6,700.00 |
| 11,585.16 |
To one-half of the items of $3,425.16, $360, and $500 in the invoice petitioner Laster added $21.25 for surveying, *847 $50 for a permit to drill the well, $41.96 for labor, $2.18 for insurance, $35 for swabbing, and $8.35 for trucking, a total of $2,301.32, all of which was paid to others. He charged the amount to intangible drilling and development costs and deducted it in the joint return filed for himself and his wife for 1937.
The respondent disallowed the deductions of $4,813.67 and $2,301.32 taken on account of the drilling of F. A. Taylor well No. 3 and J. T. Brown well No. 6 upon the ground that the amounts represented expenditures under turnkey contracts.
On September 28, 1936, E. C. Laster, Inc., entered into the following contract with the Producers Supply & Tool Co. for the drilling of a well known as Rollins No. 6:
Confirming conversation between yourself and our Mr. Peters we will drill and equip your number 6 L. B. Rollins Lease for $10,750.00 cash, to be paid when we have completed contract on the well, as herein specified.
You are to furnish water, fuel, tanks and flow lines. We will dig the slush pit, furnish 87' galvanized pumping derrick erected, 200' of New 10" surface casing, 7" new 20# seamless casing, 2 1/2 new seamless upset tubing, approximately 100' 5 3/16" perforated*848 liner, cut the hole, drill the plug, wash the well and run the liner and tubing. You are to swab the well in. We will use 100 sacks of cement on the surface pipe and 300 sacks of cement for the 7" and will, of course, pay for the cementing service. We will furnish 7" float shoe and ring type Braden head. We will also furnish Christmas Tree and hook-up, as you desire, said not to exceed $125.00 resale price. Should you want Christmas Tree or hook-up which comes to more than this the difference between $125.00 and the resale price, is to be added to the above turnkey price of $10,750.00.
The well is to be drilled to the woodbine sand area, approximately 3600'. You are to have a man present when pay depth is approached to supervise the setting of the casing and also the drilling of the sand area. This price does not include any coring.
In 1936 E. C. Laster, Inc., and the Producers Supply & Tool Co. entered into a written contract, the original and copies of which have been lost, for the drilling of wells known as Coates Nos. 1, 3, 4, and 5. The agreement provided that the Procucers Supply & Tool Co. would furnish the pipe, casing, and tubing and drill the hole and set the*849 pipe, and E. C. Laster, Inc., would furnish water and fuel and supervision.
*164 Upon the completion of the wells the Producers Supply & Tool Co. rendered invoices to E. C. Laster, Inc., for drilling services and equipment. The amounts thereof, together with amounts paid to others for labor, insurance, and other expenses, were as follows:
| Well | Drilling | Equipment | Labor and insurance | Other expense |
| Rollins No. 6 | $2,736.55 | $4,430.12 | $40.81 | $84.66 |
| Coates No. 1 | 7,938.07 | 4,911.93 | 140.94 | 1 413.42 |
| Coates No. 3 | 5,809.63 | 4,740.37 | 31.00 | 1 317.33 |
| Coates No. 4 | 5,405.84 | 4,944.16 | 127.94 | 1 270.24 |
| Coates No. 5 | 5,718.89 | 4,831.11 | 14.41 | 1 204.84 |
| Total | 27,608.98 | 23,857.69 | 355.10 | 1,290.49 |
The total cost of $29,254.57, not including the charges for equipment, was claimed as a deduction in the return of E. C. Laster, Inc., for 1936 as intangible drilling and development costs. The respondent disallowed all of the amount of $2,736.55 paid for drilling services performed in connection with Rollins well No. 6 and $25,458.33 of the amount deducted on account*850 of the wells on the Coates lease.
Issue II.
Wells Nos. 1 and 2 on the Lambert lease were not flowing wells and it was necessary to connect them with pumping equipment to extract the oil. In 1935 the Continental Supply Co. installed pumping equipment on the wells for $1,124.82, of which it allocated $491.82 as its price for equipment and $633 for installation service. The bid of the Continental Supply Co. for the job reads in part as follows:
F.O.B. "Turnkey Installation."
We are listing below materials, which we propose to furnish and install in order to connect two wells to the Nick Barbare Power for you.
EQUIPMENT
* * *
| TOTAL EQUIPMENT | $491.82 |
| We will install the above listed equipment, including your Jacks and Pull Rods, which you already have, and turn to you ready for operation, for a consideration of | 633.00 |
| TOTAL TURNKEY INSTALLATION | $1,124.82 |
Installation cost does not include furnishing of water, we assume this is available.
In the joint return filed by petitioner E. C. Laster and his wife for 1935 the amount of $633 was deducted as intangible drilling and development costs incurred in the installation of oil well pumping equipment. *851 The respondent disallowed the deduction upon the ground that the amount was a capital expenditure.
*165 Issue III.
Petitioner E. C. Laster received in 1936, in connection with the dissolution of E. C. Laster, Inc., three oil payments, the original face values, and the uncollected face amounts and the values of which on December 31, 1936, were as follows:
| Oil payment | Original face value | Uncollected Dec. 31, 1936 | Value Dec. 31, 1936 |
| Rollins | $21,897.14 | $10,774.68 | $6,464.81 |
| Keeling | 35,000.00 | 4,121.72 | 3,709.55 |
| Urshel | 27,000.00 | 20,250.52 | 12,150.31 |
During 1937 petitioner E. C. Laster received the following income from the oil payments and was allowed the following amounts for depletion:
| Oil payment | Income | Depletion |
| Rollins | $1,998.20 | $1,198.88 |
| Keeling | 4,257.57 | 3,709.55 |
| Urshel | 4,455.83 | 2,673.50 |
The Rollins oil payment was payable out of seven thirty-seconds of the first oil as, when, and if produced and marketed from a lease covering an 11-acre tract of land "but not otherwise" and to secure the payment of which a vendor's lien was reserved against seven thirty-seconds of all oil produced and marketed from*852 the lease. The Keeling oil payment was payable out of one-fifth of seven-eighths of the first oil produced from a specified tract of land. The Urshel oil payment was payable out of one-fourth of seven-eighths of the first oil produced, saved, and marketed from a certain lease.
Issue IV.
Petitioner E. C. Laster acquired the Coates and Rollins leases on December 31, 1936, in the liquidation of E. C. Laster, Inc. The leases, including the equipment thereon, were taxed to him on the basis of a valuation of $40,000 for the Coates lease and $93,334 for the Rollins lease. The well equipment on the Coates, Rollins, and Lambert leases had a depreciated cost on December 31, 1936, of $27,254.92, $13,861.91, and $13,240.01, respectively, a total of $54,356.84. On January 1, 1937, petitioner E. C. Laster exchanged the Coates, Rollins, and Lambert leases with the Retsal Drilling Co. for its producing Brittain, Cooper, Taylor, and Nathan-Deason leases, on which there was well equipment having a depreciated cost of $21,361.11, $3,141.55, $13,901.55, and $436.25, respectively, a total of $38,840.46, which amount respondent used as a basis for determining depreciation allowable to the*853 Retsal Drilling Co. on the equipment for 1937. In his determination of the *166 deficiency against petitioner E. C. Laster and his wife for 1937 the respondent allowed depreciation upon a basis of $17,382.77, $3,092.36, $9,864.10, and $436.25 for the Brittain, Cooper, Taylor, and Nathan-Deason leases, respectively, a total of $30,775.48, which amount represents cost, determined to be $42,111.05, less $11,335.57 for depreciation reserve on December 31, 1936.
Issue V.
E. C. Laster, Inc., and H. C. Miller each owned a one-half interest in a lease executed by J. T. Brown and his wife on 32 acres of land in Rusk County, Texas. On May 31, 1935, the lessees entered into a turnkey contract with F. H. Brown for the drilling of one or two wells on the lease. The consideration to be paid the contractor for each well was $6,000 for well equipment, $5,000 for ordinary developing, and expenses such as labor and other footage items, and $2,500 for financing, bonus, overhead expenses, telegraph, telephone, and general expenses other than well equipment. The consideration was payable in accordance with the following provisions of the contract:
There being now three wells situated*854 on said property [land covered by lease] and flowing oil, it is hereby agreed that the oil herein specified may be spread to the entire lease and that Second Party shall be paid out of seven-eighths (7/8ths) of that fractional part of all of the oil which the well or wells which Second Party drills shall bear to the total number of wells situated on the lease and producing oil therefrom that is to say, if only one well is drilled, the payment to Second Party shall be seven-eighths (7/8ths) of one-fourth (1/4) of all of the oil produced from the lease and in the event two wells are drilled, it shall be seven-eighths (7/8ths) of two-fifths (2/5ths) of all of the oil produced.
* * *
For the payment of the foregoing consideration [$13,500 for each well], E. C. Laster, Inc., and H. C. Miller hereby grant, bargain, sell and convey unto F. H. Brown, the Second Party, and his successors, and assigns, the seven-eighths (7/8ths) of all of the oil, gas and minerals produced and to be produced from the well or wells herein contracted to be drilled in and on the following described tract of land * * *.
* * *
TO HAVE AND TO HOLD unto him the said F. H. Brown, his heirs and assigns, *855 the foregoing described undivided interest in and to said property and First Parties do hereby warrant that they are the owners of the title to said property and have a right to convey the same and do convey it unto the said F. H. Brown, his heirs, successors, and assigns, against the claim or claims of all persons whomsoever.
The contractor completed the drilling of the two wells, known as Brown wells Nos. 4 and 5, in 1935.
In his determination of the deficiency against E. C. Laster, Inc., for 1935, the respondent determined that the oil wells had a fair market value of $22,000, of which one-half represented gain realized in an exchange of oil payments, payable out of a lease having no basis, for completed wells.
*167 Issue VI.
In 1932 E. C. Laster, Inc., and other coowners of an oil and gas lease, known as the Brown-Olsan lease, on 32.93 acres of land located in Rusk County, Texas, entered into a written agreement with the Delta Drilling Co. for the drilling of two wells on the lease, in consideration of which the lessees agreed to pay the contractor $32,000:
* * * out of the proceeds of the sale of twenty-eight thirty seconds (28/32nds) of the first oil and/or*856 gas produced, saved and marketed from the said wells Nos. 5 and 6, to be drilled hereunder on the above described property, when and as such oil and/or gas shall be so produced, saved and marketed, and the Owners shall not be obligated to the Contractor in any sum except as above stipulated.
The contract contained the following additional provisions:
VIII.In consideration of the agreements and obligations to be done, paid and performed on the part of the Contractor, the Owners, the present owners of the leasehold estate in the above described land, do hereby bargain, grant, sell, transfer, assign and convey unto the Contractor, its successors and assigns, twenty eight thirty-seconds (28/32nds) of all of the oil and/or gas and/or casinghead gas that may be produced, saved and marketed from the above described wells drilled upon the above described tract of land by the Contractor until the Contractor shall have received the sum of thirty two thousand ($32,000.00) Dollars, free of costs and taxes, and the pipe line or other purchaser of the oil and/or gas from said wells shall pay to the Contractor, its successors or assigns, twenty-eight thirty-seconds (28/32nds) of all of the*857 oil and/or gas and/or casinghead gas produced from the said wells until the said amount of thirty-two thousand ($32,000.00) Dollars shall have been fully paid. The Contractor is hereby granted and given a first and prior lien upon the said wells, No. 5 and No. 6, until the said sum of thirty-two thousand ($32,000.00) Dollars shall have been paid.
IX.It is understood and agreed that the oil produced from Nos. 5 and 6 to be drilled under this contract will be delivered and stored in the same tanks with the oil produced from the other wells on the entire 32.93 acres, and it is hereby agreed that for the purpose of determining the amount of oil produced by Wells No. 5 and 6, that the said wells shall be deemed to produce their equal proportion of all the oil produced on the entire 32.93 acre tract, from the date of their respective completion; that is to say, that on and after the completion of the first well to be drilled under this contract, said well shall be deemed to produce 1/5th of all the oil produced on the 32.93 acres until the second well has been completed, and on the completion of the second well under this contract both wells shall be deemed to produce 2/6ths of all*858 the oil produced on the property; but no portion of the consideration herein mentioned shall be a personal liability on the part of Owners, and shall never be paid out of any oil and gas but that produced from the above described wells, No. 5 and No. 6.
The amount reported by E. C. Laster, Inc., in its return for 1935 as income from the lease included $2,105.40 actually paid to the Delta Drilling Co. under its oil payment. The respondent disallowed certain *168 intangible drilling and development costs used by E. C, Laster, Inc., to reduce the amount of the gross receipts, but did not eliminate the item of $2,105.40 from gross income.
Issue VII.
On February 10, 1936, E. C. Laster, Inc., assigned in writing to the Retsal Drilling Co., effective February 1, 1936, an oil payment, originally in the amount of $5,486.40, on which $4,008.25 was unpaid on February 1, 1936, payable out of seven thirty-seconds of the first oil and gas produced, saved, and marketed from 22.86 acres of a 50-acre tract of land in Rusk County, Texas, owned by J. P. Maxwell.
In 1936 E. C. Laster, Inc., informed the De Sota Crude Oil Purchasing Co. that it was transferring to the Retsal Drilling*859 Co. its interest in an oil payment on a certain lease known as the Talbot-Maxwell lease and to record on its division order that the Retsal Drilling Co. was the owner of the oil payment. Since that time the Retsal Drilling Co. has been receiving and reporting as income to it amounts paid under the oil payment.
No consideration was paid by the Retsal Drilling Co. for the assignment of the oil payments. The Retsal Drilling Co. was the lessee of the properties at the time the oil payments were transferred to it.
In his determination of the deficiency against E, C. Laster, Inc., for 1936 the respondent held that the Hunt-Maxwell and Talbot-Maxwell oil payments had a fair market value of $6,243.78 and constituted income to it in accordance with the provisions of section 45 of the Revenue Act of 1936.
Issue VIII.
In 1936 E. C. Laster, Inc., employed the law firm of Weeks, Hankerson & Potter to perform all of its legal work for a retainer of $350 per month. The contract was in force throughout the year 1936. The fee of $4,200 for 1936 was accrued on the books of E. C. Laster, Inc., as of the close of 1936 and was paid by the Retsal Drilling Co. and charged to E. C. Laster*860 in 1937.
During the latter part of 1936 E. C. Laster requested the law firm to prepare the necessary instruments to create two trusts for the benefit of his children. W. F. Weeks, senior member of the law firm, referred E. C. Laster to his brother, Harry C. Weeks, for advice respecting tax matters connected with the creation of the trusts. Harry C. Weeks and W. F. Weeks agreed to divide the fee to be charged for their services. The law firm drafted the trust instruments, *169 but received no fee for its services other than the monthly retainer. Harry C. Weeks rendered a bill to E. C. Laster for $750 for the services performed by him and the law firm. In 1937 when the amount was paid, W. F. Weeks directed Harry C. Weeks to retain the entire amount. In its return for 1936 E. C. Laster, Inc., deducted the sum of $4,200 for legal expenses accrued in favor of the firm of Weeks, Hankerson & Potter. The respondent disallowed the deduction as an ordinary and necessary business expense upon the ground that the amount represented legal fees paid in connection with the creation of two trusts and the dissolution of E. C. Laster, Inc.
OPINION.
Issue I.
DISNEY: The first*861 issue involves amounts disallowed by the respondent for intangible drilling and development costs deducted by the petitioners on account of the Lambert, Taylor, Brown, Coates, and Rollins wells upon the ground that the wells were drilled under turnkey contracts. The petitioners do not deny that amounts paid by an operator for the drilling of a well under a turnkey contract must be capitalized. The first point argued by the petitioners upon brief is that they did not in any instance receive a completed and equipped well, and, accordingly, the wells were not drilled under turnkey contracts as determined by the respondent.
The contract entered into on October 22, 1935, under the terms of which the Lambert wells were drilled, was construed in , in connection with the deductibility of intangible drilling and development costs in the drilling of two wells on the Crosbar-Maxwell lease. Under that contract the leaseholder agreed to swab the wells in and to furnish water, fuel, tanks, flow lines, and a man to supervise the drilling of the sand area and the running of casing. We said that the Retsal Drilling Co. had contracted for a*862 finished job and that its contract obligation to furnish items necessary to complete the work did not operate to convert the contract into one for the employment of labor and the purchase of equipment. So holding, we decided that no part of the amounts paid to the contractor was deductible as intangible drilling and development costs. The petitioners did not in any of the other contracts involved herein agree to furnish more than they agreed to furnish under the contract for the drilling of the Lambert wells.
The petitioners contend, however, that, aside from the question of whether the agreements were turnkey contracts, the amounts are deductible under article 23(m)-16 of Regulations 94, since they were incurred for wages, fuel, hauling, etc., under a contract for the drilling *170 of wells to a specified depth at a specified price per foot. The same contention was made in the Retsal Drilling Co. case and it was answered by pointing out that the contracts were for the drilling of wells to a designated sand and not to a specified depth and could not be classified as footage contracts. Here the contracts for the Lambert wells and the Rollins well obligated the contractor*863 to drill wells to the Woodbine Sand. The written contract under the terms of which the Coates wells were drilled could not be produced at the hearing, and the testimony on the contents of the contract does not cover the point. There is testimony that the terms of the oral agreements under which the Taylor and Brown wells were drilled provided for the drilling of the wells to "a certain depth." Petitioners do not rely, however, upon this testimony as proof that the wells were to be drilled to depths ascertainable in a manner other than under the Lambert contract, that is, to a specified sand, and there is nothing of record proving otherwise. Accordingly, petitioners have not shown that the Coates, Taylor, and Brown wells were to be drilled otherwise than to a specified sand.
The first issue is controlled by our decision in , and, following that case we sustain the action of the respondent in disallowing the amounts in controversy.
Issue II.
The amount of $633 involved in the second issue is alleged by the petitioners to be deductible as an intangible drilling and development cost under the provisions of article 23(m)-16(a)*864 (1) of Regulations 86, reading, to the extent material here, as follows:
* * * All expenditures for wages, * * * incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas, may, at the option of the taxpayer, be deducted from gross income as an expense or charged to capital account. Such expenditures have for convenience been termed intangible drilling and development costs. Examples of items to which this option applies are, all amounts paid for labor, * * * in the construction of such derricks, tanks, pipe lines, and other physical structures as are necessary for the drilling of wells and the preparation of wells for the production of oil or gas. * * * For the purpose of this option labor, * * * are not considered as having a salvage value, even though used in connection with the installation of physical property which has a salvage value. * * *
The respondent cites article 23(m)-16(c) (1) in contending that the item should be capitalized. This regulation provides, in part:
* * * The options do not apply to any expenditure for wages, fuel, repairs, hauling, supplies, etc., in connection with equipment, facilities, *865 or structures, not incident to or necessary for the drilling of wells, such as structures for storing or treating oil or gas. These are capital items and are returnable through depreciation.
*171 The petitioners extend the regulations to wages paid to prepare a well for the production of oil, including pumping equipment necessary to extract the oil from the ground, and the respondent, by implication, and without extended discussion of the point, confines the regulations to drilling operations, exclusive of pumping equipment. As we view the question it will not be necessary for us to interpret the regulations to determine their meaning on the point of difference between the parties.
The bid of the Continental Supply Co. for the installation which Laster accepted was a lump sum for a completed job, ready for operation. This is shown beyond serious question by statements appearing in the bid that the work was to be a "Turnkey Installation."
The situation does not differ from a turnkey contract for the drilling of a well, in which the contractor for a lump sum furnishes equipment and labor for a completed job. In such cases, the wages paid by the contractor are not the*866 costs, as such, of the leaseholder and are not deductible by him under the regulations as intangible drilling and development costs. ; certiorari denied, ; . The respondent committed no error in refusing to allow the item as a deduction for intangible drilling and development costs.
Issue III.
The different between the parties on this issue is whether the basis of E, C. Laster in three oil payments acquired in the dissolution in 1936 of E. C. Laster, Inc., is recoverable through allowances for depletion, as determined by the respondent, or whether receipts under the oil payments are taxable only when and to the extent that they exceed cost. The same question was considered and decided adversely to petitioner's contention in . , relied upon by the petitioner here, was considered by us in reaching our decision in the Lee case. On this issue we sustain the action of the respondent.
Issue IV.
The parties are in agreement*867 that where, as here, there is a taxfree exchange, the property acquired takes the basis of the property given up. Secs. 113(a)(6), 113(b), and 114(a), Revenue Act of 1936. The respondent followed the statute by assigning to the leases, including well equipment received, the basis of the property petitioner exchanged therefor, but allocated the amount thereof to *172 the properties acquired according to the relative values of the properties exchanged, and in doing so decreased the basis for well equipment and increased the basis for the leaseholds, exclusive of well equipment. The petitioner alleges that respondent should not have altered the basis he had in his original well equipment. In other words, that he should have assigned to the newly acquired well equipment the basis he had in the well equipment given up in the exchange.
The petitioner's argument is based upon the theory that there was an exchange of well equipment for well equipment and leasehold rights for leasehold rights. There is no support in the record for such a conclusion. The showing is that three leaseholds were exchanged for four leases, including the well equipment on each. There is some evidence*868 of the value of two of the leaseholds exchanged by petitioner, but no evidence on the value of the other leaseholds or any of the well equipment.
The statute provides for a reasonable allowance for the exhaustion of property used in a trade or business. Sec. 23(l), Revenue Act of 1936. Section 113(a)(6) of the same act provides, in effect, that when property is received in a nontaxable exchange the basis of the property given up "shall be allocated between the properties (other than money) received, and for the prupose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange." Under a lide provision of the 1926 Act, we held in , that upon the exchange in a nontaxable transaction of shares of common stock of one corporation for common and preferred stock of another corporation, the basis of the stock given up should be allocated between the two classes of new stock according to its fair market value at the time acquired. See *869 ; . Where a combination of depreciable and nondepreciable property is acquired for a lump sum, so much of the total consideration is assigned as a basis for the exhaustible property as its value bears to the aggregate value. .
If it could be held that there was an exchange of well equipment for well equipment, as alleged by the petitioner, there would still remain the question of how the basis of petitioner in the equipment on the leases should be allocated to the depreciable property on the four leases. Some sort of a division would be necessary under the circumstances, but none is suggested by petitioner. The method employed by the respondent does not reduce the basis petitioner had in the whole property exchanged. The amount by which the basis on the well equipment was reduced was added to the remainder, so *173 that the entire basis will eventually be recouped - the equipment through allowances for depreciation and the leasehold rights by way of depletion, or as an offset in the event of sale. The respondent's allowances*870 for depreciation on the equipment are sustained.
Issue V.
The underlying theory of respondent's action in taxing petitioner E. C. Laster, Inc., on a gain of $11,000 realized in the drilling by F. H. Brown of two wells on the Brown lease under turnkey contracts for $13,500 each, payable out of oil produced by all of the wells on the lease, is that there was an exchange of an oil payment, payable out of a fully depleted leasehold, for completed oil wells having a fair market value of $22,000. No attempt was made by petitioner to prove that the leasehold had a basis. We are not aware of the method pursued by respondent in determining the fair market value of the wells. Upon brief he contends that the evidence contains no proof that the oil payments did not have a fair market value of $22,000 and that, therefore, the wells, upon completion, had a value of that amount. The respondent determined a fair market value of $22,000 for the completed wells in connection with his determination of the deficiency and no evidence was offered by the petitioner to establish a different valuation. The record contains no showing that he ever determined a value for the oil payments, as such. *871 There is indication, however, that respondent's valuation of the wells is based upon an equal value for the oil payments. The respondent argues that there was a transfer of an interest in the lease for completed wells, resulting in taxable gain under .
The Midfield Oil Co. case involved an exchange of an oil payment, limited in amount, for an overriding royalty giving the holder the right to a return on his investment so long as oil or gas might be produced from the property. The taxpayer admitted a gain measured by the difference between the fair market value of the overriding royalty and the unrecovered cost of the oil payment if the transaction was not a nontaxable exchange under section 112(b)(1) of the Revenue Act of 1934. We held that the exchange was not of properties of like kind and recomputed the gain under the admission of the taxpayer.
The only consideration received by the drilling contractor here for the drilling of the wells was a right to share in the proceeds of production of the lease to the extent of the oil payments. This interest in oil in place was something growing out of rights acquired by the lessees*872 from the fee owner, but did not give the contractor *174 an interest in the lease by purchase or otherwise, as contended by the respondent. .
In , percentage interests in the proceeds of production of a well to be drilled were issued as additional consideration for assignment of the lease and for legal and supervisory services performed and to be performed in the drilling of the well, and for cash. All of the cash was to be used to finance drilling operations and purchase oil well equipment. Each 1 percent interest was liable for $10 per month to pay taxes and the cost of operating the well. All of the cash received from the disposition of percentage interests was expended in the drilling of the well, The Commissioner contended that royalty interests were disposed of in sales and that, as the lease had no recoverable base, the total amount received constituted taxable income. We held that the cash was received subject to an implied trust to use it in the drilling of the well and, as all of it was expended for that purpose, no income was received by*873 the lessee subject to tax.
The Transcalifornia Oil co. case and this one do not differ in substance. In the former cash was invested in a well for a right to participate in its production so long as it continued to produce oil. The holder of the oil payment had a capital investment in oil in place and was entitled to deductions for depletion. . Upon the completion of the well the lessee held title to it and was required to share its production with the percentage certificate holders, according to their interests. Here the drilling contractor, instead of advancing cash to the lessees for drilling costs in consideration of oil payments, paid drilling costs from his own funds and turned over to the lessees completed wells for oil payments limited in amount. The lessees here received nothing more than completed wells, the cost of which constituted an investment of a third party for a right to share in production. The wells no doubt enhanced the value of the lease, but, as we held in effect in *874 , that fact alone does not make the transaction taxable.
On this issue we hold for the petitioner.
Issue VI.
The parties differ under this issue only upon whether it is controlled by , or . The respondent contends that the Anderson case governs, upon the assumption that the oil payment was secured by a lien upon the wells drilled, Nos. 5 and 6, and was payable out of two-sixths of the production of the six wells on the lease.
*175 The respondent's contention as to the lien appears to be based upon a single sentence in the drilling contract reading as follows: "The Contractor is hereby granted and given a first and prior lien upon the said wells, No. 5 and No. 6, until the said sum of thirty-two thousand ($32,000.00) dollars shall have been paid." Other provisions of the contract demonstrate lack of intention to give the contractor a lien upon the wells themselves for payment of the amount of the oil payment. The contract provides that the consideration of $32,000 is payable out of proceeds of 28/32 of the*875 first oil and gas produced, saved and marketed from wells Nos. 5 and 6, that the lessee shall not be personally liable for the consideration, and that the consideration "shall never be paid out of any oil and gas but that produced from the above described wells, No. 5 and No. 6." These provisions of the contract make it clear that the security was confined to the production of wells Nos, 5 and 6, and did not cover any other property. A lien upon production alone does not make the proceeds therefrom taxable to the lessee.
What has been said respecting the contents of the drilling contract partially answers the second point raised by the respondent. Other provisions of the contract are that for measuring the production of wells Nos. 5 and 6, and therefore the extent of the contractor's right to participate in the proceeds of each run of oil, the wells shall be deemed to produce their proportionate share of all of the six wells on the lease. This was nothing more than a means agreed upon in advance to gauge the quantity of oil produced by the wells to which the contractor was required to look for recovery of his investment. In*876 other words, it was a mere substitute for actual production of wells Nos. 5 and 6 and in nowise alters the fact that the oil payment was payable out of production and from no other source. Accordingly, the case of , applies and it follows that the sum of $2,105.40 in question does not constitute taxable income of E. C. Laster, Inc.
Issue VII.
Petitioner E. C. Laster owned all of the stock of E. C. Laster, Inc., and the Retsal Drilling Co. The latter acquired the working interest in two leases, part of the production of which was subject to oil payments held by E. C. Laster, Inc. The interest of the Retsal Drilling Co. in the leases was increased in 1936 by the transfer to it without consideration of oil payments held by E. C. Laster, Inc. Petitioner E. C. Laster testified that "We just demolished the oil payment in favor of the Retsal Drilling Company." The *176 respondent placed an aggregate fair market value of $6,243.78 on the oil payments and included the amount in gross income of E. C. Laster, Inc., citing section 45 of the Revenue Act of 1936 as his authority. The petitioner admits that the oil payments were assigned*877 without consideration and does not question the valuations determined by the respondent.
Section 45 authorizes the Commissioner in any case where, as here, two businesses are owned by one individual, "to distribute, apportion, or allocate gross income or deductions between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses."
Petitioner upon brief contends that the respondent's action was not an allocation of gross income to prevent evasion of taxes or necessary to clearly reflect income, but created income where none existed.
The respondent does not contend that the application of section 45 is necesary in order to prevent evasion of taxes. He does argue that he exercised the right conferred upon him by the provision in order to clearly reflect the income of each corporation. The effect of his argument seems to be that the transferee realized taxable income upon the receipt of the oil payments equal to the increase in value of its assets because of their "cancellation" *878 and that the amount thereof should be allocated to the transferor on account of its failure to obtain full consideration for the oil payments.
An acquisition of property without or for less than an adequate consideration does not ordinarily result in taxable income. The respondent cites , and , on the point. Those cases involved the question of whether forgiveness of indebtedness results in the receipt of taxable income. Here, the transfers increased the value of the assets of the transferee, whether it canceled the oil payments upon their receipt or kept then alive for probable sale. Not having paid any consideration for the additional interest in production, it had no basis in the oil payments, and if it sold them, the whole of the selling price would represent taxable gain. They were income-producing assets in the hands of the transferor, not liabilities such as accounts or notes payable, and any income received by the transferee under the oil payments would be taxable to it.
The situation is similar to the one before the court in Tennessee-*879 . There the same interests owned the stock of two corporations which agreed that certain equipment owned by one of them could be used by the *177 other in 1934 without charge. The Commissioner determined a rental of $12,000 for the year and included the amount in gross income of the owner as a proper allocation of income under section 45. The court, in deciding that the petitioner realized no taxable income in the transaction, said: "Section 45, supra, did not authorize the Commissioner to set up income where none existed. The principal purpose of the section was to clearly reflect income that did exist."
The acquisition by the Retsal Drilling Co. of the oil payments without cost did not result in income to it or the transferor. It follows therefrom that there was no income to distribute or allocate under section 45. On this issue our holding is for the petitioner.
Issue VIII.
The disallowance by the respondent of a deduction of $4,200 taken by E. C. Laster, Inc., in 1936 as ordinary and necessary business expenses for legal fees was upon the ground that the amount was accrued for legal*880 work performed in connection with the dissolution of the corporation and the creation of two trusts by E. C. Laster, the sole stockholder of the corporation.
It is established by the record that the law firm was retained for a monthly fee of $350 to perform general legal services for the corporation and its fee of $4,200 for 1936 was paid in 1937. It is well settled that legal fees properly accrued by corporations for general legal services and for services rendered in connection with dissolution proceedings are deductible as ordinary and necessary business expenses. ; . The evidence also establishes that no part of the fee in controversy was paid for services performed by the firm in connection with the creation of the trusts by E. C. Laster for the benefit of his children. E. C. Laster consulted the senior member of the firm about the matter and the firm drafted the instruments. The fee of the firm and Harry C. Weeks for their services was included in one bill rendered to E. C. Laster by the latter and when the fee was paid the senior member of the firm declined to accept the*881 firm's share thereof.
It is apparent from the facts before us that no part of the item of $4,200 was accrued by E. C. Laster, Inc., for legal services rendered by the law firm to the corporation's sole stockholder in connection with the formation of the two trusts. For this service a separate charge was made and presumably paid by E. C. Laster. The entire amount of the item is deductible as an ordinary and necessary business expense of E. C. Laster, Inc., and we so hold.
Decision will be entered under Rule 50.
Footnotes
1. Proceedings of the following petitioners are consolidated herewith: E. C. Laster, Inc. (Dissolved): Edward Carroll Laster, Transferee; Carolyn Faust Laster, Transferee; E. C. Laster, Transferee; E. C. Laster; and Mrs. Eugenia F. Laster. ↩
1. These figures include $695 for swabbing and $116.32 for fuel and water. ↩