*76 Held: A royalty provision requiring petitioner to execute nonrecourse promissory notes payable solely out of coal production and secured only by mining rights under a coal sublease, as well as to pay cash and to execute a recourse promissory note, is not a "minimum royalty provision" within the meaning of
*969 OPINION
Respondent determined deficiencies in petitioner's Federal income taxes for taxable years 1977 and 1978 of $ 83,164.63 and $ 27,267.85, respectively. The case is before this Court on respondent's motion for partial summary judgment under Rule 121 1 on the issue of whether petitioner may deduct her claimed losses for the years in issue to the extent they resulted from alleged advanced minimum royalty payments.
*78 At the time she filed her petition in this case, petitioner resided in Colts Neck, New Jersey. Petitioner filed Federal *970 income tax returns, on which she elected the accrual method of tax accounting, for 1977 and 1978.
In her objection to respondent's motion, petitioner claims the following: 2 The Grand Coal Venture (GCV), a partnership electing under section 761(a)(2) to be excluded from the provisions of subchapter K, was formed during 1977 for the purpose of developing and mining certain coal-bearing property. Petitioner, based in large part upon a preliminary geologist's report attached to the GCV offering memorandum that estimated "probable minimum reserves" of 30-million tons of lignitic coal at a depth of less than 200 feet, decided to invest in GCV. On December 31, 1977, she executed a sublease agreement with Ground Production Corp. (the lessee of the property and petitioner's sublessor) for the right to mine coal, a subscription agreement with GCV for 7.2 units, a nonrecourse note in favor of Ground Production Corp., and a security agreement for the note. In relevant part, the sublease agreement provided as follows:
Subject to the terms, provisions and conditions*79 hereof and of the Lease, the Sublessor does hereby sublet unto the Sublessee the Percentage Interest in all of the coal contained in, on and underlying the tracts of land * * *, and the mining rights and privileges appurtenant thereto * * * for a period of [8] years 3 from the date hereof, provided however that the term of this Lease may be extended from year to year at the option of the Sublessee * * * until the Sublessee shall have mined and removed all merchantable coal from the Property.
* * * *
Sublessee agrees that for each twelve month period during the term hereof (the "term" being the initial year period plus all extensions), but not to exceed a total of 20 years (although this Sublease may be further extended) commencing with the date hereof and ending one year thereafter (each such twelve month period is hereinafter referred to as a "term year"), it will pay to Sublessor a non-refundable minimum annual royalty of $ 40,000 (FORTY THOUSAND DOLLARS) (the "Minimum Annual Royalty") payable as hereinafter provided. * * *
At the closing the Sublessor requires payment of the Minimum Annual Royalty for the first year of the term of the Sublease in the amount of *971 $ 40,000.00*80 per Unit ($ 10,000.00 in cash and $ 30,000.00 by non-recourse Note per Unit) and in addition $ 10,000.00 per Unit (toward the second year's Minimum Annual Royalty) by the Sublessee's delivering his Recourse Promissory Note * * *
On or before December 31, 1978, the Sublessee shall execute and deliver his Non-Recourse Note for $ 30,000.00 per Unit and on or before December 31, 1979, and each year thereafter the Sublessee shall execute and deliver his Non-Recourse Promissory Note for $ 40,000.00 per Unit.
The Non-Recourse Promissory Notes will bear interest at the rate of 10% per annum or the maximum legal contract rate of interest, whichever is less, and shall be due and payable on December 31, 1997. The Promissory Notes will require payments of $ 2.00 per ton of coal mined, removed, shipped and sold to be applied first toward payment of accrued interest and the balance in reduction of principal.
* * * *
Sublessor shall look solely to the security interest given by Sublessee to Sublessor in certain property and assets of the Sublessee, for the payment of the Minimum Annual Royalty Note [nonrecourse] * * * In no event shall the Sublessee be personally liable for the payment of the * *81 * * Note * * * and in the event of any default hereunder or under the * * * Note no deficiency or other personal judgment will be rendered or entered against the Sublessee with respect to the obligations evidenced hereby or by the * * * Note.
The nonrecourse promissory notes executed by or for petitioner in 1977 and 1978 required monthly payments of $ *82 2 per ton of coal mined, removed, and shipped from the property, "provided, however, that in the event such monthly installments have not theretofore been sufficient to pay this Note in full, the unpaid principal balance of this Note and all unpaid and accrued interest shall be due and payable on December 1, 1997." 4 The notes each also provided that --
The holder of this Note shall look solely to the property and assets covered by the Security Agreement for the payment of this Note and the performance of the Participant's obligations hereunder and in no event shall the Participant be personally liable for the payment of the Note or the performance of the obligations hereunder. In the event of any default hereunder, no deficiency or other personal judgment shall be rendered or entered against the Participant with respect to the obligations evidenced by this Note.
*83 *972 The security agreement grants to Ground Production Corp. a security interest in all coal lying under the property, petitioner's interest in all personal property thereon, and all accounts receivable, contract rights, and general intangible rights to the payment of money for coal, goods, and services that may become due to petitioner as a result of the mining, processing, and sale of coal from the property. A security interest in the proceeds from all of the above property was also given.
Petitioner paid $ 78,000 cash and executed a nonrecourse note for $ 216,000 (i.e., $ 30,000 X 7.2 units) in 1977, and executed a recourse note for $ 78,000 and a nonrecourse note for $ 216,000 in 1978. 5 No mineral product was produced or sold by petitioner or GCV during the years in issue.
*84
in the case of advanced mineral royalties paid or accrued in connection with mineral property as a result of a minimum royalty provision, the payor, at his option, may instead treat the advanced royalties as deductions from gross income for the year in which the advanced royalties are paid or accrued. See
Initially, petitioner argues that, irrespective of the impact of
Petitioner next contends that the requirement under the sublease agreement that nonrecourse notes be executed in the amounts of $ 30,000 per unit for the first 2 years and $ 40,000 per unit per year thereafter for the remainder of the sublease term satisfies the regulation, in that the royalty provision requires yearly accruals of royalties. Respondent argues that because the nonrecourse notes are payable solely out of the proceeds of coal production, the sublease agreement does not require a substantially uniform annual royalty, and thus does not contain a "minimum royalty provision," within the meaning of the regulation. Thus, respondent argues that, as a matter of law, petitioner may deduct royalties only to the extent that coal was sold during the years*87 in issue. For the reasons hereinafter stated, we agree with respondent.
The interpretation of
More recently, in
In the instant case, petitioner is obligated annually to "pay to Sublessor a non-refundable minimum annual royalty of $ 40,000" per unit, "payable as hereinafter provided," until the earlier of the termination date of the sublease and December 31, 1997. However, as in Wing and Maddrix, the substance of the entire transaction undoes what appears at first glance to *975 be a uniform annual requirement. According to the documents, petitioner's "payments" are for the most part to consist of nonrecourse notes, which are payable in monthly*90 amounts calculated per ton of coal shipped; the note balances not paid in this way come due on December 1, 1997 -- some 20 years after the date of execution of the notes in question. In the event of default, the holder's sole recourse is against the securing property, i.e., petitioner's interest in the coal and its proceeds. The sublease agreement runs through 1985, but is renewable, if petitioner so chooses, from year to year until all the merchantable coal is removed.
Petitioner contends that
However, petitioner raises a legal issue not discussed in Wing or Maddrix, i.e., that the express, repeated reference in*93
On one hand, the language of the regulation allows a deduction for advanced royalties paid or accrued as a result of a minimum royalty provision "in the year in which the royalties were paid or accrued"; on the other hand, it defines a minimum royalty provision as one that "requires that a substantially uniform amount of royalties be paid at least annually."
*977
Just as nonrecourse notes upon which payment is wholly contingent on production are so illusory as to be "inherently inconsistent with the regulatory definition of a minimum royalty provision" (
In the instant case, the facts put forth by petitioner reveal that repayment of the notes in question is, at least*97 until December 1, 1997, wholly contingent on production. Thus, *978 petitioner's only possible argument, under the broad interpretation of
While there may be situations in which taxpayers may properly accrue liabilities under nonrecourse notes (a question we need not address), the instant case is not one of those situations. The property securing petitioner's notes was nothing more than the right to mine coal from the subject land for a limited period of time, and the right to any proceeds therefrom. Unlike other types of property, this property by definition had absolutely no value apart from the anticipated stream of income*98 from the production of coal. Thus, the value of the property securing eventual payment of the notes was no less contingent on production than was the periodic payment obligation. Consequently, petitioner's nonrecourse note obligations were wholly contingent on production. See
*99 *979 We hold, as a matter of law, that all the events necessary to establish liability on the notes in question did not occur during the years in issue, and that accruals of the royalty obligations would therefore be improper. See
Thus, even if the definition of "minimum royalty provision" under
An appropriate order will be entered.
Footnotes
1. All Rule references are to the Rules of Practice and Procedure of this Court, and, unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue.↩
2. We note that we view the facts and inferences to be drawn therefrom in the light most favorable to the party opposing the motion for summary judgment, i.e., petitioner.
Wright v. Commissioner, 84 T.C. 636">84 T.C. 636 , 638↩ (1985). Moreover, respondent assumes, for purposes of his motion, that the transactions took place as described in the documents.3. We note that the copies of the sublease agreement submitted by each party as exhibits leave the number of years blank. However, the offering memorandum mentions 8-year subleases, and respondent, in the memorandum of law in support of his motion, characterizes the sublease as an "8 year lease."↩
4. There is no explanation given for the discrepancy in the due dates between the notes and the sublease agreement. The discrepancy is immaterial insofar as concerns our decision herein.↩
5. We note that petitioner would appear to be obligated under the sublease agreement only to pay $ 72,000 cash in 1977 and to execute a $ 72,000 recourse note in 1978 (i.e., $ 10,000 X 7.2 units). Petitioner's moving papers allege, in a footnote, that the note should have been in the amount of $ 210,000, and that, in any event, petitioner claimed only $ 288,000, and not the full $ 294,000 "paid," as a deductible royalty expense in each of the years in issue.↩
6. For a discussion of the economics of minimum royalty provisions, see
Wing v. Commissioner, 81 T.C. 17">81 T.C. 17 , 38↩ n. 30 (1983).7. Neither party brought
Maddrix v. Commissioner, 83 T.C. 613">83 T.C. 613↩ (1984), on appeal (11th Cir., Mar. 12, 1985), to the Court's attention, although the opinion was published on Oct. 22, 1984, respondent's motion was not filed until Dec. 20, 1984, and petitioner's response to said motion was filed on Feb. 14, 1985.8. Petitioner treats the sublease term as extending for 20 years from Dec. 31, 1977, on the basis that the initial 8-year term could, at her option, be extended until Dec. 31, 1997. Assuming, but not deciding, that petitioner's treatment is correct, it can do no more than to put her in the same position with regard to the sublease term as the taxpayer in
Maddrix v. Commissioner, supra↩. 9. For an explanation of the relationship between the First and Third Circuits' holdings on the accrual issue and this Court's opinion in
Brountas v. Commissioner, 73 T.C. 491">73 T.C. 491 (1979), seeSaviano v. Commissioner, 80 T.C. 955">80 T.C. 955 , 963↩ n. 9 (1983).10. We note that this conclusion is further supported by the cases denying the inclusion of contingent nonrecourse liabilities in the cost basis of property acquired. See, e.g.,
Brountas v. Commissioner, 692 F.2d 152">692 F.2d 152 , 157-158 (1st Cir. 1982), vacating and remanding on other grounds73 T.C. 491">73 T.C. 491 (1979);Denver & Rio Grande Western R.R. Co. v. United States, 205 Ct. Cl. 597">205 Ct. Cl. 597 , 505 F.2d 1266">505 F.2d 1266 (1974);Estate of Baron v. Commissioner, 83 T.C. 542">83 T.C. 542 , 549-553 (1984), on appeal (2d Cir., Mar. 26, 1985). A taxpayer claiming a current deduction has no better claim than one seeking an increased cost basis."The only difference lies in the nature of the expense, generally speaking, whether the expense creates an asset with a useful life greater than 1 year. Thus, those cases which do not recognize a note or an obligation for purposes of computing the basis of an asset are equally applicable when the taxpayer is claiming a current expense. An expenditure funded with the proceeds of a contingent obligation represents neither a payment by, or cost to, a taxpayer for tax purposes. [
Graf v. Commissioner, 80 T.C. 944">80 T.C. 944 , 949 (1983); fn. ref. omitted.]"We reject petitioner's argument that the Supreme Court's opinion in
Commissioner v. Tufts, 461 U.S. 300 (1983) , requires recognition of nonrecourse debt for purposes of accrual. The Court's holding in Tufts that a transfer of property encumbered by a nonrecourse liability results in realization of income to the extent of the liability does not require that nonrecourse debt not be considered illusory in other contexts. SeeOdend'hal v. Commissioner, 748 F.2d 908">748 F.2d 908 , 913 (4th Cir. 1984), affg.80 T.C. 588">80 T.C. 588 (1983);Graf v. Commissioner, supra at 952-953 . The Tufts↩ case does not alter our analysis regarding accrual of liabilities in the instant case.