*4126 1. Net income of a trust determined for the years 1921 and 1922.
2. A certain instrument construed to be a sale and another to be a sublease or operating agreement.
*361 In this proceeding the petitioner seeks a redetermination of his income-tax liabilities for the years 1921 and 1922, for which the Commissioner, as set forth in his deficiency letter dated September 29, 1925, determined deficiencies in the amounts of $322.99 and $193.94, respectively.
The petition alleges that the respondent erred in determining the net income of a trust known as M. B. Sanders, Trustee, in which the petitioner had a one-eighth interest for both the years 1921 and 1922, in that the respondent failed to include certain items of income and failed to allow certain items of expense, and, secondly, that the respondent erred in refusing to allow M. B. Sanders, Trustee, any depletion for the year 1922.
FINDINGS OF FACT.
The petitioner is an individual residing in the State of Arkansas. In 1919 he and seven other individuals formed a trust known as M. B. Sanders, *4127 Trustee, and acquired from J. R. Burns and wife, lessors, a certain oil and gas lease on 520 acres in Union County, Arkansas, *362 prior to any commercial production of oil in that vicinity. The petitioner had a one-eighth interest in M. B. Sanders, Trustee.
In 1921, M. B. Sanders, Trustee, sold all of its rights to 400 acres of the Burns' lease for $60,000. The cost in 1919 of the property sold was $7,000. During 1921 M. B. Sanders, Trustee, received interest on bank deposits of $99.71. During the same year it paid out expenses as follows:
| Legal expense | $675.35 |
| Telephone and telegraph | 56.31 |
| Office expense | 30.94 |
| Traveling expense | 1,016.57 |
| Lease rentals | 296.95 |
| Miscellaneous expense | 65.00 |
| Total expense | 2,141.12 |
The net income of M. B. Sanders, Trustee, for the year 1921 was $50,958.59. The petitioner's one-eighth interest therein was $6,369.83. The respondent in his deficiency letter determined the petitioner's one-eighth interest to be $6,625.
During 1922 M. B. Sanders, Trustee, received income as follows:
| Oil sales | $76,399.00 |
| Interest received | 447.63 |
| Fuel oil sales | 478.57 |
| Total | 77,325.20 |
During 1922 M. B. Sanders, *4128 Trustee, paid out expenses as follows:
| Telephone and telegraph | $195.08 |
| Lease rentals | 76.95 |
| Salaries | 3,850.00 |
| Traveling expense | 789.49 |
| Miscellaneous expense | 167.20 |
| Legal expense | 307.86 |
| Commissions | 5,459.96 |
| Printing | 19.50 |
| Total expenses | 10,866.04 |
On December 15, 1921, M. B. Sanders, Trustee, entered into an agreement with the Woodley Drilling Co. in which the latter agreed to operate 40 acres (NE. 1//4 sec. 32, T. 18, S., R. 15 W.) of the remaining 120 acres of the burns' lease in consideration of 52 1/2 per cent of all oil and gas produced and saved from the premises. On July 29, 1922, the same parties entered into a further agreement in which M. B. Sanders, Trustee, sold all of its interest in this 40 acres for a total consideration of $61,088.12, the sale to take effect as of July 1, 1922. The material part of the latter agreement is as follows:
Whereas, on the 15th day of December, 1921, the said M. B. Sanders, Trustee, and Woodley Drilling Company, Inc., entered into a certain contract whereby *363 certain rights and privileges in said lease, so far as the same covered the said NE. 1/4 of NE. 1/4 of Section 32, Township*4129 18 South, Range 15 West, were granted to the said SECOND PARTY and certain duties were imposed upon it; said contract being recorded in Volume 128 in the records of Union County, Arkansas, at page 432; and
Whereas, it is the desire of FIRST PARTY to sell all of its right, title and interest in and to said lease to SECOND PARTY for a stipulated consideration to be paid and discharged in accordance with the terms and conditions of this contract; and
Whereas, it is the desire of SECOND PARTY to purchase all of the right, title and interest of said FIRST PARTY in and to said lease for the consideration and upon the terms and conditions hereinafter expressed and set forth:
Now, Therefore, the following contract of assignment has been made and entered into:
1.
FIRST PARTY for and in consideration of SIXTY ONE THOUSAND EIGHTY EIGHT & 12/100 ($61,088.12) Dollars, to be paid in accordance with the terms set forth in Paragraph Two following, does by these presents bargain, grant, sell, convey, transfer, deliver and assign unto and in favor of SECOND PARTY all of its right, title and interest in and to the oil, gas and mineral lease first described herein, in so far as same covers*4130 and effects the following described land, to-wit:
Northeast Quarter of North East Quarter (NE 1/4 of NE 1/4) Section Thirty Two (32), Township Eighteen (18) South, Range Fifteen (15) West, Union County, Arkansas.
2.
SECOND PARTY shall pay the said SIXTY ONE THOUSAND EIGHTY EIGHT & 12/100 ($61,088.12) Dollars, same being the consideration of this contract of assignment, to FIRST PARTY as follows:
(A) FIVE THOUSAND EIGHTY EIGHT & 12/100 ($5,088.12) Dollars cash in hand paid with the signing of this contract of assignment, the receipt of which is hereby acknowledged.
(B) FIVE THOUSAND & No/100 ($5,000.00) Dollars, represented by SECOND PARTY'S promissory note this date given and secured by FIVE THOUSAND & no/100 ($5,000.00) Dollars, par value, first mortgage Six per cent (6%) Gold Bonds of the Oakland Hills Country Club of Detroit, Michigan, which bonds are attached to said note and delivered with same to FIRST PARTY, with numbers and denominations, as follows:
| No. 722 | $1,000.00 |
| No. 738 | 1,000.00 |
| No. 740 | 1,000.00 |
| No. 742 | 1,000.00 |
| No. 186 | 500.00 |
| No. 183 | 500.00 |
| Total | 5,000.00 |
said note is payable to FIRST PARTY at the First National Bank of Shreveport, *4131 Louisiana, on the First day of November, 1922, upon the surrender and return of the said FIVE THOUSAND & No/100 ($5,000.00) Dollars, par value, of Six per cent (6%) Gold Bonds of the Oakland Hills Country Club attached to said note as security.
*364 (C) FIFTY ONE THOUSAND & No/100 ($51,000.00) Dollars to be paid by applying forth three and three-quarters (43 3/4%) per cent of the oil produced, saved and marketed from said lease, same being one-half (1/2) of the oil accruing to the seven-eighths (7/8) Working Interest under said lease, by delivering said 43 3/4% of said oil to the pipe line company with which said lease is connected for credit to the account of said FIRST PARTY until the said FIRST PARTY has received the said sum of $51,000.00.
3.
In further explanation of Article Two above, it is hereby understood and agreed by the Parties that effective as of July 1, 1922, all oil runs by the pipe line companies connected with said lease shall be credited as follows:
12 1/2% to Royalty Owners designated in the original lease,
43 3/4% to the Woodley Drilling Company, Inc., 43 3/4% to M. B. Sanders, Trustee, until he has received a sum of $51,000.00 referred to in*4132 Paragraph Two above, after which time 87 1/2%, or a total 7/8th Working Interest of said oil, shall be credited to the account of the said Woodley Drilling Company, Incorporated.
* * *
8.
In the event that the production from said lease becomes so small as to make production of oil a nonpaying operation on said lease before the said $51,000.00, to be paid out of oil as provided for in Paragraph Two above, is fully paid, and SECOND PARTY desires to abandon said lease, it is hereby agreed that SECOND PARTY shall so notify FIRST PARTY and before said abandonment shall give FIRST PARTY thirty days to test said production, permitting FIRST PARTY to operate the lease during said period of thirty days, and if, at the end of that time, FIRST PARTY desires to take over the wells on said property, he may do so by paying the operator for the casing in each well at the rate of Five Hundred and no/100 ($500.00) Dollars for each well it so elects to take over, it being understood that the SECOND PARTY may, after said thirty days test, remove all structures, machinery, pipe and equipment of whatever nature from said lease and abandon same; and in the event FIRST PARTY does not elect to purchase*4133 the casing then in wells, then the operator may also pull and remove casing from said wells. In case SECOND PARTY elects to abandon said lease and FIRST PARTY elects to purchase the casing in wells as above provided, then and in that event, after SECOND PARTY has removed its machinery, pipe, buildings, rigs and other equipment from the lease, SECOND PARTY shall assign its interest in said lease back to FIRST PARTY. * * *
During 1922 M. B. Sanders, Trustee, received at least $21,790.56 of the purchase price of the said rights to 40 acres sold to the Woodley Drilling Co. The respondent concedes that the amount of depletion sustained in connection with the said 40 acres in 1922 prior to sale and allowable to M. B. Sanders, Trustee, is $11,696.07.
On December 16, 1921, M. B. Sanders, Trustee, entered into an agreement with the firm of Harrell & Hatcher in which the latter agreed to operate a second 40 acres (NW. 1//4, sec. 32, T. 18, R. 15) of the Burns' lease in consideration of 58 per cent of all oil and gas produced and saved from the premises. The respondent *365 concedes that the amount of depletion sustained in 1922 and allowable to M. B. Sanders, *4134 Trustee, in connection with this second 40 acres is $13,119.10.
On December 16, 1921, M. B. Sanders, Trustee, entered into an agreement with the Fullilove Drilling Co., Inc., in which the latter agreed to operate the remaining 40 of the 120 acres (SE. 1//4, sec. 29, T. 18, R. 15) of the Burns' lease in consideration of 43.75 per cent of all oil and gas produced and saved from the premises until M. B. Sanders, Trustee, had received $250,000, at which time the title to such lease and leasehold rights was to vest in the Fullilove Drilling Co., Inc., subject to the terms and conditions of the original lease and the further condition that after 400,000 barrels of oil had been produced, M. B. Sanders, Trustee, was to receive 11.875 per cent of all oil produced and saved thereafter as long as oil was produced from the premises. The pertinent parts of this agreement are as follows:
Now, therefore, know all men by these presents:
That the undersigned M. B. Sanders, Trustee, for and in consideration of One Dollar to me in hand paid by the Fullilove Drilling Company, Incorporated, and the covenants, agreements and undertaking hereinafter set forth, to be paid, kept*4135 and performed by the said Fullilove Drilling Company, Incorporated, its successors and assigns, does hereby convey, transfer and assign all the right, title and interest of the original lessee and of the present owner therein, to the Fullilove Drilling Company, Incorporated, and its successors and assigns, in so far as the same covers and affects the following described lands, located in Union County, Arkansas, to-wit:
* * *
In consideration thereof the Fullilove Drilling Company, Inc., for itself, its successors and assigns, as follows, to-wit: [sic.]
1st. That it will pay unto the said M. B. Sanders, Trustee, his successor and assigns the sum of $250,000.00 out of the one-half of the first oil or gas produced and saved from said premises, under said lease and this assignment to be paid as follows, to-wit:
The Fullilove Drilling Company, Inc., will deliver to the credit of the said M. B. Sanders, Trustee, his successors or assigns, free of all cost in the pipe lines to which it may connect its wells, the equal one-half part and portion of all the oil produced and saved from said lands after deducting the royalty due under the terms of said lease until the full amount of*4136 $250,000.00 has been paid to the said M. B. Sanders, Trustee, at which time all payments hereunder shall cease and the title to said lease and leasehold rights shall vest absolutely in the said Fullilove Drilling Company, Inc., subject to the terms and conditions of said original lease.
* * *
3rd. That said Fullilove Drilling Company, Inc., covenants and agrees with the said M. B. Sanders, Trustee, his successors and assigns that it will, within five days from delivery of this agreement begin operations on said land for the drilling of two wells with due diligence to a depth of 2250 feet, unless oil or gas in paying quantities is discovered and produced at a lesser depth. And it will complete said wells in good and workmanlike manner, and in the drilling and *366 completion thereof will comply with all the laws, rules and regulations governing the drilling and completion thereof, now or that then be in force, under laws of the State of Arkansas. And that it will pay all costs of drilling said wells and will pay for all material and labor used in the drilling thereof; and protest said lease against any and all liens for labor done or material furnished in the drilling*4137 of said two wells or any other wells that it may thereafter drill on said lands.
* * *
7th. The Fullilove Drilling Company, Inc., further agrees that it will handle and operate any producing wells drilled by it on said land, in proper and approved manner, and will equip the same and operate the same at its own expense, and will use reasonable care and diligence to cause said wells to produce their maximum amount of oil or gas reasonably obtainable therefrom.
* * *
9th. It is further agreed and understood that, after the full sum of $250,000.00 has been paid as herein provided, to the said M. B. Sanders, Trustee, his successors and assigns and after the total amount of oil produced and marketed from said lands, amounts to 400,000 barrels, then the said Fullilove Drilling Company, Inc., shall in that event deliver to the credit of the said M. B. Sanders, Trustee, his successors and assigns, free of all cost in the pipe line or pipe lines to which it may connect its wells, the equal one-fourth of seven-eighths of all the oil produced and saved from said land, so long as oil is produced therefrom, as a one-fourth excess royalty, but until said leased premises shall have produced*4138 the full amount of 400,000 barrels of pipe line oil and the said M. B. Sanders, Trustee, shall have been paid out of his one-half of the same, as hereinbefore provided, the sum of $250,000.00 the said over-riding one-fourth royalty shall not attach or become effective.
* * *
13th. If the Fullilove Drilling Company, Inc., shall fail or refuse to perform any of its obligations hereunder, the said M. B. Sanders, Trustee, shall have the right to declare this assignment void and of no further effect. * * *
The amount of depletion sustained in 1922 and allowable to M. B. Sanders, Trustee, in connection with this last mentioned 40 acres is $29,119.19.
OPINION.
GREEN: We have set out in the findings all the facts necessary to recompute the deficiencies for both years. The basis for such findings consisted of an accountant's audit report as to income and expenses and an engineer's valuation report as to the amount of depletion allowable, together with certain depositions, which were offered in evidence by the petitioner and admitted without objection from the respondent.
The major issue in the case was the question of depletion for 1922. The respondent in his deficiency*4139 letter did not allow M. B. Sanders, Trustee, any depletion deduction, on the ground that the various agreements with Woodley Drilling Co., Harrell & Hatcher, and the *367 Fullilove Drilling Co., Inc., were in fact sales to those persons of all the trustee's rights in the Burns' lease, and having disposed of all its rights in the lease there remained no interest upon which depletion could be allowed. At the hearing, however, the respondent withdrew from this contention with respect to the 80 acres operated by the Woodley Drilling Co. until July 1, 1922, and Harrell & Hatcher during the entire year 1922, and conceded that the trustee was entitled to depletion on the production from such 80 acres in the respective amounts of $11,541.95 and $13,605.60. He offered no evidence as to how he arrived at these amounts and in the absence thereof we have accepted the proof given by the petitioner with one exception, namely, we have allowed depletion on the 40 acres operated by the Woodley Drilling Co. only on the production from January 1 to July 1, 1922, for the reason that we agree with the respondent that the agreement of July 29, 1922, between the trustee and the Woodley Drilling*4140 Co., set out in the findings, constituted a sale of the trustee's interest in such 40 acres as of July 1, 1922. The respondent has also conceded that only the amounts received on account of this sale in 1922 in excess of cost are taxable income for 1922. The record shows that the entire cost was returned in 1921 in computing the profit on the sale of the trustee's rights to the 400 acres. The entire amount received in 1922 as a part of the purchase price, which we have found was at least $21,790.56, constitutes taxable income of the trustee for that year. Cf. .
Addressing ourselves to the agreement of December 16, 1921, between the trustee and the Fullilove Drilling Co., Inc., we agree with the petitioner that under that agreement the trustee did not part with all of his interest in the 40 acres there involved. Although legal title was to pass to the Fullilove Drilling Co., Inc., as soon as the latter had paid the trustee $250,000, out of one-half of seven-eighths of all the oil produced and saved, it passed with the condition that as soon as 400,000 barrels had been produced, the trustee was to receive as an excess royalty*4141 one-fourth of seven-eighths of all the oil produced thereafter for as long as production continued. The effect of the agreement was merely to change the basis of the over-riding royalty due the trustee from one-half to seven-eighths to one-fourth of seven-eighths of all the oil produced. Under such circumstances we are of the opinion that the Trustee is entitled to a depletion deduction on his interest retained in accordance with section 214(a)(10) of the Revenue Act of 1921. In accordance with the evidence we find this deduction to be $29,119.19 for the year 1922. The petitioner's one-eighth interest in the net income of M. B. Sanders, Trustee, for the year 1922 is, therefore, $4,289.42, instead of $10,842.30 *368 determined by the respondent. The amount of $4,289.42 is arrived at as follows:
| Gross income of trustee: | ||
| Income from oil sales and interest | $77,325.20 | |
| Income from sale of lease rights | 21,790.56 | |
| Total | 99,115.76 | |
| Less deductions of trustee: | ||
| Expenses | $10,866.04 | |
| Depletion (Woodley Drilling Co.) | 11,696.07 | |
| Depletion (Harrell & Hatcher) | 13,119.10 | |
| Depletion (Fullilove Drilling Co.) | 29,119.19 | |
| Total deductions | 64,800.40 | |
| Net income of trustee for 1922 | 34,315.36 | |
| Petitioner's one-eighth share | 4,289.42 |
*4142 Judgment will be entered on 15 days' notice, under Rule 50.