1932 BTA LEXIS 1386">*1386 At the date of discovery of an oil well a partnership owned an undivided interest in a lease on the property, which interest had been acquired at a nominal cost. After discovery the partnership purchased the outstanding interest for a substantial sum. Held that under the Revenue Acts of 1921 and 1924 depletion may be computed on the discovery basis as to the interest owned by the partnership at the time of discovery and on cost as to the interest thereafter purchased. Held, further, that under the Revenue Act of 1926 depletion should be computed on the percentage of income basis, without reference to discovery value.
25 B.T.A. 1364">*1365 The respondent determined deficiencies in income taxes as follows:
| Petitioner | Docket No. | Year | Amount |
| 1923 | |||
| Ed. Peterson | 36066 | 1924 | $2,990.34 |
| 1925 | 900.87 | ||
| Do | 42020 | 1926 | 225.73 |
| 1923 | 631.69 | ||
| Adah McCarty | 36067 | 1924 | 1,228.29 |
| 1925 | 615.35 | ||
| Do | 42029 | 1926 | 1,086.93 |
| 1923 | |||
| J. A. McCarty | 36029 | 1924 | 2,016.19 |
| 1925 | 799.53 | ||
| Do | 42021 | 1926 | 1,269.30 |
| 1923 | 1,090.42 | ||
| Ida Belle Peterson | 36093 | 1924 | 1,831.42 |
| 1925 | 716.69 | ||
| Do | 42027 | 1926 | 181.91 |
1932 BTA LEXIS 1386">*1387 The parties filed a written stipulation agreeing upon the proper deductions to be allowed under several of the issues raised. They further stipulated that the partnership income, after allowing for the deductions agreed upon, should be divided on the basis of 50 per cent to J. A. McCarty and wife and 50 per cent to Ed. Peterson and wife, and that the income of each husband and wife should be computed in accordance with the community property laws of Texas. These matters will be given effect under Rule 50.
The remaining issue in each case is the proper method of computing depletion allowance under the Luke Wilson lease for each of the years 1923 to 1926, inclusive. The facts respecting this issue were also stipulated. We set forth here as our findings the substance of the stipulation, but omitting the proposed computations which are a matter of contention between the parties.
FINDINGS OF FACT.
At all times material to these proceedings the McCarty Oil Company was a partnership of which petitioners J. A. McCarty and Ed. Peterson were copartners, each having an equal interest in said partnership.
Petitioner Adah McCarty was the wife of petitioner J. A. McCarty, and petitioner1932 BTA LEXIS 1386">*1388 Ida Belle Peterson was the wife of petitioner Ed. Peterson. Each of the petitioners was a resident of the State of Texas.
On or about December 15, 1922, the McCarty Oil Company acquired an interest in an oil lease which lease covered a seven-eighths working interest on 100 acres of land in Archer County, Texas. This lease is known as the Luke Wilson lease.
25 B.T.A. 1364">*1366 On or about February 22, 1923, a test well was completed on said 100 acres of land, which resulted in the discovery of oil thereon. Prior to such discovery the property was not a proven tract or lease.
At the time of such discovery, the McCarty Oil Company owned four-sevenths of the seven-eighths working interest in the north 40 acres of said tract and two-thirds of the seven-eighths working interest in the remaining 60 acres thereof.
On May 11, 1923, the McCarty Oil Company purchased the remaining three-sevenths of the seven-eighths working interest in the north 40 acres and the remaining one-third of the seven-eighths working interest in the remaining 60 acres, all for the total sum of $184,787.93.
The oil reserves of the Luke Wilson lease for the purpose of computing depletion upon discovery value1932 BTA LEXIS 1386">*1389 and upon subsequent cost are 317,437 barrels.
The production from the Luke Wilson lease, seven-eighths working interest, was as follows:
| Barrels | |
| 1923 | 62,102 |
| 1924 | 115,333 |
| 1925 | 78,932 |
| 1926 | 74,288 |
The discovery value of the Peterson and McCarty interest in the Luke Wilson lease on or about February 22, 1923, was $206,510.34.
The division of oil reserves and yearly production on the basis of the fraction owned by McCarty Oil Company at date of discovery and the fraction acquired by the said McCarty Oil Company by subsequent purchase is 60 per cent of the former fraction and 40 per cent for the latter fraction.
The depletion allowances computed by respondent on the Luke Wilson lease are as follows:
| 1923 | $52,495.08 |
| 1924 | 67,706.24 |
| 1925 | 46,337.03 |
| 1926 | 49,828.31 |
OPINION.
ARUNDELL: The several revenue acts applicable to these cases (Acts of 1921, 1924 and 1926) each permit a deduction in respect of oil and gas wells of "a reasonable allowance for depletion * * * according to the peculiar conditions in each case * * *." Each of the revenue acts (with exceptions not material here) further provides that the primary basis for computation1932 BTA LEXIS 1386">*1390 of depletion shall be cost, 25 B.T.A. 1364">*1367 with further provisos in the Acts of 1921 and 1924 allowing the use of discovery value in place of cost where the wells were discovered by the taxpayer on or after March 1, 1913, and "where the fair market value of the property is materially disproportionate to cost." The several revenue acts limit the depletion allowance as follows:
Section 214(a)(10), Revenue Act of 1921:
* * * And provided further, That such depletion allowance based on discovery value shall not exceed the net income, computed without allowance for depletion, from the property upon which the discovery is made, except where such net income so computed is less than the depletion allowance based on cost * * *.
Section 204(c), Revenue Act of 1924:
* * * but such depletion allowance based on discovery value shall not exceed 50 per centum of the net income (computed without allowance for depletion) from the property upon which the discovery was made, except that in no case shall the depletion allowance be less than it would be if computed without reference to discovery value.
Section 204(c)(2), Revenue Act of 1926:
In the case of oil and gas wells the allowance1932 BTA LEXIS 1386">*1391 for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year. 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 be less than it would be if computed without reference to this paragraph.
The computations of the parties, which they claim are correct, are as follows:
| Respondent's computation | |
| 1923 | |
| Net income before depletion | $52,495.08 |
| Depletion on discovery appreciation | 40,400.77 |
| Depletion on cost | 36,150.82 |
| Total depletion | 76,551.59 |
| Depletion allowable | 52,495.08 |
| Petitioner's computation | |
| 1923 | |
| Depletion on 60% discovery interest | $31,497.05 |
| Depletion on 40% cost interest | 36,150.82 |
| Total allowable | 67,647.87 |
| 1924 | |
| Net income before depletion | $126,421.87 |
| 50% of net income | 63,210.93 |
| Depletion on cost | 67,706.24 |
| Depletion allowable | 67,706.24 |
| 1924 | |
| Discovery interest - 60% of net income | $75,853.12 |
| Discovery depletion (50% of above) | 37,926.56 |
| Depletion on cost | 67,706.24 |
| Depletion allowable | 105,632.80 |
| Respondent's computation | |
| 1925 | |
| Gross income | $166,374.46 |
| Net income before depletion | 124,075.37 |
| 27 1/2% gross income | 45,752.98 |
| Depletion on cost | 46,337.03 |
| Depletion allowable | 46,337.03 |
| Petitioner's computation | |
| 1925 | |
| 60% of net income before depletion | $74,445.22 |
| 40% of net income before depletion | 49,630.15 |
| 27 1/2% of 60% of gross income | 27,451.78 |
| Depletion on cost | 46,337.03 |
| Depletion allowable | 73,788.81 |
| 1926 | |
| Net income before depletion | $116,412.68 |
| 27 1/2% of gross income | 49,828.31 |
| Depletion on cost | 21,999.65 |
| Depletion allowable | 49,828.31 |
| 1926 | |
| 60% of net income before depletion | $69,847.60 |
| 40% of net income before depletion | 46,565.08 |
| 27 1/2% of 60% of gross income | 29,896.99 |
| Depletion on cost | 21,999.65 |
| Depletion allowable | 51,896.64 |
1932 BTA LEXIS 1386">*1392 25 B.T.A. 1364">*1368 From these computations it appears that the respondent for each of the years figured the depletion separately (1) on cost and (2) on discovery value or in the later years on percentage of income, and compared the two figures, and allowed the greater as a deduction, except for 1923, when the deduction allowed was limited to the net income from the property. Petitioners have figured depletion on cost as being attributable to 40 per cent of their leasehold interest and have added thereto depletion on discovery, or depletion measured by a percentage of income under the later acts, as being attributable to a 60 per cent discovery interest, and claim the total of the two sums as a proper deduction.
The provisions of the revenue acts above cited are designed to permit a return of cost through the depletion deductions authorized. Or, as stated in the Commissioner's regulations:
The essence of these provisions of the statute is that the owner of mineral deposits, whether freehold or leasehold, shall, within the limitations prescribed, secure through an aggregate of annual depletion * * * deductions the return of either cost of his property, or the value of his property1932 BTA LEXIS 1386">*1393 on the basic date * * *. Art. 201, Regulations 62, 65 and 66.
The Revenue Acts of 1921 and 1924 allow depletion deductions on discovery value, limited however, in the 1921 Act to the net income from the property and in the 1924 Act to 50 per cent of the net income. In the enactment of the Revenue Act of 1926, discovery provisions in the case of oil and gas wells were purposely omitted because of the difficulty of administration (see Senate Rept. 25 B.T.A. 1364">*1369 No. 52, 69th Cong., 1st sess., p. 17), and in lieu thereof it was provided that depletion deductions should be allowed at the rate of 27 1/2 per cent of gross income, but not to exceed 50 per cent of the net income from the property. All three of the revenue acts provide further that in no case shall the depletion deductions be less than if computed on the basis of cost.
Years 1923 and 1924.
Discovery value is limited by law to those persons making the discovery and is not allowed as a basis to purchasers of proven property. The interest on which petitioners are entitled to a discovery value for purposes of depletion is a 60 per cent interest. By the purchase of the 40 per cent interest theretofore owned by other1932 BTA LEXIS 1386">*1394 parties, petitioners acquired no right to a discovery value on that interest, because at the time of purchase a discovery thereon had already been made. It is the respondent's position, as we understand it, that the discovery value of the 60 per cent interest theretofore owned by petitioners is to be compared with the cost of the 40 per cent interest (as in the instant case no cost is shown for the 60 per cent interest before discovery), and depletion will be allowed in the greater of the two amounts. While the statement of respondent's position may seem fair and may seem to give that reasonable allowance for depletion that the statute contemplates, a simple example shows its fallacy. If A owns a one-eighth interest in an oil lease acquired without cost and on which he is entitled to a discovery value of $50,000, and thereafter buys another one-eighth interest in the same lease for $49,000, it would be respondent's position that the total depletion on the entire two-eighths interest would be limited to the $50,000 theretofore allowed on the one-eighth interest, for he would take cost or discovery value and allow the greater of the two amounts. In other words no additional depletion1932 BTA LEXIS 1386">*1395 whatever would be allowed on the newly acquired one-eighth interest. If, on the other hand, A had acquired without cost a two-eighths interest, and the same discovery had been made, A's basis for depletion allowance on discovery value would be $100,000. So incongruous a result can not, in our opinion, give that reasonable allowance for depletion contemplated by the statute. The difficulty with respondent's formula is that it compares unlike interests - a discovery interest and a cost interest - and allows only a portion of the total depletion sustained. As petitioners are the owners of the entire leasehold, they are entitled to deductions for depletion of their whole interest, and we can not believe the statutes contemplate that the deductions should be reduced by the application of such a formula as worked out by the respondent. While, as 25 B.T.A. 1364">*1370 pointed out above, cost is the primary basis for computation of depletion, that basis can be applied here to only a portion - 40 per cent - of petitioner's interest. The remaining 60 per cent was acquired under circumstances which give the petitioners the right to use a discovery basis. Although the use of discovery value as a1932 BTA LEXIS 1386">*1396 basis has been termed an "exceptional benefit" ( and an "extraordinary basis" (), still, taxpayers are entitled to use it when they come within the terms of the statute. The parties are agreed that petitioners made a statutory discovery when they owned a 60 per cent interest and we see no reason for denying them the right to a discovery basis with respect to that interest. As to the remaining 40 per cent, cost is established and we think petitioners are entitled to use it.
Years 1925 and 1926.
Discovery basis, as pointed out above, may not be used under the Revenue Act of 1926, which as far as material here, is retroactive to January 1, 1925. Section 286. Depletion deductions are allowable under the 1926 Act equal to 27 1/2 per cent of gross income, and this, in our opinion, precludes any consideration of the source of title. The depletion allowed under this act is to be determined by the amount of income from petitioner's interest in the property during the year without regard to the method of acquisition. An exception is made in cases where depletion based on cost is greater1932 BTA LEXIS 1386">*1397 than on the percentage basis, and this has been recognized by the respondent and given effect for the year 1925, the only year in which the exception is applicable under the facts here. It thus appears that the respondent has correctly applied the statute to the years 1925 and 1926.
Concluding, we are of the opinion that the method of petitioners is proper for the years 1923 and 1924, and that the respondent's method is proper for 1925 and 1926.
Reviewed by the Board.
Decision will be entered under Rule 50.