*1525 1. Petitioner was the owner with two others of an oil payment payable out of seven-sixteenths of the oil produced by designated wells. A seven-sixteenths interest in the oil produced by these wells was assigned to petitioner and his coowners until the payment was completed. Held, petitioner was the owner of an economic interest in the oil properties involved and amounts received during the taxable year under these payments must be included in income, the cost basis of such payments to be recouped only through depletion. T. W. Lee,42 B.T.A. 1217">42 B.T.A. 1217, followed.
2. Petitioner as trustee of a certain trust, the provisions of which did not allocate the depletion allowable on the trust income as between trustee and beneficiary, was given by the trust instrument the power to distribute the trust income to the beneficiary in such amounts and at such times as he saw fit. In both of the taxable years certain portions of the trust income were distributed to the beneficiary. Held, the trust is entitled to depletion on only that portion of the trust income which it retained in each year.
*230 The respondent has determined deficiencies in income tax for the fiscal years ended August 31, 1935, and August 31, 1936, in the amounts, respectively, of $2,500.53 and $3,020.80. Two questions are presented for decision: (1) whether petitioner is entitled to apply the entire amount of receipts from a certain oil payment owned by him to liquidation the cost before reporting any of such receipts as taxable income, and (2) whether petitioner is entitled to deduct the full amount of the depreciation and depletion allowance made for the trust property during the taxable year or only that portion which represents the percentage of trust income retained by the petitioner.
Additional questions raised in the petition have been settled by the parties.
The facts have been stipulated and as so stipulated are adopted as our findings. The material portion of them is set out hereinafter.
FINDINGS OF FACT.
Petitioner, who resides in Ft. Worth, Texas, is the sole trustee of a trust established by him and his wife on December 30, 1933, for the benefit of their daughter, *1527 Mary D. Fleming.
Issue No. 1.
The trust acquired on September 17 and on October 2, 1934, interests in certain oil payments known as the Haddaway Oil Payments by means of agreements executed on those dates which provided as follows: Petitioner and two others agreed to drill immediately two oil wells on certain described parcels of land, certain equipment and materials, labor, and fuel costs to be supplied by petitioner and his two cocontractors. The consideration for drilling these two wells was two oil payments each in the amount of $22,500 payable each out of seven-sixteenths of the total oil produced by each well. By further provision of the agreement seven-sixteenths of all the oil and gas produced by each well was assigned to the petitioner and his two cocontractors, to be held by them until the payments had been made, when such interest was to revert to the owner of the lease. In the event that the oil and gas produced was not sufficient to pay the payments agreed to be made, petitioner and his cocontractors were authorized to salvage the materials placed in the wells and to apply the amounts realized first to salvaging expenses and then to the balance due on the $22,500*1528 payments. Any balance then remaining due was to be paid out of seven-eighths of the oil produced from another well which petitioner was in such instance authorized to drill.
The petitioner's share of the oil payments to be received under the agreements was $29,250, of which $3,376.18 and $5,365.15 were received by him in the fiscal years 1935 and 1936 respectively. His portion *231 of the drilling costs incurred pursuant to the agreements was $13,134.26. The Commissioner has determined that petitioner may apply to the liquidation of the cost of the drilling only that percentage of the payments received each year which drilling cost bears to the total payment to be received. In this way he has determined that 13,134.26/29,250 of the payments or $1,516.02 for 1935 and $2,409.14 for 1936 may be applied to cost and the balances of $1,860.16 and $2,956.01 must be taxed as income for those respective years.
Issue No. 2.
The trust instrument executed on December 30, 1933, as heretofore mentioned gave to the petitioner as trustee full and complete management of the affairs of the trust and made the following provision regulating distributions to be made to the beneficiary:
*1529 * * * The Trustee may pay over to the beneficiary, from time to time, such portions of the corpus of income of this trust as he may in his uncontrolled discretion see fit, or may expend from the corpus or income of this trust such sums for her support, maintenance or benefits as he may in his uncontrolled discretion see fit. After any such payments or distributions, which may be in cash or kind, such payments and disbursements shall no longer be considered a part of this trust. Any income not disbursed shall be added to the trust fund and be governed by and held under the terms hereof.
The trust instrument contained no provisions with respect to whether or not depreciation or depletion was to be taken into consideration in determining the income of the trust.
During the fiscal years ended August 31, 1935, and August 31, 1936, there were distributed to the beneficiary the sums of $25,000 and $35,000, respectively, which amounts were duly reported by the beneficiary as a part of her taxable income in the year of distribution without deducting any allowance for depreciation or depletion. The petitioner filed returns showing the amounts of trust income not distributed to the*1530 beneficiary during the taxable years and remitting the tax due thereon. In these returns petitioner deducted the full amount of depreciation and depletion which was allowable for the entire trust income.
Respondent has determined that depreciation and depletion are allowable for the entire trust income in the amounts of $15,364.47 and $18,526.21 for the fiscal years 1935 and 1936 respectively.
He further has determined that petitioner retained 67.454 percent and 64.14 percent of the trust income in the taxable years 1935 and 1936, respectively, and has allowed the petitioner these percentages of the depreciation and depletion allowances in those years. The remainder of such depletion and depreciation allowances respondent has deducted in computing income of the beneficiary and she has, accordingly, filed claim for refund based thereon.
*232 OPINION.
ARUNDELL: The issues in this proceeding have been enumerated at the outset and will be considered in the order there set forth.
Issue No. 1.
We are called on here to say whether petitioner may apply the whole of the proceeds received during the taxable year 1935 under the Haddaway Oil Payment to the cost of*1531 that payment as claimed by him or may thus apply only the portion representative of cost and report the residue as taxable income as claimed by the respondent. The petitioner concedes on brief that the issue here is substantially the same as that presented in . In that case contrary to the contentions of both parties in the instant case, we held that the basis of oil payments which represented an economic interest in the oil properties to which they applied, as evidenced either plainly by an assignment to the payee of the oil interest out of which the payments were to be made or more remotely by other factors, must be recovered through depletion. Accordingly, we held that proceeds received under such oil payments must be included in taxable income, with appropriate deductions for depletion. The disposition of the present case is governed by that holding. In the situation before us there was an assignment of the interest from which the payments were to be made and accordingly no close question arises as in *1532 It is clear that petitioners had an economic interest in the oil payment recoverable only through depletion.
Accordingly, petitioner must include in income the entire amount of the proceeds received during the taxable year under the oil payments and is not entitled to the allowance for the return of cost made by the respondent.
Issue No. 2.
The question here is whether the petitioner, trustee, is entitled to deduct the entire depreciation and depletion that may be allowed on the trust income for the taxable year where the pertinent provisions the trust income for the taxable year where the pertinent provisions of the trust instrument no not direct whether the trustee or the beneficiary shall take the deduction, and the distribution of the income is placed entirely in the discretion of the trustee. The respondent claims that under section 23(l) and (m) of the Revenue Act of 1934 2 allowance *233 for depreciation and depletion must be divided, in the absence of specific trust provisions, between the trust and the beneficiary on the basis of the amount of income distributed and retained in that year. The petitioner contends that, *1533 properly interpreted, the statute awards the allowance only to those to whom the trust income is "allocable" under the trust instrument and that in the present case the income was in the first instance allocated entirely to the trustee. Distributions made thereafter in his discretion, argues the petitioner, do not alter this result.
*1534 The statute when properly read in the light of the circumstances attendant on its enactment does not support petitioner's view. Prior to the Revenue Act of 1928 it was held in the case of a trust, the income of which was currently distributable, that the allowance for depreciation and depletion might not be deducted by the beneficiary but only by the trust, even though it retained no income against which the deduction might be applied. See ; . The following provision was thereupon added to section 23(k) and (l) of the Revenue Act of 1928 and made applicable to both depletion and depreciation deductions:
In the case of property held in trust the allowable deduction [for depreciation and depletion] shall be apportioned between the income beneficiaries and the trustee in accordance with the pertinent provisions of the instrument creating the trust, or, in the absence of such provision, on the basis of the trust income allocable to each.
The purpose of this change in the law was to eliminate the "considerable hardship" which was imposed on the beneficiaries under prior*1535 law and to secure to them their fair portion of these allowances in proportion to the income distributable to them. See Senate Report No. 960, Revenue Act of 1928, (70th Cong., 1st sess.) p. 20. See also ; .
The force of these facts in the instant case requires the apportionment of the allowance here in question between the trust and the beneficiary. The single factor which stands out against it is the uncontrolled power in the trustee to determine the amount of income to be distributed in any year. This placing of the trust income under *234 the control of the trustee does not, however, constitute the allocation contemplated by the statute. The theory of the petitioner that the income is in the first instance allocable in toto to the trustee is not decisive of the question. That is true in all cases where a trustee receives and distributes income, in that it must first go to the trustee before it can be distributed to the beneficiaries. In view of its purpose to insure a fair portion of the allowance to the beneficiary, the statute properly goes beyond the act of*1536 placing the funds in a position for distribution and takes account of the distribution itself.
The argument of the petitioner consists principally in a request that the allowance here in question be governed by his bookkeeping practice, but, against what we deem the plain direction of the statute, his position may not be sustained.
Respondent's method of computing the allowance is accordingly affirmed.
Decision will be entered under Rule 50.
Footnotes
2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * *
(1) DEPRECIATION. - A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. In the case of property held by one person for life with remainder to another person, the deduction shall be computed as if the life tenant were the absolute owner of the property and shall be allowed to the life tenant. In the case of property held in trust the allowable deduction shall be apportioned between the income beneficiaries and the trustee in accordance with the pertinent provisions of the instrument creating the trust, or, in the absence of such provisions, on the basis of the trust income allocable to each.
(m) DEPLETION. - In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case; * * *. In the case of property held in trust the allowable deduction shall be apportioned between the income beneficiaries and the trustee in accordance with the pertinent provisions of the instrument creating the trust, or, in the absence of such provisions, on the basis of the trust income allocable to each. * * * ↩