*645 1. Where a partnership in which petitioners were interested drilled oil and gas wells for others and took its compensation in future oil payments the fair market value of the oil payment contracts is not taxable as income.
2. Under such contracts the partnership obtained an economic interest in the oil in place and was entitled to the statutory percentage depletion on such payments.
*844 In these consolidated cases the respondent determined deficiencies in income tax and penalty as follows:
| Petitioner | Docket No. | Year | Deficiency | Penalty |
| Willis R. Dearing | 84192 | 1932 | $10,955.92 | |
| Willis R. Dearing, executor, R. H. Dearing trust estate. | 84193 | Nov. 24 to Dec. 31, 1932. | 623.35 | $155.84 |
| Willis R. Dearing, executor, estate of R. H. Dearing, deceased. | 84194 | 932 | 7,042.08 | |
| Willis R. Dearing, executor, estate of Roy E. Dearing, deceased. | 84195 | 1932 | 67.79 | |
| Mrs. R. H. Dearing | 84196 | 1932 | 7,178.37 | |
| Mrs. Willis R. Dearing | 84197 | 1932 | 10,955.92 |
The principal income of the petitioners came from a partnership, R. H. Dearing*646 & Sons, in which they were interested. The partnership was engaged in the business of drilling oil and gas wells for itself and others. During the taxable year the partnership entered into a number of contracts to drill wells and as part of the consideration it was to receive payments solely in oil produced from the premises, and in some instances it received part cash and the balance in oil payments. In making its returns the partnership returned the cash received, but made no return relative to the future oil payments, claiming it was entitled to reimbursement for its costs before making a return of profit.
In making his determination the respondent fixed a fair market value for the oil payment contracts and included in income of the partnership the difference between the fair market value and cost of drilling. He also added to income of the partnership such percentage of the oil payments actually received during the year as represented the difference between the face value of such contracts and their fair market value as determined by him, and disallowed depletion. Petitioners allege these actions of the respondent were erroneous and ask redetermination.
FINDINGS OF FACT.
*647 The principal facts have been stipulated as follows:
1. That all of the above-entitled causes may be consolidated for the purpose of a hearing before the United States Board of Tax Appeals, said causes involving similar issues and being related in subject matter.
2. That the partnership of R. H. Dearing and Sons, from which the principal income of all of above petitioners is derived, is owned as follows: Petitioners Willis R. Dearing and wife, Mrs. Willis R. Dearing, own jointly a community one-third interest in said partnership; that R. H. Dearing owned, until the date of his death on November 23, 1932, together with his wife, Mrs. R. H. Dearing, jointly a community one-third interest in said partnership; that since the death of said R. H. Dearing, said Mrs. R. H. Dearing and the Estate of R. H. Dearing Trust Estate own jointly a one-third interest in said partnership; and that Roy E. Dearing and Mrs. Roy E. Dearing owned, until the date of said Roy E. Dearing's *845 death on January 19, 1932, a community one-third interest in said partnership, and that since said January 19, 1932 the Trust Estate of Roy E. Dearing, deceased, owns a one-third interest in said partnership.
*648 3. That all of the petitioners above-named have consistently kept their books and records and filed their income tax returns on the cash receipts and disbursements basis, and filed their returns on the calendar year basis.
4. That said partnership of R. H. Dearing and Sons was organized in 1886 for the purpose of drilling oil and gas wells for themselves and others and have continually operated since organization in such business.
5. That the partnership of R. H. Dearing and Sons, from which the principal income of above petitioners was derived, set up on its books as a deferred cost the amount expended in the drilling of said wells where the amount received in cash was insufficient to return said cost of drilling, and the collections from the sale of oil and gas which was produced, saved and marketed from the wells drilled on a deferred basis, or partly deferred basis, were applied as a credit against said deferred costs as, if and when the cost was fully recovered and the remaining receipts were, and are, considered as income, and were so reported in the income tax returns filed by the several petitioners any by the partnership of R. H. Dearing and Sons.
6. That in*649 the event that the Board of Tax Appeals shall find that the Commissioner erred in his action in setting up as additional income to the partnership of R. H. Dearing and Sons the sum of $290,972.47, which he arrived at, as shown by Exhibit "B-1" and Exhibit "B-3" of the 90-Day Letter, under the Commissioner's theory that the fair market value of the drilling contracts (as determined by the Commissioner), in excess of the cost of drilling such wells, represented taxable income in the sum of $222,939.91, as shown by Exhibit "B-1" in the 90-Day letter, and by setting up as additional income such percentage of the collections actually received during the year as was represented by the difference between the face value of such drilling contracts and their fair market value as determined by the Commissioner, and as shown by Exhibit "B-3" in the 90-Day letter, amounting to the sum of $68,032.56; then in such event, the income of the partnership of R. H. Dearing and Sons, as set up by the Commissioner, shall be reduced accordingly, in to wit, the sum of $290,972.47.
7. That the Commissioner failed to allow depletion as a deduction on the oil and gas produced to either the partnership of*650 R. H. Dearing and Sons or to any of the above petitioners.
8. It is further agreed and stipulated that photostatic copies of any contract under the terms and conditions of which the oil and/or gas wells involved in these causes were drilled by the partnership of R. H. Dearing and Sons, may be admitted in evidence in lieu and instead of the original contracts; that only one such photostatic copy of each of said contracts shall be required to be submitted and that the photostatic copies, together with the original contracts submitted in evidence, are true and correct and fully set forth the terms and conditions under which the several wells involved in these causes were drilled, and that no further proof shall be required as to the execution or genuineness of such contracts; that Exhibits "B-1" to "B-26" inclusive constitute all the contracts and set forth all the terms and conditions under which all the wells involved in these causes were drilled; that each of said contracts truly shows by the writing on the face thereof the true and correct well or wells to which it relates.
9. It is further stipulated that the hereto attached schedule, Marked "Stipulation Exhibit A", is a*651 correct statement of cost of contracts, cash received *846 on contract prices, oil payments to be received on contract prices, fair market value oil payment contracts, total collections for the years 1932 to 1936, inclusive, on oil runs from contracts, and said collections by years, 1932 to 1936, separately. But the several petitioners herein reserve the right to except to the consideration by the Board of Tax Appeals of that part of said stipulation Exhibit which sets forth the total collections for the years 1932 to 1936, inclusive, and the collections for the years 1933 to 1936, inclusive, as separately set up therein, on the ground that the same are immaterial and irrelevant and should not be taken into consideration in determining taxable income of said petitioners for the year 1932.
The partnership entered into a large number of drilling contracts during the taxable year, entitling it to receive $805,990.17 in oil payments. The respondent determined that these contracts had a fair market value of $501,726.98 and after deducting the cost of drilling therefrom he added to the income of the partnership on account of this valuation the sum of $222,939.91.
In addition, *652 as the oil payments were made, the respondent determined that a tax was due on such payments in proportion to the difference between the face and fair market values of the oil payment contracts and on this account he added $68,032.56 to the income of the partnership. This was arrived at in the following manner:
The face value of the contracts was $817,974.21 (Exhibit B-3, attached to petition) (stipulation under contract price designates $14,000 cash and oil payments $805,990.17); and their fair market value was $501,726.98. The total collections for the year 1932 was $172,385.21. Under this method of computation there was added realized income of $68,032.56.
The manner in which the $68,032.56 was arrived at may be illustrated by taking, for example, Alexander No. 1. The oil contract price was $9,227.50. The fair market value determined by the Commissioner was $6,920.62, which represents seventy-five per cent of the total oil payment. In other words, seventy-five cents of every dollar of this oil payment is included in the fair market value and taxed, leaving twenty-five cents of every dollar received through oil runs to be taxed. As each dollar is thereafter received seventy-five*653 cents of each dollar should and would be exempted from tax and twenty-five cents of each dollar treated as income. The collections on Alexander No. 1 for the year 1932 was $4,060.63, therefore, in 1932 twenty-five per cent of the $4,060.63, or $1,015.16, should be taxed. Treating each oil well in the same manner with its proper percentage results in a total taxable income on collections of $68,032.56.
The drilling contracts in controversy were all substantially alike and all contained clauses similar to the following extracts from Anderson No. 1:
CONSIDERATION CLAUSE.
In consideration of labor done, materials furnished, and the faithful performance of this agreement, Owner hereby promises, and agrees to pay to said Contractor the sum of $30,000.00, said sum to be paid out of one-half (1/2) of the 7/8ths oil and/or gas produced, saved, and marketed from any part of the above described property until such time as the full amount has been paid: *847 said one-half of the 7/8ths of oil and/or gas is equal to the amount of 7/16th of all the oil and/or gas produced, saved and marketed from any part of the above described property.
ASSIGNMENT CLAUSE
Owner hereby and herewith*654 assigns, sets over and transfers to Contractor the oil and/or gas and in the proportions as hereinabove agreed to, a nd this instrument is to be considered an assignment of such interests as of this date; and Owner further agrees that if said well has been completed and it should become necessary to have further assignment, that Owner will then make the Contractor such assignments as will carry out this contract in so far as the oil runs and lease hereby assigned and contracted about are concerned.
There was no personal liability on the part of the owner or lessee to pay the amounts.
The respondent did not allow depletion on the oil payment collections of $172,385.21 made during the taxable year.
OPINION.
HILL: Our first question is the correctness of the respondent's action in including in gross income the fair market value of the oil payment contracts.
We had this same question before us in the recent case of Edwards Drilling Co.,35 B.T.A. 341">35 B.T.A. 341, where we held that the fair market value of future oil payment contracts is not accruable as taxable income. We said in part:
In *655 E. F. Simms,28 B.T.A. 988">28 B.T.A. 988, rights under oil leases were sold for cash and notes, together with a right to 400,000 barrels of oil produced from the property, if the land produced such an amount, and an overriding royalty on all oil produced. We concluded that the rights reserved to future payments in oil and money were contingent in character and, following the principle of Burnet v. Logan,283 U.S. 404">283 U.S. 404, did not represent property received or amounts accruable for the purpose of determining gain realized from the sale.
Here the petitioner's rights to receive the consideration for drilling the wells were contingent upon the happening of events which could not be foretold during the taxable period with any fair degree of certainty because of the nature of the mineral from the sale of which the money was to be paid. As we said in E. F. Simms, supra, "A 'gusher' of today may be a mere 'pumper' or even a dry hole tomorrow." In addition to this usual uncertainty that an oil well will continue to be a producer, the petitioner's rights to payment were subject to the possibility that the Railroad Commission of Texas would decrease the*656 daily production of the wells. The owners of the wells were not at any time in 1931 under a definite obligation to pay, since no liability was to come into existence until oil produced and saved had been marketed. The promise of the owners of the wells to pay for the drilling thereof was, therefore, contingent. Throughout the taxable period it was doubtful whether the petitioner would ever receive its consideration. The risk was always present.
The fact that the rights had a fair market value does not of itself require that the amount thereof be accrued as taxable income. Bedell v. Commissioner, 30 Fed.(2d) 622; Commissioner v. Darnell, Inc., 60 Fed.(2d) 82; Teck Hobbs,26 B.T.A. 241">26 B.T.A. 241; *848 Woods, v. Lewellyn, supra; Workman v. Commissioner, supra. See E. F. Simms, supra.
Under the facts in this case, we are of the opinion, and so hold, that only the cash actually received by the petitioner in 1931 for drilling the wells constitutes taxable income. Accordingly, it was error for the respondent to increase gross income by an amount for the contingent rights to future payments under*657 the drilling contracts.
See also Teck Hobbs,26 B.T.A. 241">26 B.T.A. 241; Commissioner v. Moore, 48 Fed.(2d) 526; Commissioner v. Garber, 50 Fed.(2d) 588; Bede ll v. Commissioner, 30 Fed.(2d) 622.
It is urged upon us that the fair market value of the contracts was stipulated and can not now be questioned, but such stipulation does not necessarily make them taxable. As we said in the Edwards Drilling Co., case, supra, "The fact that the rights had a fair market value does not of itself require that the amount thereof be accrued as taxable income."
Respondent relies mainly on the case of W. L. Walls,21 B.T.A. 1417">21 B.T.A. 1417; affd., 60 Fed.(2d) 347, where a lawyer accepted certain oil payments extending over several years as a fee. The Commissioner fixed a fair market value of $16,500 for the contract and included it in the taxpayer's income for the year in which the contract was made. His action was approved by the Board and the Circuit Court. The facts in that case, however, were considerably different from those in the instant cases. In that case Walls was the owner of an one-eighth*658 interest. The Midway Co. had bought five one-eighth interests at $16,500 each and stood ready to pay Walls a like sum for his interest, but Walls preferred to retain his oil payments. These facts, we think, differentiate that case from the instant cases, rendering it of no value as a precedent.
We hold that the respondent erred in including the fair market value of the oil payment contracts in the income of the partnership for 1932. Such payments are taxable as, if, and when received.
During the taxable year there was received on account of oil payments the sum of $172,385.21. Petitioners did not return any of this for taxation on the theory they were entitled to the return of costs of drilling before making any return of profit for taxation. Of these oil payment collections during the taxable year the respondent included $68,032.56, representing the proportionate difference between the contract price and the fair market value of the contracts. In view of our holding that the fair market value of the oil payment contracts may not be included in the income of the partnership, it results that the actions of both petitioners and the respondent were erroneous. The entire collections*659 of $172,385.21 are includable in the gross income of the partnership but this should be credited by the $68,032.56 already included therein and proper deduction be made for depletion.
*849 The remaining question is that of depletion on the oil payments which respondent disallowed.
Under the terms of the contracts in question it is clear to us that the petitioners are entitled to a deduction for depletion. They had an economic interest in the oil in place, which was depleted by extraction. In Palmer v. Bender,287 U.S. 551">287 U.S. 551, the Court said:
* * * It will be observed that the statute directs that reasonable allowance for depletion be made as a deduction in computing net taxable income, "in the case of * * * oil and gas wells, * * * according to the peculiar conditions in each case." The allowance to the taxpayer is not restricted by the words of the statute to cases of any particular class or to any special form of legal interest in the oil well. It is true that under article 215 of Treasury Regulations 62 the lessor of an oil or gas well is entitled to a depletion allowance upon the bonus and royalties received from the lessee. See Murphy Oil*660 Company v. Burnet, supra. But there is nothing in the statute or regulations which confines depletion allowances to those who are technically lessors. The concluding sentence of the section that "In the case of leases the deductions allowed by this paragraph shall be equitably apportioned between the lessor and the lessee" presupposes that the deductions may be allowed in other cases. The language of the statute is broad enough to provide, at least, for every case in which the taxpayer has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extration of the oil, to which he must look for a return of his capital.
* * *
In the present case the two partnerships acquired by the leases to them, complete legal control of the oil in place. Even though legal ownership of it, in a technical sense, remained in their lessor, they, as lessees, nevertheless acquired an economic interest in it which represented their capital investment and was subject to depletion under the statute. Lynch v. Halworth-Stephens Co., supra. When the two lessees transferred their operating rights to the two oil companies, *661 whether they became technical sublessors or not, they retained, by their stipulations for royalties, an economic interest in the oil, in place, identical with that of a lessor. Burnet v. Harmel; Bankers' Pocahontas Coal Company v. Burnet, supra. Thus throughout their changing relationships with respect to the properties, the oil in the ground was a reservoir of capital investment of the several parties, all of whom, the original lessors, the two partnerships, and their transferees, were entitled to share in the oil produced. Production and sale of the oil would result in its depletion and also in a return of capital investment to the parties according to their respective interests. The loss or destruction of the oil at any time from the date of the leases until complete extraction would have resulted in loss to the partnerships. Such an interest is, we think, included within the meaning and purpose of the statute permitting deduction in the case of oil and gas wells of a reasonable allowance for depletion according to the peculiar conditions in each case.
The statute makes effective the legislative policy, favoring the discoverer of oil, by valuing his capital investment*662 for purposes of depletion at the date of the discovery rather than at its original cost. The benefit of it accrues to the discoverer if he operates the well as owner or lessee, or if he leases it to another. It would be an anomaly if that policy were to be defeated *850 and all benefit of the depletion allowance withheld because he chose to secure the return of his capital investment by stipulating for a share of the oil produced from the discovered well through operation by another.
See also Chester Addison Jones,31 B.T.A. 55">31 B.T.A. 55; 82 Fed.(2d) 329, and William Fleming,31 B.T.A. 623">31 B.T.A. 623; 82 Fed.(2d) 324.
In the recent case of Thomas v. Perkins,301 U.S. 655">301 U.S. 655, the United States Supreme Court held that any one having an economic interest in oil and gas in place is entitled to the statutory percentage depletion.
Under section 114(b)(3) of the Revenue Act of 1932 petitioners are entitled to depletion of 27 1/2 per centum of the oil payments during the taxable year.
In the Edwards Drilling Co. case, supra, it was held that the entire cost of drilling wells was deductible as an ordinary and*663 necessary business expense in the year in which incurred.
No such claim is made in this case, and the question of depletion was not presented in the Edwards case. In view of the decisions of the Supreme Court in Thomas v. Perkins, supra and Palmer v. Bender, supra, we think the correct rule is for the petitioners to recoup their expenditures by depletion.
In Docket No. 84193 respondent determined a 25 percent delinquency penalty, pursuant to the provisions of section 291 of the Revenue Act of 1932, for failure to make and file a return within the time prescribed by law. Subsequently, in 1935, a return was prepared by respondent, pursuant to section 3176 of the U.S. Revised Statutes, as amended. Petitioner has offered no evidence to show that the failure to file a return within time was due to reasonable cause and not to willful neglect. Respondent's determination is, therefore, approved, but the amount of the penalty will be recomputed on the basis of the tax finally redetermined to be due under Rule 50. Decision will be entered under Rule 50.