*281 Decisions will be entered under Rule 50.
The petitioners and other individuals each owned fractional interests in certain oil leaseholds which they assigned to the X corporation under an agreement which provided for the operation of the properties in the event test wells produced oil in commercial quantities and for the payment by the X corporation of 25% of the profits derived therefrom to petitioners and the other individuals. Held, the petitioners retained an economic interest in and to the oil and are entitled to appropriate depletion allowances. Kirby Petroleum Co. v. Commissioner, 326 U.S. 599">326 U.S. 599, affirming Commissioner v. Crawford, 148 Fed. (2d) 776.
*295 These proceedings, which have been consolidated for hearing and disposition, involve deficiencies in income tax as follows:
| Docket No. | 1940 | 1941 |
| 4553 | $ 2,047.72 | $ 1,437.98 |
| 4554 | 936.96 | 1,383.13 |
The sole question is whether the petitioners retained economic interests in certain oil leaseholds so as to entitle*282 them to depletion allowances.
The facts have been stipulated and, as stipulated, we adopt them as our findings of fact. The material facts are as follows:
FINDINGS OF FACT.
Petitioners are husband and wife, residing at Carlyle, Illinois. They filed separate income tax returns for the years here involved with the collector for the eighth Illinois district.
The petitioners, along with thirteen other individuals, were the owners and holders of certain oil and gas leases covering property located in and about Clinton County, Illinois. Said leases were held in the name of Carl Willi, an individual, for the use and benefit of petitioners and the other owners. On May 22, 1937, petitioners and the other individuals entered into a contract, entitled "Operating Agreement," with the Adams Oil & Gas Co., a corporation, and the Felmont Corporation, both of which corporations will hereinafter be jointly referred to as Adams. The above agreement stated, preliminarily, that petitioners and others were the owners and holders of oil and gas leases covering certain described lands and that they desired to arrange for a drilling test for oil and gas thereon and for future operations in the event*283 of the discovery of oil and/or gas in commercial quantities, and that Adams agreed to take over the block of leases and drill a test well on terms and conditions set forth therein.
The agreement provided that petitioners and others, as lessees, would execute and deliver to Adams deeds of assignment, containing covenants of general warranty, which would legally vest in Adams the full and undivided oil and gas leasehold estates in and to the lands, together with all the rights and privileges of the lessees under the leases held by them. In consideration for the assignment, it was understood and agreed that petitioners and the other individuals should *296 receive and be entitled to share in the net profits that might accrue from the development and operation of the leased acreage for oil and gas, or from the sale of any or all of said leases or any undivided interest therein, or from any other source from which net profits might accrue from the "venture," to the extent of one-fourth of said net profits.
Adams agreed that within thirty days after the contract became effective it would commence operations for the drilling of a test well and would use due diligence in so doing. *284 In the event the operation resulted in a dry hole, it was to be plugged and the machinery and equipment removed from the premises, and all expenses of the drilling and removal were to be borne by Adams. In the event the test well proved productive, Adams was to complete and fully equip the well, and the costs thereof were to be chargeable to a "Net Profits Account" which was to be maintained pursuant to the agreement between the parties. Adams was to credit the net profits account with the proceeds from the sale of seven-eighths working interest (one-eighth having been retained by fee owners) of the production from any well drilled and operated by Adams on any of the leases, less any overriding royalty interests which might be chargeable against such working interests, and also with any other proceeds from the sale by Adams of any or all of said leases or properties, whether developed or undeveloped, or any undivided interests therein, which would in any way affect or diminish the rights of participation of the individuals.
The operating agreement provided that Adams should at all times have the sole management of the sale of oil and/or gas produced and that Adams should be entitled*285 to receive all proceeds from such sales, but should account to petitioners and the others for the money value of their share of participation in the profits. Adams was to have exclusive control over drilling, development, operation, and abandonment of all the leases and authority to make any and all necessary expenditures in connection with the operation. A detailed "Accounting Procedure" was worked out by the parties and made a part of the contract. The parties are referred to therein as the "Operator" and "Non-Operator." It speaks of a "Joint Lease Schedule" and a "Joint Lease" and refers to the net profits account as a "Joint Lease Account." It provided for the acquisition, handling, and disposition of lease equipment and materials; and it was agreed that sales to outsiders of major materials should be made only with the consent of the nonoperator and that division of materials in kind, if made between operator and nonoperator, should be in proportion to their respective interests in the lease.
Under the contract Adams was to furnish petitioner William R. Murphy, as trustee for all the assignors, with monthly itemized statements of account covering complete operations and showing*286 all charges *297 and credits to the net profits account. One-fourth of the net profits was to be paid by Adams to William R. Murphy, as trustee, for distribution, pursuant to a stipulation of interest, to the various individuals. The petitioners herein were entitled jointly to receive 20 percent of one-fourth of the net profits from the venture. This percentage was subsequently reduced to 19 percent. Petitioners, at the time of entering into the contract, executed deeds of assignment of their interests in the oil and gas leaseholds. Adams agreed to maintain all of said leaseholds by payment of delay rentals in lieu of drilling operations, and such rental payments were chargeable to the net profits account. It was agreed, however, that Adams could be relieved of its obligation to so maintain any or all of the leases by written notice to Murphy and the others thirty days before any such rental became due and payable, indicating its desire to forfeit the lease or leases and giving Murphy and the others the opportunity to pay the rental on their own account and to receive assignment of the lease or leases. Petitioner had a right of access to the leased premises for purposes*287 of inspection and had access to all books and records bearing on the operations contemplated by the contract. The instrument stated that nothing contained in the contract should be construed to constitute a partnership and that the rights of the parties should be restricted to the express terms of the contract. All contact between Adams and the individual assignors was to be carried out through petitioner William R. Murphy, as trustee for all the individuals.
The contract was in effect during the taxable years. As a result of the contract, petitioner William R. Murphy received during the years 1940 and 1941, as his proportionate part of the profits derived from the extraction and sale of oil, the amounts of $ 19,830.41 and $ 16,133.66, respectively. He claimed depletion allowances in his income tax returns for the respective years in the amounts of $ 5,453.36 and $ 4,426.03.
Petitioner Mary Murphy received the sum of $ 19,830.40 in 1940 and the sum of $ 16,113.66 in 1941. She likewise claimed depletion allowances of $ 5,453.36 and $ 4,426.03 for 1940 and 1941, respectively. The respondent, in his notice of deficiency, held that the petitioners were not entitled to depletion *288 with respect to such payments for the above taxable years. Only so much of the deficiencies and claimed overpayments in each docket as relates to this adjustment is in controversy.
OPINION.
The sole issue before us involves a determination of whether the petitioners have retained a capital investment in the oil in place so as to entitle them to a depletion allowance. As stated by the Supreme Court in , "The words 'gross income from the property', as used in the statute governing the allowance for depletion, mean gross income received from the operation of the oil and gas wells by one who has a capital investment therein, -- not income from the sale of the oil and gas properties themselves." The applicable statute is set out in the margin. 1
*289 The respondent has taken the position that pursuant to the contract of May 22, 1937, the petitioners transferred all of their interest in the leaseholds, retaining no depletable economic interest in the oil or gas in place, and that the sums here in question received by the petitioners during the taxable years did not constitute gross income from the property, but were received as part of the sale price of the leaseholds. Petitioners, on the other hand, contend that they were the owners and holders of the original oil leases, having the ownership of the oil, and that the transaction entered into between the parties was a joint venture for the exploration and development of leases and the production of oil and/or gas thereon for the benefit of all the parties. Petitioners insist that the "operating agreement" was devised for the purpose only of providing for the more efficient and economical operation of the properties and that it did not serve to cause a relinquishment of their entire economic interest in the oil or gas in place. They argue that title to the property was held by Adams for the use and benefit of all concerned and that Adams occupied a position of trust to hold and*290 manage the property, while all of the parties were to share in and have an interest in the oil if and when produced.
While the "operating agreement" states that all right, title, and interest in the leaseholds and the gas and oil produced therefrom is to be in Adams, a careful examination of the entire instrument, in the light of the circumstances surrounding its execution, clearly leads us to the conclusion that the instrument was not intended to and does not deprive petitioners of all economic interest in the leasehold estate. At its outset the agreement states that the owners of the leases in question desire to arrange for drilling tests for oil and for future operations in the event of the discovery of oil in commercial quantities. It speaks of the parties as the "operator" and the "non-operator." It speaks of a "joint account" and refers to the contract as a "venture" *299 and to the leasehold interests as "joint lease." If the parties intended that the transaction be a sale of petitioners' economic interest in the leases, then the above and many other terms of the contract, such as "Adams shall at all times have the sole management of the sale of all the oil, gas and/or*291 casinghead gas that may be produced * * *"; "Adams shall be entitled to and shall receive the entire proceeds from the sale of said products"; and other similar provisions, would be meaningless. The arrangement, in our view, was designed to furnish a more simplified form of management and operation of the leaseholds. There were fifteen individuals owning different fractional interests in the various leases. Even prior to their entry into the contract here considered, legal title to the various interests was held by one person for the benefit of all. Such arrangement was carried through in the operating contract for ease of operations. The fact that Adams held legal title and the sole right to sell or dispose of the property is not controlling, for the right to the depletion allowance may inure to beneficial owners. . Only taxpayers with an economic interest in the oil are entitled to depletion, ; , but, as is pointed out in ,*292 this means only that under his contract the taxpayer must look to the oil in place as the source of the return of his capital investment.
Relying upon the decision by the Fifth Circuit in , the respondent makes much of the recital in the instrument that petitioners are entitled only to one-fourth of the net profits from the enterprise and not to one-fourth of the oil produced. It is apparent that the parties designed the agreement to make sure that the expenses of operation and production would be deducted from the income thereof before any distribution was made. Such procedure was adopted in lieu of having the payments for the oil made directly to the interested parties and thus necessitating the collection from them of their proportionate part of the operating expenses and costs of production. In its recent decision reversing the decision of the Fifth Circuit in the Kirby case, supra, and affirming the decision of the Ninth Circuit in , the Supreme Court held that an economic interest in the oil is not lost*293 merely because the right is to share a net profit. .
The only payment for the right of extracting the oil to be made by Adams to the petitioners was a portion of the net profits to be derived from the sale of the oil. Such payment was dependent entirely upon the sale of the oil and it would end only upon the exhaustion of the supply. It seems clear that the payments here in question should be *300 regarded as rents or royalties paid for the extraction of oil which resulted in a reduction of petitioners' capital investment. Accordingly, we conclude that the petitioners are entitled to a depletion allowance.
Decisions will be entered under Rule 50.
Footnotes
1. SEC. 114. [I. R. C.] BASIS FOR DEPRECIATION AND DEPLETION.
* * * *
(b) Basis for Depletion. --
* * * *
(3) Percentage depletion for oil and gas wells. -- In the case of oil and gas wells the allowance for depletion under section 23 (m) shall be 27 1/2 per centum of the gross income from the property during the taxable year, excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance under section 23 (m) be less than it would be if computed without reference to this paragraph.↩