*2715 1. Legal expenses and a payment in compromise of a suit alleging petitioner acquired oil properties by fraudulent means and seeking to recover the properties, together with an accounting for profits obtained from dealings with such properties, were not personal expenses, nor were they deductible as business expenses, for that portion allocable to the defense of the claim against title was a capital expenditure.
2. The claim for an accounting was a distinct claim involving a distinct group of assets and that portion of the expenses and compromise payment allocable to the defense and settlement of such claim, if a capital expenditure, has nothing to do with the oil properties and should not be added to the depletable capital account thereof, and, in the absence f evidence permitting a proper allocation of the expenses and payment between the two claims, no allowance may be made as a business expense or as additional depletion.
3. A cash bonus payment by the lessee for an oil and gas lease represents taxable income and, having no relation to exhaustion of resources, does not reduce the depletable base of the lessor.
4. The depletable base determining the depletion allowance*2716 under the 1918 Act is reduced by the exhaustion actually sustained in prior years and not by the amount of the deductions allowable for prior years under prior Revenue Acts. Thompson Oil & Gas Co.,15 B.T.A. 993">15 B.T.A. 993, followed.
*1196 This proceeding results from a determination of deficiencies in income and excess-profits taxes for the calendar years 1919 and 1920 in the amounts of $76,740.20 and $321,660.33, respectively, all of which are in controversy. The errors assigned are as follows:
(1) The respondent erred in refusing to allow, as a deduction from gross income for the year 1919, the sum of $1,200,000 paid in that year in settlement of a suit for an accounting brought against the petitioner relative to its Coyote Oil Properties.
(2) The respondent erred in refusing to allow as a loss deduction for the year 1919 the sum of $170,877.24 paid in that year as legal expenses in defending an*2717 action against the petitioner for an accounting relative to a portion of its oil properties, to wit, its Coyote Oil Properties.
(3) The respondent further erred in determining that the legal expenses incurred in 1918 and 1919 and the amount of the compromise payments in 1919 in connection with such suit constitute capital expenditures, and at the same time failing to determine that such amounts should be amortized over the remaining life of the said oil properties.
(4) The respondent erred in deducting from the capital sum returnable through depletion of the petitioner's Coyote Oil Property, an amount of $4,517,402.70, representing a bonus received by the petitioner upon the leasing of the said oil property, in computing the amount of depletion sustained by the petitioner in connection with the said Coyote Oil Property for the calendar years 1919 and 1920.
(5) The Commissioner erred in reducing petitioner's depletable base for both the Whittier and Coyote Oil Properties by an amount alleged to represent depletion sustained on the March 1, 1913, value and subsequent cost of the said properties during the period from March 1, 1913, to December 31, 1915, whereas he should have*2718 reduced petitioner's depletable base by the amount of depletion which *1197 petitioner was legally entitled to take as a deduction in determining its taxable income for the said period from March 1, 1913, to December 31, 1915.
FINDINGS OF FACT.
Petitioner corporation was organized on or about August 18, 1904, under the laws of California and has its home office at Whittier, Calif. It took over from Simon J. Murphy certain oil properties among which was an oil and gas lease on certain land situated in California and owned by Domingo Bastanchury. The petitioner, through Edmund W. Bacon, one of its officers and its agent, purchased 2,240 acres of the land (hereinafter referred to as the Coyote Properties) covered by such lease for $35 per acre, or $78,400, the deed to Murphy being dated December 15, 1904, and the deed from Murphy to petitioner being dated January 9, 1905. The purchase agreement involved also a cancellation of the oil and gas lease and the leasing of the surface rights to Bastanchury for 10 years for grazing purposes.
At the time Bacon purchased property a well (hereinafter referred to as well No. 1) had been drilled to considerable depth under the lease, *2719 drilling operations had ceased, and the well had been capped. Drilling operations were resumed after the land was acquired by petitioner.
On August 26, 1918, after petitioner had leased the Coyote properties to the Standard Oil Co. as set out below, Maria Bastanchury, as administratrix of Domingo Bastanchury, filed a complaint in the Superior Court of Los Angeles County against petitioner and Bacon. The complaint alleged that petitioner and Bacon had fraudulently misrepresented to the Bastanchurys that well No. 1 was a dry hole, that indications of the presence of oil were destroyed or covered up to prevent the Bastanchurys from learning of their existence, and, that petitioner was about to abandon the lease. It was further alleged that no grounds for suspecting fraudulent misrepresentations had been discovered by the Bastanchurys until shortly before the filing of the complaint; that the misrepresentations had been made to induce complainants to sell the property for far less than its real worth; and that the Bastanchurys relied upon the misrepresentations in canceling the lease and selling the land.
The bill prayed that the defendants be required to account to plaintiff*2720 for all moneys or other things of value (in excess of $78,400, the price paid) obtained by them from their dealings with the Coyote properties, or from their dealings with the proceeds from the sale or operation thereof. It was also prayed that the defendants be required to assign and transfer to plaintiff all rights to receive such moneys and things of value in the future; that a receiver be appointed *1198 to collect and receive from the then lessee, the Standard Oil Co., for the benefit of the plaintiff that which such lessee has become obligated to pay defendants as respects such properties; and such other and further relief as the court may deem meet and agreeable to equity, the premises considered, and for costs.
The answer filed late in 1918 denied all of the allegations set forth in the bill. The answer alleged that plaintiff, or her deceased husband, his heirs, devisees and personal representatives, had knowledge or notice by 1906 of all of the facts alleged to indicate fraud; that defendant Bacon had received any portions of the moneys or things of value derived from dealing with the land; that the land when purchased had a value in excess of $87,400. Other defenses*2721 set up in the answer include the statute of limitations (sec. 318, 319, 338, 343 and 353, Code of Civil Procedure of the State of California); laches; adverse possession and user since January of 1905; drilling and development of the property (with the knowledge and acquiescence of the Bastanchurys) by petitioner at heavy expense until the property was leased in 1913 which greatly enhanced the value thereof; transfers of stock of petitioners to purchasers for value without notice of the alleged fraud, etc.; and alleged the relief prayed for would be inequitable and that plaintiff's remedy, if any, was for damages.
Legal expenses incurred during the year 1918 amounted to $32,151.77. During the year 1919, further legal expenses totaled $170,877.24. During the latter year judgment in the amount of $1,200,000, as damages for the alleged wrongful acts was entered against, and paid by, petitioner in such suit pursuant to an agreement between the parties in compromise settlement. Petitioner, after investigation, had concluded that the action had no merit, but agreed to pay the amount agreed upon in compromise rather than continue the litigation, as the anticipated cost thereof would*2722 have equaled the amount of the settlement. Petitioner also deemed it advisable to avoid the disagreeable notoriety accompanying the suit. An instrument was executed by the Bastanchurys, including all the heirs and legatees, releasing petitioner, and all other persons or corporations claiming to own any interest in the land conveyed by the deed of December 15, 1904, from any further causes or actions for damages or rights on account of the alleged fraudulent acts.
The legal expenses incurred in 1918 were deducted as an expense in that year. Those incurred in 1919, together with the $1,200,000 paid in final settlement, were deducted as expenses of that year. The deductions claimed were disallowed.
The respondent failed or refused to treat such legal expenses and the amount paid in compromise settlement as capital amortizable over the remaining life of the oil properties.
*1199 By an instrument dated December 1, 1913, petitioner leased certain oil properties, known as the Whittier and Coyotte Oil Properties, to the Standard Oil Co. of California for 40 years, and by the same instrument, sold to that company specified personal property, including fixtures, appurtenances, *2723 tools, machinery and equipment, which were at that time located on or used in connection with such oil properties. The instrument recited cash consideration of $10 (and other consideration, the receipt of which was acknowledged, which a stipulation shows to have totaled $1,500,000) and additional payments to be made from time to time. The due date, the actual date of payment, and the amount of such additional payments may be tabulated as follows:
| Due date | Date paid | Amount |
| Apr. 30, 1914 | Apr. 1, 1914 | $1,000.000 |
| Mar. 31, 1915 | Mar. 1, 1915 | 250,000 |
| June 30, 1915 | June 1, 1915 | 250,000 |
| Sept. 30, 1915 | Sept. 1, 1915 | 250,000 |
| Dec. 31, 1915 | Dec. 31, 1915 | 250,000 |
| June 30, 1916 | July 13, 1916 | 500,000 |
| Dec. 31, 1916 | Dec. 1, 1916 | $500,000 |
| Dec. 31, 1917 | Dec. 1, 1917 | 500,000 |
| Dec. 31, 1918 | Dec. 1, 1918 | 500,000 |
| Total | 4,000,000 |
The $1,500,000 paid down brings the total of such payments to $5,500,000. Petitioner also was to receive for the first five years a royalty of one-fourth of all oil produced in each year in excess of 730,000 barrels, and after the five-year period the royalty reserved amounted to one-fourth of the oil produced. The gas royalty*2724 agreed upon was a payment of 2 cents for each 1,000 cubic feet of gas saved and sold.
Of the $5,500,000 payments, the respondent determined that $326,404.82 represented payment for the personal properties sold and the remainder of $5,173,595.18 represented a bonus payment on the two properties. The respondent allocated such total bonus payment, $656,192.48 to the Whittier property and $4,517,402.70 to the Coyote property, and deducted the amount of such bonuses from the capital sums returnable through depletion in determining the unit of depletion sustained in 1919 and 1920, the years in controversy. Depletion deductions were based on March 1, 1913, value.
The gross production of the two properties in barrels of oil and the value thereof at the mouth of the wells from March 1, 1913, through the year 1915, is as follows:
| Coyote | Whittier | |||
| During period | Barrels | Amount | Barrels | Amount |
| Mar. 1, 1913, to Nov. 30, 1913 | 344,094.63 | $292,480.44 | 221,178.85 | $133,968.52 |
| Dec. 1, 1913, to Dec. 31, 1913 | 6,697.47 | 5,744.52 | ||
| Calendar year 1914 | 151,424.90 | 127,000.42 | 5.50 | 3.30 |
| Calendar year 1915 | 322,064.60 | 278,124.21 | 16,943.54 | 10,166.13 |
| Total | 824,281.60 | 703,349.59 | 238,127.89 | 144,137.95 |
*2725 *1200 The depletion determined by the respondent to have been sustained by the petitioner from March 1, 1913, through the year 1915 is as follows:
| Period, Mar. 1, 1913, to | 1914 | 1915 | Total | |
| Dec. 31, 1913 | ||||
| Whittier | 74,048.17 | $17,738.65 | $38,021.95 | $129,808.75 |
| Coyote | 183,327.41 | 135,572.08 | 306,749.76 | 625,649.25 |
| Total | 257,375.58 | 153,310.73 | 344,771.69 | 755,458.00 |
The respondent reduced petitioner's depletable base by the above amount of $755,458 in determining the depletion allowable for the years 1919 and 1920.
The respondent determined that the amount of oil produced from petitioner's share of the Coyote Oil property during the years 1919 and 1920 was 1,644,897 barrels and 1,340,237 barrels, respectively.
The respondent determined the oil reserves in the Coyote property at December 31 of 1918 and 1919 amounted to 5,051,424 and 3,406,527 barrels, respectively.
OPINION.
SIEFKIN: The issues raised in the first three allegations question the respondent's determination that the cost of the litigation in question and the payment made in compromise are neither deductible expenses nor caital cost which may be amortized over the*2726 remaining life of the properties. Apparently such determination was based on the conclusion that such expenditures represented personal expenses.
We think such conclusion unsound. The act complained of was committed, if at all, in the course of a business transaction. Kornhauser v. United States,276 U.S. 145">276 U.S. 145, citing with approval an administrative ruling of the Bureau where expenses of a suit for malpractice were allowed as a business expense deduction by a physician. In this case the suit brought was in no sense a prosecution for a crime or an attempt to impose a penalty. The only remedy sought was a restitution of the property, together with income derived therefrom in the interim. See Consolidated Mutual Oil Co.,2 B.T.A. 1067">2 B.T.A. 1067; and Frederick McLean Bugher,9 B.T.A. 1155">9 B.T.A. 1155.
We can not agree, however, with petitioner's contention that the expenses and payment under discussion were deductible as business expenses or losses. The complaint filed in the suit alleged fraud and the relief prayed for was an accounting and that petitioner be required to assign and transfer to complainant all rights to receive moneys and*2727 things of value derived from the property in the future. *1201 That is, the prayer asks for restoration of the property and all past income therefrom in excess of the consideration paid.
It should be noted at this point that the action was brought to recover two distinct classes of assets. One such class of assets was the oil properties as they existed at the time the suit was instituted. Petitioner recognized that the complaint questioned its title to the property and in answer to the prayer for restoration asserted such relief to be inequitable, and that complainant's remedy, if any, was for damages. The other asset (the accumulated earnings resulting from petitioner's operation or production in years prior to the beginning of the suit) was no longer a part of such oil properties as they had been severed from the realty. They formed a distinct group of assets to which claim was made in the action. It should, therefore, be borne in mind that, though both claims grew out of the alleged fraud, there were, nevertheless, two distinct claims asserted against two different groups of assets.
To the extent that the expenses and payment were incurred and made in defense*2728 of the claim against the oil properties they were capital expenditures. We have repeatedly held that the cost of defending title, whether in the from of legal fees or compromise payments, is a capital expenditure representing additional cost of the property. Lincoln L. McCandless,5 B.T.A. 1114">5 B.T.A. 1114; Gopher Granite Co.,5 B.T.A. 1216">5 B.T.A. 1216; Seletha O. Thompson,9 B.T.A. 1342">9 B.T.A. 1342; Frederick McLean Bugher, supra;North American Oil Consolidated,12 B.T.A. 68">12 B.T.A. 68; Phoenix Development Co.,13 B.T.A. 414">13 B.T.A. 414. The decisions in Kornhauser v. United States, supra, and the Superheater Co.,12 B.T.A. 5">12 B.T.A. 5, which are relied upon by the petitioner, are not in conflict with these cases. In the Superheater case the contemplated litigation grew out of an action of the board of directors, acting as such. The claim settled did not involve title. In the Kornhauser case the legal expenses were incurred to contest a claim against income received, differing fundamentally from the ordinary attack on title, even though the income in question consisted of shares of stock.
In view*2729 of such conclusion we must reject petitioner's contention that the total deductions claimed should be allowed. We can not allow the total and it would be idle for us to further consider whether any part of such total (i.e., that portion allocable to the defense and settlement of the claim for accounting) is allowable as the record furnishes no basis for the apportionment of the whole among the several claims defended or settled.
The petitioner's contention that if the litigation and settlement costs are not deductible they must represent capital expenditures to be added to the amortizable capital value, must likewise be rejected. That portion of such costs which is properly allocable to the defense *1202 and settlement of the accounting claim has nothing to do with title to the property or its future depletion. Assuming that such costs were capital expenditures, they relate to a claim against assets or moneys severed from the oil properties. Frederick McLean Bugher, supra.Undoubtedly that portion of such costs which we have held allocable to defense and settlement of the claim against the properties should increase the amortizable capital value, but*2730 we are again confronted with the fact that there is nothing in the record to permit a proper allocation to determine that amount. Accordingly, we must affirm the respondent's action on the points covered by the first three allegations of error.
The next error assigned is the reduction of depletable capital by the amount of the bonus received by the lessor as part consideration upon leasing the properties to the Standard Oil Co. of California in December of 1913. The respondent determined that $5,173,595.18 of the $5,500,000 payments received represented such a bonus, and petitioner finds no fault with such allocation. Petitioner complains only of the admitted reduction of the capital base for depletion purposes on account thereof.
The respondent's present contention as set forth in his brief is as follows:
The Commissioner made an error of method in requiring the bonus of $656,192.48 on the Whittier property and the bonus of $4,517,595.18 on the Coyote property to be deducted as of December 1, 1913, from the capital sum returnable through depletion. On November 13, 1926,*2731 T.D. 3938 C.B.V.-2, p. 117, was promulgated amending Article 215 of Regulations 45 (1920 Edition) to read as follows:
"Depletion - Adjustments of accounts based on bonus or advanced royalty. - (a) Where a lessor receives a bonus in addition to royalties, there shall be allowed as a depletion deduction in respect of the bonus an amount equal to that proportion of the cost or value of the property on the basic date which the amount of the bonus bears to the sum of the bonus and the royalties expected to be received. Such allowance shall be deducted from the amount remaining to be recovered by the lessor through depletion, and the remainder is recoverable through depletion deductions on the basis of royalties thereafter received."
While the Commissioner made an error of method in deducting from the depletion basis the whole amount of the bonuses as of December 1, 1913, it does not follow that the Commissioner's computation of the depletion basis is incorrect. There is nothing in the record of this case to show what royalties were on December 1, 1913, expected to be received over the lives of the leases. It is entirely possible that in the interval between December 1, 1913, and*2732 December 31, 1918, royalties expected on December 1, 1913, to be received. As to this point the taxpayer must fail for lack of proof.
The respondent confesses error to the extent that he failed to follow the regulation. It remains for us to test the validity of the rule therein promulgated. In Nelson Land & Oil Co.,3 B.T.A. 315">3 B.T.A. 315, we made it clear that, in our opinion, such a bonus received by a *1203 lessor was not a return of capital but is an advance rental or royalty and is taxable as income. That case was followed in R. H. Hazlett,10 B.T.A. 332">10 B.T.A. 332, and we are not cited and have been unable to find any authority to the contrary. See also Henry L. Berg,6 B.T.A. 1287">6 B.T.A. 1287; John T. Burkett,7 B.T.A. 560">7 B.T.A. 560; D. R. McDonald,7 B.T.A. 1078">7 B.T.A. 1078; and R. H. Hazlett, supra, in which we held that such bonuses were not gains derived from the sale of "capital assets" under the capital gain provisions of the 1921 Act.
The bonus payment in the instant case was a part of the consideration paid for the lease. While expected production undoubtedly was considered in fixing the amount of the*2733 bonus, it is elementary under the laws governing such agreements that its payment did not, in anywise, depend upon, or relate to, production. The lessee's liability therefor was fixed by the terms of the contract. On the other hand, the operation of the principle of depletion depends upon exhaustion of resources through production - i.e., the recovery of capital through its conversion from the form of oil resources or reserves into marketable products or the equivalent received for such product. Under such principle the depletion allowance for the year or years of the bonus payments can only be measured by reference to the oil produced. If, as we have pointed out, the bonus is income, no part of which represents recovery of capital, it follows that any depletion allowance against such income is a departure from the depletion concept. The regulation relied on by the respondent is clearly such a departure. While it might, in some cases at least, produce a more equitable result, the statutory allowance may not be so varied by administrative regulation.
It will be noted that the facts referred to by respondent in the last paragraph of the excerpt from his brief are essential only*2734 to the application of the rule laid down in the regulation. On the other hand, the respondent admits that he reduced the depletable base by the amount of the bonus (a known quantity) and we have held as a matter of law that no part of such bonus reduces such base. We can, on the facts presented, determine such action was erroneous. To correct such error we need only require the restoration of the amount subtracted, and it is so ordered.
The question raised by the last allegation was considered in Thompson Oil & Gas Co.,15 B.T.A. 993">15 B.T.A. 993, and decided adversely to the contention made by the petitioner herein.
Reviewed by the Board.
Judgment will be entered under Rule 50.
MILLIKEN did not participate.
LANSDON, PHILLIPS, GREEN, and MURDOCK dissent.