*2472 Disbursements made by a taxpayer under contract for drilling oil wells on another's property, for which it was to be compensated out of the fruits of the contract before dividing with the owner and which were treated by taxpayer as accounts receivable, held not deductible by taxpayer in the year of disbursement as ordinary and necessary expenses.
*86 The respondent determined deficiencies of $698.65 for 1920 and $906.84 for 1921 in income and profits taxes. The only issue now in controversy is petitioner's right to deduct certain items of cost in drilling for oil.
FINDINGS OF FACT.
The petitioner is a California corporation organized in 1911. On October 29, 1920, it contracted with Joseph B. Dabney and Louise E. Dabney, the owners of lots 18 and 20, block C, Garfield Tract, Huntington Beach, Orange County, Calif., to commence drilling operations on such property. The agreement contained the following provisions:
FIRST: That the party of the second part agrees to commence drilling operations on one*2473 or the other of said lots on or before December 1st, 1920, and to proceed diligently with the drilling of a well; and within sixty (60) days after the completion of said well it will begin drilling operations for a well on the other lot.
SECOND: That the party of the second part shall bear all the expense of drilling and equipping both of said wells, and as and when said wells are completed it will operate them and shall be entitled to take all of the proceeds from the sale of all of the oil and gas until it shall have received a sum equal to the amount expended by it in drilling, equipping and operating said wells, and when it shall have so reimbursed itself, then the proceeds from the sale of all oil and gas, less operating expense, shall be paid to the parties of the first part until the sum so paid him shall amount to the sum of Fourteen Hundred Dollars ($1400.00).
THIRD: When and so soon as the party of the second part shall have been reimbursed as aforesaid and when and so soon as the said first parties shall have received the Fourteen Hundred Dollars ($1400.00) as aforesaid then the said first parties shall make, execute and deliver to the said second party a deed conveying*2474 to it an undivided one-half (1/2) interest in and to both of said lots, free and clear of all incumbrance, and thereafter the said first and second parties shall own jointly the said lots, the wells and all the equipment, and each *87 shall bear one-half (1/2) of the operating expense and each shall be entitled to one-half (1/2) of the oil and gas, or one-half (1/2) of the proceeds from the sale thereof.
This agreement was not recorded, and it remained in effect and the petitioner drilled and operated under it until August 15, 1922, when petitioner entered into a new agreement with the land owners "putting the property on a basis of one-sixth royalty."
The petitioner expended $43,533.43 in 1920 and $104,184.82 in 1921 in drilling and equipping the wells on the Dabney property. Of these amounts, $33,017.62 was expended in 1920 and $47,544.97 in 1921 for equipment consisting of casing, reservoirs and tanks, line pumps, boiler appliance, tools, and furniture and fixtures, and $10,515.81 was expended in 1920 and $56,639.85 in 1921, as follows:
| 1920 | 1921 | |
| Labor | $9,387.00 | $39,797.28 |
| Freight and hauling | 608.06 | 10,261.12 |
| Water deposit | 36.00 | |
| Repairs to equipment used in building | 1,866.17 | |
| Cement | 484.75 | 1,142.00 |
| Fuel, light, and water | 1,919.12 | |
| Miscellaneous drilling expense | 712.10 | |
| Perforating | 125.00 | |
| Tool rental | 357.52 | |
| Shooting well | 393.00 | |
| Insurance | 66.54 | |
| 10,515.81 | 56,639.85 |
*2475 The items contained in the foregoing list are called by petitioner "intangible drilling expenses." All of the expenditures of $43,533.43 and $104,184.82 were recorded by petitioner in one account, designated the "Dabney-Huntington Beach" account. This account was treated by the managing officers of the petitioner as an account receivable, because, under the terms of the Dabney contract, the petitioner was entitled to be reimbursed for all expenditures incurred for drilling and equipment from the initial production before making any payment to the landowners. All expenditures from the time of entering into the original contract in 1920 to the time when the new agreement was entered into were charged to this account, and those made in 1920 and 1921 remained there until some time in 1922. The "intangible drilling expenses" were not charged to expense, and no depreciation was taken on the equipment. In 1922, after the new agreement, the petitioner adopted the practice of charging off "intangible drilling expenses" to expense in the year in which they were incurred. At that time it analyzed the costs incurred in 1920 and 1921, set up the "intangible drilling expenses" as expenses*2476 and subsequently charged them to surplus, and set up the remainder of the cost of equipment as assets. For some years prior to 1920 petitioner charged so-called "intangible drilling expenses" of other projects to profit and loss.
*88 The item of $43,533.43 expended in 1920 in drilling on the Dabney property appears an an asset in the balance sheet attached to the petitioner's returns for 1920 and 1921. Neither the expenditure of $43,533.43 in 1920 nor $104,184.82 in 1921 was claimed as a deduction for expenses in the original returns for those years. The petitioner filed amended returns for 1920 and 1921 claiming these amounts as deductions, accompanied by claims for refund. The claims for refund were rejected by the respondent.
A reasonable allowance for depreciation of the aforesaid equipment for the last two months of 1920 is $351.20, and for 1921 is $4,989.52.
On November 24, 1911, petitioner acquired from A. Borland the S. 1///4 sec. 19, T. 30 S., R. 22 E., M.D.B. & M., situate in Kern County, California, known as the McKittrick property. The consideration paid for it was 300,000 shares of the capital stock of the petitioner. *2477
The fair market value of the property as of March 1, 1913, was not in excess of $75,000.
OPINION.
STERNHAGEN: The petitioner abandons its attempt to prove a fair market price or value on March 1, 1913, of the McKittrick property greater than that of $75,000 determined by respondent, and we sustain that determination without discussion.
The respondent has conceded petitioner's claimed deduction of $351.20 for 1920 and $4,989.52 for 1921 as reasonable allowances for exhaustion, wear and tear of equipment, and the deficiency should in this respect be adjusted accordingly.
As to the disbursements made during the taxable years in drilling under the Dabney lease, we see no sufficient reason at this late date to order their deduction as ordinary and necessary expenses. Petitioner's accounting method was such that it was at liberty to and did treat them as accounts receivable, showing them on its balance sheet as assets, and in its returns it made no attempt to deduct them. The deduction is first claimed in amended returns and this petition. Even, therefore, if article 223, Regulations 45, were controlling (but see *2478 ), as petitioner seems to contend, it had no such practice as would require the deduction under that article. Petitioner regarded these expenditures as an investment to be returned to it out of the fruits of the Dabney contract. Respondent adopted this treatment. There is no principle of law clear enough to require us to say that respondent's determination was in this respect incorrect.
Judgment will be entered under Rule 50.