*16 Decision will be entered under Rule 50.
Held, where petitioner's rights to certain interests in an oil lease were conditional and qualified in 1953, the fair market value of the interests was not taxable income in 1953 under the doctrine of constructive receipt of income. Petitioner did not have unfettered command and was not free to enjoy the interests at his option until 1957. Held, further, the fair market value of the interests received in the oil lease was ordinary income subject to depletion in 1957 and the services rendered by petitioner as consideration for the interests did not represent petitioner's capital investment in the development of the oil lease.
*483 The respondent determined a deficiency in the income tax*17 of petitioner for the year 1957 in the amount of $ 30,111.85. The adjustments to income are as follows:
| Taxable income shown on return | $ 62,290.82 | |
| Additional income and unallowable deduction: | ||
| (a) Value of property received | $ 50,500.00 | |
| (b) Depreciation disallowed | 7,407.41 | |
| Total | 57,907.41 | |
| Taxable income as adjusted | 120,198.23 |
Only adjustment (a) is in issue. It is explained in the deficiency notice as follows:
(a) It is determined that you received in this year for services rendered property having a fair market value of $ 50,500.00.
Petitioner assigns error as to adjustment (a) as follows:
4. The determination of tax set forth in said notice of deficiency is based upon the following error:
(a) The Commissioner erred in determining that the petitioner received in the year 1957 for services rendered property having a fair market value of $ 50,500.00.
(b) In the alternative only, if the Commissioner did not err as alleged in paragraph 4(a), the Commissioner erred in failing to allow the petitioner an additional deduction in the amount of $ 15,379 [sic] for depletion on account of the sale during 1957 of a production payment out of the property*18 here involved.
Petitioner states in its brief as to the issues raised by its assignment of error as follows:
(a) Whether or not the petitioner acquired its interest in the property here under consideration in 1953, as it contends, or in 1957, as contended by the Commissioner.
(b) Whether or not petitioner realized taxable income upon the acquisition of this interest, in exchange for its engineering services in connection with a waterflood program as contended by the Commissioner or made a contribution of its services to the development of the properties involved, as it contends.
FINDINGS OF FACT.
Most of the facts have been stipulated and a stipulation of facts, together with exhibits attached thereto, was filed by the parties and is incorporated herein by this reference. Only such facts as seem *484 necessary to an understanding of the issues will be recited herein.
Petitioner James A. Lewis Engineering, Inc. (sometimes hereinafter called Lewis Engineering), is a corporation incorporated under the laws of the State of Texas, with its principal office in Dallas, Texas. It filed a cash basis income tax return for the taxable year ended December 31, 1957, with the district *19 director of internal revenue at Dallas.
Since its incorporation in 1950 petitioner has been engaged in the business of petroleum engineering on a consulting basis. During 1951 petitioner, at the request of the operators of an oil and gas lease covering lands in Jefferson County, Oklahoma (sometimes hereinafter called the Seay lease), made a preliminary study and certain proposals with respect to the installation of a waterflood program for the secondary recovery of oil from the lease. The Seay lease had been producing oil in commercial quantities under ordinary primary production methods for many years prior to 1951. At the request of the operators of the Seay lease, petitioner, in 1953, completed and delivered to the operators a comprehensive report concerning the feasibility of waterflood operations on this lease.
On November 10, 1953, petitioner mailed a letter to J. B. Stoddard and Continental Oil Company, two of the owners of the Seay lease. This letter was signed by James A. Lewis Engineering, Inc., and was accepted and agreed to by two of the principal owners of the Seay lease on November 23, 1953, and it was the basic agreement of the parties. This agreement provided, *20 inter alia, that: (1) Petitioner's services in connection with the waterflood operations on the Seay lease were to be supervisory only and limited to flood operations; (2) if and when Stoddard and Continental elected to proceed with a leasewide water injection program, petitioner would prepare an exhibit to be designated "Schedule A -- Gross Primary Oil Production"; (3) petitioner was to furnish Stoddard and Continental a copy of Schedule A and after approval of Schedule A by the operators, all oil, exclusive of outside production, produced from the Seay lease which was in excess of primary oil production for the purpose of the agreement was to be called "flood oil production"; (4) compensation for petitioner's services heretofore rendered is $ 35,000; and (5) compensation for petitioner's services hereafter to be rendered shall be $ 65,000, payable out of production if and when the total proceeds from one-eighth of seven-eighths of total flood production shall have amounted to $ 35,000, then on the first day of the next month petitioner shall own and be entitled to receive the proceeds from the sale of one-eighth of seven-eighths of such flood oil production until the aggregate*21 amount so received shall equal $ 65,000. When the $ 65,000 oil payment shall have been paid, petitioner is entitled to own an overriding royalty of *485 one-sixteenth of seven-eighths of the flood oil production until the termination date as defined by the letter agreement. This letter agreement also provides, inter alia, as follows:
Upon request, you will execute, acknowledge and deliver to us a proper, recordable instrument vesting in us the production payment and overriding royalty interest above set forth.
The terms and provisions of the letter agreement were not adopted, ratified, and confirmed until 1956 by all the other interested owners in the Seay lease, other than the two owners who accepted the letter agreement in November 1953.
On October 19, 1953, a suit was filed in the United States District Court for the Eastern District of Oklahoma by the Choctaw and Chickasaw Indian Nations against Wilmer D. Seay and others with respect to title to a portion of the property covered by the Seay lease. The operators of the Seay lease were made parties to this suit. As a result of the pendency of this suit, the operators of the Seay lease determined to postpone consideration*22 of the installation of a fullscale waterflood program. The suit filed by the Indian Nations was finally disposed of favorable to the operators of the Seay lease by the denial of certiorari by the Supreme Court of the United States in December 1956.
During 1956, the operators of the Seay lease were notified by the Corporation Commission of the State of Oklahoma to dispose of salt water produced on said lease other than by dumping it into the Red River or by running it into open pits. The salt water being produced on said lease was approximately 1,200 barrels per day and was sufficient for a pilot waterflood operation. It is stipulated by the parties: "the operators, with the advice and services of petitioner, began on May 1, 1956 injection of water into producing formations on the Seay Lease."
The purpose of the pilot waterflood operation was to determine whether or not the introduction of water would result in an increased oil recovery from producing wells. A waterflood program is a method of secondary recovery, the purpose of which is to provide additional energy into the reservoir rock and in turn increase the oil recovery from the rock. The program consists of the introduction*23 of water into the underground reservoir or oil sand for the purpose of recovering additional oil. Waterflooding is therefore a method for the recovery of oil in place from the present producing horizon. The water injections on the Seay lease, begun on May 1, 1956, by a pilot waterflood operation, resulted quickly in an increase in the production of oil and in October 1956 there was beginning to be produced "waterflood production."
*486 On November 9, 1956, petitioner mailed a letter to J. B. Stoddard and Continental with attached "Schedule A -- Gross Primary Oil Production" and attached an oil decline curve utilizing the slope agreed to as defined in the latter agreement between the parties dated November 10, 1953. At a meeting of the principal parties on December 17, 1956, the decline curve and primary production schedule attached to the letter of November 9, 1956, were orally agreed to and it was agreed that petitioner would participate in production beginning January 1, 1957. Pursuant to this oral agreement the letter of November 9, 1956, was executed in the spaces provided on December 27, 1956, by Continental Oil Company and on February 22, 1957, by Republic National *24 Bank of Dallas, temporary administrator of the estate of J. B. Stoddard, deceased.
A full-scale waterflood program was, under the supervision of petitioner, installed on the Seay lease during September 1957. The $ 65,000 oil payment and one-sixteenth of seven-eighths overriding royalty as described in the letter agreement dated November 10, 1953, were assigned to petitioner on October 16, 1957. The assignment provided, inter alia, as follows:
Now, Therefore, [herein are listed the assignors] * * * for and in consideration of One Dollar ($ 1.00) and other valuable considerations in hand paid, receipt of which is hereby acknowledged, do hereby ASSIGN, SELL, and TRANSFER to JAMES A. LEWIS ENGINEERING, INC.,
(1) As a production payment, one eighth of seven eighths (1/8 of 7/8) of flood oil production commencing as of 7:00 a.m. of the first day of the first calendar month next ensuing when the proceeds from the sale of 1/8 of 7/8 of flood oil production starting with January 1, 1957, shall have amounted to $ 35,000, and continuing until the proceeds from the sale of 1/8 of 7/8 of flood oil production shall have amounted to an additional Sixty Five Thousand Dollars ($ 65,000) or until*25 termination date, as hereinbelow defined, whichever first occurs, and
(2) As an overriding royalty, one sixteenth of seven eighths (1/16 of 7/8) of flood oil production commencing when, in accordance with the foregoing, the production payment in the total amount of $ 65,000 has been paid, and continuing until termination date, as hereinbelow defined.
The production payment and overriding royalty conveyed herein shall be free and clear of all costs and expenses of every kind whatsoever except taxes.
If after twenty-four (24) months from January 1, 1957, there occurs any period of four (4) consecutive months in each of which there is no flood oil production, which is not due to or the result of mechanical failure or any law, rule, or regulation of any legislative or governmental authority or the wilful act or omission of Assignors, such 4-month period is designated "nonproductive period." Within twenty (20) days after the end of any nonproductive period, the assignors, acting in concert, or James A. Lewis Engineering, Inc., shall have the right to terminate this assignment by giving the other party thirty (30) days' written notice, in which event the thirtieth day after the date of *26 such notice shall be termination date.
Executed this 16th day of Oct. 1957.
[Here follow the signatures.]
*487 The fair market value in 1957 of the mineral interests assigned to petitioner by this instrument was $ 50,500.
Petitioner received proceeds from the sale of production from its interests in the Seay lease during 1957 and subsequent thereto, which proceeds have been included in the taxable income of petitioner as received. In December 1957, petitioner sold out of its interest in the Seay lease a production payment in the amount of $ 50,000 and received as consideration $ 25,000 in cash against which it took a deduction for depletion of 27 1/2 percent, amounting to $ 6,875.
Petitioner did not file a partnership income tax return with respect to the Seay lease for any of the years 1953 through 1957.
There were 58 producing wells on the Seay lease at the time of trial. There were fewer wells in production in 1957. Several new wells have been drilled since 1957 as part of the waterflood program. As part of the water injection program, some oil wells were converted into water injection wells and some new wells were drilled as oil wells. Five new source oil wells have been*27 drilled. Twenty-three former producing wells have been converted into water injection wells. As a result of the waterflood program, there has been substantial additional recovery of oil. Since the initiation of the full-scale waterflood program in September 1957 through 1961, approximately 60 to 70 percent of the 1 million barrels of oil recovered from the Seay lease has been in addition to the calculated primary recovery. The present estimate is that the project will continue to be economic until 1965.
OPINION.
Preliminary Statement.
We should make it plain at the outset that we are not dealing here with the $ 35,000 which petitioner received for its services in making a preliminary survey of the advisability and practicability of installing a waterflood program on the Seay lease. So far as the record shows that payment was received by petitioner in cash in a prior year and was returned as gross income in that year and it is not in issue here. Petitioner received no assignment of mineral interests in the Seay lease in connection with that $ 35,000 payment. What we do have in issue is whether the fair market value of the mineral interests in the Seay lease which petitioner*28 received by way of the assignment made to it on October 16, 1957, represented taxable income paid to it as compensation for services rendered and to be rendered as the Commissioner has determined in his deficiency notice and still contends, or whether, as contended by petitioner, it represents a capital investment in the Seay lease and therefore its fair market value does not represent taxable income. It should also be made clear that the Commissioner is *488 making no contention that when petitioner received its assignment in 1957 of mineral interests in the Seay lease it did not receive an interest of oil in place which entitled petitioner to depletion. In fact it is stipulated that if we sustain the Commissioner in his contention, then in that event petitioner is entitled to an additional deduction on account of cost depletion of $ 15,279.
Issue (a).
The first issue raised by petitioner which we have designated as Issue (a) is to the effect that even though the fair market value of the mineral interests assigned to it for its supervisory services in connection with the waterflood program on the Seay lease represented income to it, it was constructively received in 1953*29 and petitioner, being a cash basis taxpayer, the income was received in 1953 and would be taxable in that year and not in 1957. In support of its contention of constructive receipt petitioner relies upon the following language which was contained in the letter agreement described in our Findings of Fact:
Upon request, you will execute, acknowledge and deliver to us a proper, recordable instrument vesting in us the production payment and overriding royalty interest above set forth.
It is respondent's position that these interests were not received until 1957, the year in which the assignment was actually executed, and that the fair market value of these interests in the Seay lease was taxable income to petitioner in that year. The interests consisted of $ 65,000 payable out of one-eighth of seven-eighths of all flood production after one-eighth of seven-eighths of the flood production equaled $ 35,000, and, in addition, an overriding royalty interest of one-sixteenth of seven-eighths of flood oil production after petitioner had received $ 65,000. It is stipulated that: "The fair market value in 1957 of those mineral interests assigned to Petitioner by said instrument was $ 50,500.00." *30 Respondent contends that petitioner's right to receive the mineral interests was not vested and absolute in 1953 but was dependent upon a number of conditions which might never be fulfilled.
Petitioner apparently concedes that if petitioner's right to receive the mineral interests was conditional in 1953, then petitioner did not receive such interests in that year. Petitioner argues that there were no conditions in existence that would deprive petitioner of the right to these interests. The following language is taken from petitioner's brief:
The crucial question is whether or not there is any contingency remaining which might deprive the taxpayer of the right to have the conveyance made.
While we agree that the formalities of conveyancing are not determinative of depletable interests, Anderson v. Helvering, 310 U.S. 404*489 (1940), we are convinced from the record presented here that petitioner had no unqualified right in the mineral interests in 1953. In the first place, we note from the stipulation that all owners of interests in the Seay lease other than the two owners who executed the letter agreement of 1953 did not adopt, ratify, *31 and confirm that letter agreement in question until 1956. Whatever rights petitioner was to receive in the Seay lease by the terms of the letter agreement were to be granted by all the owners of the Seay lease. As we have stated, this agreement was not adopted, ratified, and confirmed until 1956 and, therefore, the contract between all interested parties was not even in existence in 1953. Petitioner did not have an unqualified right to receive any interests in the Seay lease until such rights were agreed upon by all the owners.
We also find other conditions that make petitioner's rights contingent and qualified in 1953. The letter agreement of 1953 itself contains language described more fully in the Findings of Fact to the effect that "if and when" the operations of the Seay lease "elected" to proceed with a waterflood program, then petitioner would prepare a schedule and that upon approval of the schedule by the operators, "then" petitioner "shall own" a $ 65,000 oil payment as of the first day of the next month after the total proceeds shall have amounted to $ 35,000. We conclude from the letter agreement itself that the parties did not intend petitioner to*32 have any mineral rights in the Seay lease unless the above-stated conditions were fulfilled. In addition, at the time the letter of November 10, 1953, was sent by Lewis Engineering to J. B. Stoddard and Continental Oil Company it was known that title to the Seay lease was the subject of a lawsuit commenced on October 19, 1953, and it was stipulated that the pendency of this suit caused the operators to postpone consideration of the waterflood program. Petitioner had no right to the oil payment and the overriding royalty until an affirmative election was made by the operators which election they postponed until final disposition of the suit in December 1956.
Petitioner had no mineral rights in the Seay lease in 1953 while, on the other hand, there is ample evidence to support respondent's determination that the interests were received by petitioner by virtue of the assignment made to it in 1957. The operators orally agreed at a meeting on December 17, 1956, that petitioner's right to the oil payment would commence on the first day of the first month next ensuing when the proceeds from the sale of one-eighth of seven-eighths of flood oil production amounted to $ 35,000. The proceeds*33 going to make up the $ 35,000 were not to commence until January 1, 1957, and petitioner's mineral interests in the Seay lease vested subsequent to that time. The mineral interests in the Seay lease were *490 not assigned to Lewis Engineering until October 1957; accordingly, we do not believe petitioner has shown that respondent's determination, taking the fair market value of the interests received by petitioner into income in 1957, to be incorrect. We do not think it was constructively received in 1953 as petitioner contends.
Petitioner's reliance on the doctrine of constructive receipt of income is misplaced. Certainly, the Commissioner could not have attributed the fair market value of the mineral interests to petitioner under the circumstances narrated in our Findings of Fact prior to 1957 and the reverse is also true -- petitioner cannot do it. Harold W. Johnston, 14 T.C. 560 (1950). Petitioner, a cash basis taxpayer, did not have unfettered command over these interests and it was not free to enjoy the interests at its option prior to 1957, cf. Corliss v. Bowers, 281 U.S. 376">281 U.S. 376 (1930).
We hold for the *34 respondent as to the first issue.
Issue (b).
In view of the fact that we have sustained respondent's determination that the mineral interests were received by petitioner in 1957 we must consider petitioner's alternative argument. Petitioner contends that it acquired its interests in the Seay lease in return for its contribution of services to the development of the oil lease, that this is a capital investment and therefore a tax-free event and petitioner did not realize income in 1957 equal to the fair market value of the oil interests assigned.
In order to appreciate the significance of petitioner's contention it is necessary to examine the administrative, legislative, and judicial background of this issue.
Except for certain statutory exceptions set forth in the 1954 Code not applicable here, it is the general rule that in determining the tax aspects of a situation where property changes hands in a business transaction that the fair market value of the property exchanged is treated as the equivalent of cash. Where compensation for services is given in property, as was the case here insofar as the assignment of mineral interests is concerned, the fair market value of the property*35 is reported as income in the year of receipt by the one who renders the services. 1 Petitioner contends that the present case is an exception to the general rule. At least since 1925 2 the Commissioner has taken *491 the position as to drillers of oil wells where the driller in consideration for drilling obtains an interest in the oil lease that the transaction does not result in an exchange of property but that the drilling merely increases the value of the property and there is no income tax on the value of the drillers' interest thus acquired. In 1941, this administrative policy was extended to include drillers, investors, and equipment dealers for use in developing the leased property in return for agreements to make stated payments out of a share of the oil. 3 In this latter ruling the judicial authority relied upon by the Commissioner is contained in Palmer v. Bender, 287 U.S. 551">287 U.S. 551 (1933). The basic principle encompassed in this policy is that the character of the oil in place is a reservoir of the capital investments of the parties entitled to share under the agreement. The assignee relieves the assignor of a share of the risks, *36 costs, and burdens of development and the assignee thereby obtains a capital asset. The interest assigned thereby is not income to the assignee but a capital investment and the contributor's costs are to be capitalized and not expensed. These agreements are often called sharing arrangements. The capital investment is recovered by way of depletion.
*37 Petitioner, a consulting engineering service corporation, contends it is entitled to the same treatment as the driller, investor, and equipment dealer specifically mentioned in the ruling, supra. In other words, petitioner asserts that it rendered its services in the development of the oil property and that it received no taxable income when it received the oil interests assignment which is shown in our Findings of Fact but has simply made a contribution to the pool of capital invested in the oil in place. It might well be that the preliminary services which petitioner rendered to the owners of the Seay lease and for which it was paid $ 35,000 in cash would be classified as development costs, but it is not that $ 35,000 with which we are here concerned.
In its brief petitioner cites Page Oil Co., 41 B.T.A. 952">41 B.T.A. 952 (1940). In that case we held that the taxpayer, Page Oil Co., was not entitled to depreciate the cost of drilling water wells used to stimulate the production of its oil wells. At page 963 we said:
It is our opinion that the so-called "water wells" involved in this proceeding are sufficiently similar to oil wells to require the same tax *38 treatment. A water well does not wear out with use as does physical machinery or a pipe line; it is drilled, cased and shot in the same manner as an oil well; and its sole value and function is to complement the oil well by causing the oil to concentrate in the area into which the oil well has been drilled. As such, we think, it is no more than a part of the oil well itself.
From our discussion which follows, it will clearly appear that we do not have any issue of depreciation in this proceeding as was the case in the issue just referred to and discussed in Page Oil Co., supra.
*492 The letter agreement of November 10, 1953, shows that the mineral interests assignment which is involved herein was to be assigned to petitioner for its services which were to be rendered thereafter (after November 10, 1953) in supervising the operation of the waterflood program and that seems to us to involve for the most part a production activity. The letter agreement contained the following provisions:
Our compensation for our services heretofore rendered is thirty-five thousand dollars ($ 35,000) for which we submit our bill herewith in accordance with our*39 previous understanding with you.
Our compensation for our services hereafter to be rendered in accordance with the provisions hereof in this water flood operation shall be:
1. Sixty-five thousand dollars ($ 65,000), payable out of production as follows:
If and when the total proceeds from 1/8 of 7/8 of total flood oil production shall have amounted to $ 35,000, then commencing as of seven o'clock a.m. of the first day of the first calendar month next ensuing and each month thereafter in which there is flood oil production, we shall own and be entitled to receive the proceeds from the sale of 1/8 of 7/8 of such flood oil production until the total aggregate amount so received prior to any tax application shall equal $ 65,000, or until termination date (hereinbelow defined), whichever first occurs.
2. An overriding royalty interest as follows:
Effective if and when, in accordance with the foregoing, the production payment in the total amount of $ 65,000 has been paid to us or has accrued to our credit, we shall have and own as an overriding royalty, 1/16 of 7/8 of flood oil production, which shall continue until termination date, which is hereinbelow defined.
Upon request, you will *40 execute, acknowledge and deliver to us a proper, recordable instrument vesting in us the production payment and overriding royalty interest above set forth.
We conclude that the mineral interests assignment which petitioner received October 16, 1957, did not represent a capital investment in the Seay lease but it represented, to the extent of the fair market value thereof, compensation for services rendered and to be rendered by petitioner after November 10, 1953, in supervising the installation and operation of a waterflood program on the Seay lease for the owners thereof. We think this was largely a production activity and cannot be capitalized. We sustain respondent on this issue.
It has been stipulated by the parties as follows:
If the Commissioner did not err as alleged in paragraph 4(a) of the Amended Petition, Petitioner is entitled to an additional deduction on account of cost depletion in 1957 of $ 15,279.
Having held that the Commissioner did not err as alleged in paragraph 4(a) of the amended petition, it follows that in a recomputation of the deficiency under Rule 50, petitioner should be allowed an additional deduction of $ 15,279.
Decision will be entered under *41 Rule 50.
Footnotes
1. Income Tax Regs.
Sec. 1.61-2 Compensation for services, including fees, commissions, and similar items.
* * * *
(d) Compensation paid other than in cash -- (1) In general↩. If services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. If the services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.
2. S.M. 3322, IV-1 C.B. 112 (1925); G.C.M. 932, VI-1 C.B. 241 (1927)↩.
3. G.C.M. 22730, 1 C.B. 214">1941-1 C.B. 214↩.