*887 1. The petitioner drilled oil wells for others for specified amounts payable out of the proceeds derived from the sale of a proportion of the first oil produced and saved from the property. The rights thus acquired to future income are contingent and the fair market value thereof is not accruable as taxable income.
2. The drilling of the wells did not result in the acquisition of a capital asset by the petitioner and costs incurred by it in completing the wells are deductible as ordinary and necessary business expenses.
*342 This proceeding involves the redetermination of a deficiency of $4,975.03 in income tax for the period February 4 to December 31, 1931. The petitioner alleges that the respondent erred in including in its income the sum of $40,821.99 as the present worth of rights acquired to receive payments from proceeds of oil for drilling three wells. The respondent alleges, in the alternative, that he erred in allowing as a deduction the sum of $36,113.11 representing the cost*888 of drilling the wells.
FINDINGS OF FACT.
The petitioner, a Texas corporation organized February 4, 1931, is and was during the taxable period engaged in the business of drilling oil and gas wells.
During the taxable period the petitioner regularly employed the accrual method of accounting.
On October 6, 1931, the petitioner entered into a contract with the Sabinas Oil Corporation for the drilling of two oil and gas wells, known as Falvey No. 1 and Falvey No. 2, on a tract of land situated in the southeast corner of Upshur County, Texas, which the Sabinas Oil Corporation held as lessee. The provision of the contract relating to the consideration to be paid for drilling of the wells reads as follows:
In consideration of the agreement and obligations on the part of second party [petitioner] to be done and performed, as above set out, first party [Sabinas Oil Corporation] does hereby agree, bind and obligate himself, his successors and assigns, to deliver to the credit of second party, its successors and assigns, 14/32nds of all the first oil and/or gas, if, as and only when same is produced, saved and marketed from said leasehold estate until second party shall have*889 received the sum of $20,500.00, which shall be taken and accepted by second party as payment in full for the drilling of Well No. 1; provided, further, it is expressly agreed and understood that should second party drill Well No. 2 second party shall be entitled to receive, in addition to the $20,500.00 from 14/32nds of the first oil and/or gas produced, saved and marketed from said leasehold estate, an additional sum of $20,500.00; to be paid, however, from said oil produced, saved and marketed from said leasehold estate after the first payment of $20,500.00 shall have been fully paid. In other words, it is expressly agreed and understood between the parties that not more than 14/32nds of the oil, gas and other minerals shall ever be obligated to second party to discharge the obligation due for the drilling expense of said wells.
On October 8, 1931, the petitioner entered into a written contract with F. D. Spratt to drill an oil and gas well, known as Bumpas No. 1, on land situated in the city of Gladewater, Gregg County, Texas, which was under lease to Spratt. The petitioner was to receive compensation for drilling the well as set forth in the following provision of the contract:
*890 First party [F. D. Spratt], in consideration of the agreement and obligations on the part of second party [petitioner], as above set out, does hereby sell, assign, transfer and convey unto second party, its successors and assigns, *343 three-eights of seven-eighths of all the first oil, if, as and only when same is produced, saved and marketed from the above described leasehold estate until it shall have received the sum of fifty thousand ($50,000.00) dollars free of cost, and to that end it is expressly agreed by and between first and second parties that the sale of said oil shall be vested in first and second party, and fist and second party may contract with some major purchasers of oil as they may desire for the entire production of said well; provided, however, that the price received shall not be less than the standard price paid for oil of like kind and character by the leading purchasers of crude oil in the East Texas oil field.
The three wells were completed and producing oil in 1931. Upon their completion the wells were delivered to the respective owners for operation. The cost of drilling the wells was:
| Bumpas No. 1 | $13,638,87 |
| Falvey No. 1 | 10,348.75 |
| Falvey No. 2 | 12,125.49 |
| Total | 36,113.11 |
*891 At some undisclosed date prior to April 6, 1932, the petitioner assigned its right to $11,500 of the $50,000 payable to it under the contract with Spratt to a broker as commission for enabling it to acquire the drilling contract. In February 1932 Spratt paid the petitioner $2,361.45 under the terms of the contract. On April 6, 1932, the petitioner sold its remaining interest in the contract, amounting to $36,138.55, for $9,250 cash. The following amounts were received by the petitioner under the contract entered into for drilling the Falvey wells:
| Falvey No. 1 | Falvey No. 2 | |
| 1931$364.31 | $1,457.24 | |
| 1932 | 9,946.07 | 9,946.07 |
| 1933 | 4,875.72 | 1,875.72 |
| 1934 | 4,513.90 | 1,220.97 |
| 1935 | 800.00 | |
| Total | 20,500.00 | 20,500.00 |
The cost of the wells, which included amounts for wages, repairs, rental of equipment, hauling, water, fuel, and casing and other material, was charged to accounts kept for each well. The amounts received for drilling the well were credited to the accounts. At the close of 1931 the debit balance in each account was charged to profit and loss as an expense incurred in drilling the wells. At the same time the petitioner closed the accounts*892 kept for 29 other wells not in controversy and entered the credit balances therein in its profit and loss account as earnings.
The Railroad Commission of the State of Texas limited the daily production of Bumpas No. 1 to about 125 barrels, and each of the Falvey wells to about 100 barrels. There was considerable "not oil" (oil in excess of production allowed by the Railroad Commission of *344 Texas) produced in the Gladewater district, but only a small amount in the district in which the Falvey wells were located.
There was no fixed price for oil in the latter part of 1931 or the early part of 1932. Purchasers received oil in their pipe lines and about 30 days thereafter informed the sellers the price they would pay for it.
In the latter part of 1931 the fair market value of the future payments under the drilling contracts which the petitioner entered into with the Sabinas Oil Corporation and Spratt was $20,500 and $9,250, respectively.
In its income tax return for the taxable period the petitioner included in gross income the sum of $1,821.55 for the cash received in 1931 under the two contracts, and deducted as an ordinary and necessary business expense the amount*893 of $36,113.11 as the cost of drilling the wells. In his determination of the deficiency the respondent did not disturb the deduction so taken, but determined that the future payments had a present worth of $40,821.99, and increased petitioner's reported income by that amount.
OPINION.
DISNEY: Involved in the issue raised by the petitioner is the question of whether petitioner's tax liability should be determined on the cash or accrual basis of accounting. The petitioner claims it regularly employed the cash basis of accounting, not the accrual method, as determined by the respondent.
As part of its system of accounting, the petitioner maintained accounts designated notes receivable, accounts receivable, and others generally found in books kept according to the accrual method. It consistently entered expense items in its books as they were incurred, and all of such charges, except the one for Federal income tax, a nondeductible business expense, were taken into account in the computation of net taxable income. The fact that petitioner's books as of the close of 1931 did not reflect more receivables and payables was, as the evidence shows, due to prompt payment of liabilities*894 and the nature of petitioner's business, rather than its adopted method of accounting. The evidence on the point sustains, rather than overcomes, the respondent's finding that the petitioner regularly employed the accrual basis of accounting. Accordingly, the petitioner's net income will be determined by that accounting method. See Aluminum Castings Co. v. Routzahn,282 U.S. 92">282 U.S. 92; Nibley-Mimnaugh Lumber Co.,32 B.T.A. 791">32 B.T.A. 791; Louis Kamper,14 B.T.A. 767">14 B.T.A. 767; Coatesville Boiler Works,9 B.T.A. 1242">9 B.T.A. 1242.
The respondent argues that, the wells having been completed in 1931 pursuant to the contracts, in that year the petitioner definitely *345 established its right to payments out of oil and realized taxable income to the extent of the cash received, plus the fair market value of the contract right to future payments, against which it may apply "as its basis for determining its gain from said transactions in 1931, the cost of drilling the wells." The contention of the petitioner is that the drilling costs are deductible as ordinary and necessary business expenses and that, because of the indefinite and contingent character*895 of the right to future payments out of oil, only the cash actually received is taxable as income.
Under the accrual method of accounting employed by the petitioner, items must be accrued as income when the events occur to fix the amount due and determine liability to pay. United States v. Anderson,269 U.S. 422">269 U.S. 422. The rule does not, however, extend to transactions in which the right is subject to contingencies which may never happen. "Generally speaking, the income-tax law is concerned only with realized losses, as with realized gains" (Lucas v. American Code Co.,280 U.S. 445">280 U.S. 445), and a taxpayer is under no obligation to pay a tax on income he might never receive. North American Oil Consolidated v. Burnet,286 U.S. 417">286 U.S. 417.
This exception to the general rule has been recognized in numerous cases. In Commissioner v. Cleveland Trinidad Paving Co., 62 Fed.(2d) 85, affirming 20 B.T.A. 772">20 B.T.A. 772, certain cities retained a percentage of the contract price for street paving to guarantee maintenance of the pavements for an agreed period. In holding that the amounts withheld by the cities were not taxable*896 as income earned during the year in which the contracts were completed, the court remarked that "Until the expiration of the period of guaranty the obligations of the several municipalities remained only a contingent promise to pay."
Commissions on renewal premiums paid under policies of insurance written prior to March 1, 1913, do not constitute taxable income until received because of the contingent character of the right. Woods v. Lewellyn,252 Fed. 106; Workman v. Commissioner, 41 Fed.(2d) 139, affirming 14 B.T.A. 1414">14 B.T.A. 1414.
In McPherson v. Helvering, 67 Fed.(2d) 749, affirming 22 B.T.A. 196">22 B.T.A. 196, the partnership of which McPherson was a member performed services prior to March 1, 1913, in connection with the purchase and protection of timber lands for which it was to receive a percentage of the net profits "if, when, and as fast as" the lands were sold. The petitioner contended that the amounts received by the partnership for services rendered were not taxable until it had recovered the fair market value on March 1, 1913, of the right to future income. The Board and the court were unable to agree*897 with this idea and taxed the amounts received under the contract during *346 the taxable years without any deduction for the alleged March 1, 1913, value of the contingent right to income.
In 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 *898 E. F. Simms, supra, "A 'gusher' of today may be a mere 'pumper' or even a dry hold 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 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; *899 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 the drilling contracts.
Under the alternative issue the respondent argues that the drilling costs "were capital in their nature", and under the provisions of section 24(a)(2) of the applicable statute 1 and rulings of the courts *347 and the Board are not deductible as ordinary and necessary business expenses.
The completion of producing wells results in the acquisition by the lessees of capital assets, the cost of which is*900 recoverable therough depletion deductions. United States v. Dakota-Montana Oil Co.,288 U.S. 459">288 U.S. 459. But it does not necessarily follow that the expense incurred by the petitioner in drilling the wells resulted in the acquisition by it of a like asset. The petitioner undertook to drill the wells not for itself, but for the losses; hence upon their completion it had nothing as the result of its expense other than a claim for the contract price, payable out of the proceeds of oil and gas marketed from the wells. The petitioner so construed the contracts. It did not capitalize its outlay or enter the consideration for drilling the wells on its books as an account receivable. A contingent right to future income is not a capital asset. Workman v. Commissioner, supra, and McPherson v. Commissioner, supra.The petitioner was engaged extensively in a regular business, drilling oil or gas wells, and, considering the extent of its business and the fact that its books were kept on a consistent basis, we think that petitioner's income was reflected by its returns as nearly as possible under the circumstances.
*901 If the expenses were capital expenditures, as respondent argues, then that which the petitioner received was capital. But in Gilbert v. Commissioner, 56 Fed.(2d) 361, the Circuit Court of Appeals for the First Circuit held that stock received by a contracting firm as pay for constructing a building was income and not a capital asset. The court took that view in spite of the fact that the stock was held for more than two years, adhering to the idea that it was property held by the taxpayer primarily for sale in the course of his trade or business. In the body of the opinion the court observed:
It is not uncommon for engineering or contracting firms to take their pay in stock, as the petitioners did in these cases. This stock was income when received; it remained income for two years; and thereafter it continued to be "property held by the taxpayer primarily for sale in the course of his trade or business."
The cases relied upon by the respondent to support his contention are clearly distinguishable from the instant case.
In *902 State Consolidated Oil Co. v. Commissioner, 66 Fed.(2d) 648, certiorari denied, 290 U.S. 704">290 U.S. 704, the taxpayer, as consideration for drilling a well, first recovered his cost of drilling and equipping the well and $1,400 out of sales of oil and gas, and thereafter, subject to no contingency, received an undivided one-half interest in the lots owned by the persons for whom the well was drilled, including the well and its equipment, and one-half of the proceeds derived from the sale of oil and gas produced by the well.
*348 In Consolidated Mutual Oil Co.,2 B.T.A. 1067">2 B.T.A. 1067, the expense involved the redrilling and deepening of an oil well by the owner thereof for his own account to put it on a productive basis. The cost was held to be a capital expenditure, recoverable through depreciation or depletion.
The case of Old Farmers Oil Co.,12 B.T.A. 203">12 B.T.A. 203, involved the drilling of a well for the taxpayer and we held that the transaction resulted in the acquisition by taxpayer of a capital asset.
In *903 Blockton Cahaba Coal Co. v. United States, 24 Fed.(2d) 180, the expenditure was made by the taxpayer to increase the depth of a coal mine and it was held that the cost should be included in invested capital.
The case of Nunn-Stubblefield Oil Co.,31 B.T.A. 180">31 B.T.A. 180, is like State Consolidated Oil Co. v. Commissioner, supra, except that as Consideration for its drilling operations the taxpayer acquired an interest in an oil and gas lease, dependent upon no contingency.
The petitioner properly deducted the cost of drilling the wells as an ordinary and necessary business expense.
Reviewed by the Board.
Decision will be entered under Rule 50.
LEECH, dissenting: In my opinion, the petitioner in this case occupies a position no different from that of any other purchaser of oil payment contracts. Certainly, it would not be held that a bank purchasing contracts of this character for cash, as is often done, has expended that money as an ordinary and necessary business expense and not as the cost of a capital asset. The use of labor and material, instead of money, in the acquisition of these oil payment*904 contracts, in my judgment, does not justify any different conclusion. Burnet v. Logan,283 U.S. 404">283 U.S. 404.
Any other treatment results in a clear distortion of income, as repugnant to the controlling law as it is to common sense.
Footnotes
1. SEC. 24. ITEMS NOT DEDUCTIBLE.
(a) General rule. - In computing net income no deduction shall in any case be allowed in respect of -
* * *
(2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. ↩