*866 Petitioners entered into contracts with a partnership for the drilling of oil wells on their properties on a "cost-plus" basis. The partnership agreed to furnish certain equipment and petitioners agreed to pay the entire cost of drilling the wells, including materials and labor, plus a bonus to the partnership of approximately $5,000 for each well, the exact amount of which was to be determined on a sliding scale based on actual cost of drilling each well. When the partnership procured materials and hired labor the costs thereof were charged to petitioners' account and when the wells were completed the petitioners, after examining invoices, payrolls, etc., paid such costs plus the bonus then determined. Held, petitioners are entitled, under Regulations 86, article 23(m)-16, to deduct the intangible drilling and development costs of the wells paid during the taxable year.
*1405 The respondent has determined a deficiency against each petitioner in income tax for the year 1934 in the amount of $6,073.45. The only*867 question presented is whether petitioners are entitled to deduct, as intangible drilling and development costs, certain amounts paid for the drilling of oil wells.
FINDINGS OF FACT.
The petitioners are husband and wife, residing at Fort Worth, Texas. They filed separate income tax returns for the taxable year 1934 with the collector for the second district at Dallas, Texas.
On February 12, 1934, petitioner, W. D. Ambrose, entered into a written agreement with Ross Drilling Co., a partnership, relative to the drilling of an oil well on the south one-half of a 40.46-acre tract known as the Jones lease, in Gregg County, Texas. The petitioner and the Ross Drilling Co. are referred to in the agreement as the first party and the second party, respectively, which agreement provides in part as follows:
WHEREAS, First Party is the owner of the entire 7/8ths working interest in the following described oil and gas lease, subject to an oil payment balance of $27,639.09 as of October 15th, 1933, in favor of Charles Pettit from 1/8th of the production from said lease as outlined in that certain assignment of record dated October 26th, 1933, in which said lease is conveyed to First Party*868 by Amada Oil Company, a Texas corporation:
* * * *1406 together with five producing oil wells and all personal property used in connection therewith and located thereon; and
WHEREAS, First Party is desirous of drilling well No. 3 upon said property and Second Party has agreed to drill and complete said well No. 3 for the consideration and upon the terms and conditions following:
1 - First Party represents that he holds a valid Permit from the Railroad Commission of Texas authorizing the drilling of said well No. 3 at a location known to both parties.
2 - Second Party agrees to furnish all machinery, tools, pipe, tubing, material and labor of every kind and character necessary for the drilling and equipping of said well No. 3, into the tanks now located on said lease. Second Party shall carry Workmen's Compensation and Public Liability Insurance during the period of its operations hereunder. The drilling of said well No. 3 shall be begun at once and Second Party agrees to continue said drilling with due diligence and in a good and workmanlike manner until said well is completed.
3 - Second Party agrees to use casing, tubing and connections that will be first approved*869 by and acceptable to First Party - it being understood between the parties hereto that a wooden derrick, second hand surface casing, new 7" OD 22# seamless oil string and 2 1/2" new upset tubing will be used on said well. If materials brought to the location shall not be satisfactory to First Party, the Second Party agrees to replace same with materials which meet the approval of First Party.
4 - It is agreed between the parties hereto that this contract is given by First Party and accepted by Second Party on what is commonly known as a "COST-PLUS" basis.
5 - Second Party shall keep an accurate record of all drilling costs hereunder, which costs shall include a drilling rig rental charge of not to exceed Seven Hundred Fifty ($750.00) Dollars.
6 - When said well No. 3 has been completed, as aforesaid, First Party shall be indebted to Second Party for the cost of drilling said well No. 3 and its profit, as hereinafter provided, said cost to be the sum shown by statement furnished by Second Party to First Party, accompanied by supporting invoices showing all charges appearing in said statement.
7 - It is agreed between the parties hereto that Second Party shall include in*870 said statement, as its profit for the drilling of said well No. 3, the sum of Five Thousand ($5,000.00) Dollars, plus a sum equivalent to the difference between the actual cost of drilling and Ten Thousand ($10,000.00) Dollars - if said actual cost of drilling is $10,000.00 or less. Should actual cost of drilling exceed $10,000.00, Second Party shall include in said statement, as its profit for the drilling of said well No. 3, the sum of $5,000.00; and actual cost of drilling in excess of $10,000.00 shall be shared equally between the parties hereto. The following table illustrates this arrangement:
| Actual Drilling Costs | Second Party's Profit | Cost to First Party |
| $9,000.00 | $6,000.00 | $15,000.00 |
| 10,000.00 | 5,000.00 | 15,000.00 |
| 12,000.00 | 4,000.00 | 16,000.00 |
8 - This contract shall be deemed complete, insofar as Second Party is concerned, when said well No. 3 is fully completed and producing oil into the tanks.
In accordance with the terms and conditions of the above agreement, the well referred to therein, known as the Jones #3, was drilled to completion on February 25, 1934. During that year the Ross Drilling Co. drilled for the petitioner on the same*871 tract of land three additional *1407 wells, known as Jones #2, #10, and #9, under written agreements containing provisions substantially identical to the above quoted portion of the written contract relative to Jones #3.
Prior to the taxable year and during 1933 the Ross Drilling Co. drilled for the petitioner four wells on the same tract of land under a written agreement containing provisions substantially similar to the above quoted portion of the contract relating to Jones #3. That agreement, dated October 30, 1933, also contained the following provisions:
11 - It is agreed between the parties hereto that Second Party [Ross Drilling Co.] shall manage, control and operate said property until all sums due it hereunder have been paid. Second Party agrees that oil will not be marketed from the wells at a price lower than the prevailing posted price in the East Texas field by a majority of the responsible oil purchasing companies operating in that field. For the management of said property, effective as of November 1st, 1933, it is agreed between the parties hereto that Second Party shall be allowed a fixed overhead charge of One Hundred ($100.00) Dollars per month - *872 said overhead charge to include all superintendence and bookkeeping. All other charges against the property shall be for actual labor and supply bills incurred in the operation thereof.
In connection with the drilling of the four wells in 1934, the petitioner furnished the following items: (1) Drilling permits; (2) surveying preparatory to drilling; (3) water and fuel used in the drilling operations; (4) separator for each well; and (5) flow lines and tanks. The written contracts contained no provisions relating to the procurement of these items. The water and fuel were obtained from wells previously drilled on the lease, which if purchased from outside sources would have cost approximately $1,000 per well. The wells were drilled to a depth of approximately 3,600 feet.
During 1934 the Ross Drilling Co., as agent for petitioner, kept all his books and records for a monthly charge. These records showed all of his income from oil runs and other sources. Petitioner kept no other books. The company kept a complete record of the intangible drilling and development costs in connection with the drilling of each of the four wells during 1934 and charged them to petitioner's account, *873 a summary of which is as follows:
| Jones lease wells | |||||
| #3 | #2 | #10 | #9 | Total | |
| Labor | $1,133.00 | $1,064.00 | $1,848.00 | $1,196.00 | $5,241.00 |
| Rig Rental | 700.00 | 850.00 | 750.00 | 750.00 | 3,050.00 |
| Cement | 166.60 | 185.00 | 286.68 | 638.28 | |
| Cementing | 240.00 | 240.00 | 240.00 | 240.00 | 960.00 |
| Trucking | 250.00 | 444.25 | 214.35 | 347.50 | 1,256.10 |
| Teaming & Pits | 183.00 | 121.50 | 86.50 | 90.50 | 481.50 |
| Comp. & Pub. Lia. Insurance | 162.49 | 151.62 | 262.11 | 163.81 | 740.03 |
| Fire Insurance | 105.00 | 105.00 | |||
| Skidding Derrick | 387.00 | 172.75 | 168.60 | 332.65 | 1,061.00 |
| Incidentals | 65.50 | 83.95 | 103.45 | 118.05 | 370.95 |
| Total | 3,392.59 | 3,313.07 | 3,959.69 | 3,238.51 | 13,903.86 |
| Bonus to contractors | 5,370.76 | 5,434.64 | 3,632.19 | 4,751.13 | 19,188.72 |
| Total | 8,763.35 | 8,747.71 | 7,591.88 | 7,989.64 | 33,092.58 |
*1408 From time to time petitioner inspected the books and records kept for him by the Ross Drilling Co., which records showed in detail the cost of all material used as well as all other expenses. He also inspected the invoices from those who furnished materials, the payrolls, and, sometimes, the materials which went into the wells.
The separate income*874 tax returns of the petitioners were prepared from information obtained from the books and records kept by the Ross Drilling Co. They deducted from gross income the intangible drilling and development costs shown above in the total amount of $33,092.58. The respondent disallowed the deductions.
OPINION.
TURNER: The petitioners contend that under Regulations 86, article 23(m) - 16, 1 they are entitled to deduct from gross income the intangible drilling and development costs of the four wells drilled in 1934. The respondent contends that the contracts under which the wells were drilled were "turnkey" contracts and that such costs should be capitalized. On brief, the parties seem to center their argument around the question of whether the four contracts are or are not "turnkey" contracts.
*875 A "turnkey" contract is generally understood as one which requires the drilling contractor to furnish all the material and equipment and to turn over a completed well for a stipulated price. The contracts in question do not conform with that definition in any respect. Here the contracts were entered into by the parties on what is commonly known as a "cost-plus" basis. The petitioners agreed to pay the cost of drilling the wells, including materials and labor, plus a bonus to the drilling company. The amount of the bonus was to be determined on the basis of the cost of materials and labor and neither the cost nor the amount of the bonus could be ascertained until the wells were completed. Obviously these contracts are not "turnkey" contracts.
The above disposition of that question is only preliminary, however, and it does not necessarily follow that the petitioners are entitled to the deduction. In , we said that "If any part of the amount expended for drilling, equipping, *1409 and completing an oil well is to be deducted, it must meet the test of the statute and regulation, and it is not enough to say that such*876 expenditures are deductible because the contract under which they were made is not, strictly speaking, a turnkey contract." In that case the taxpayer did not hire labor or buy materials and supplies, but agreed to pay an independent contractor a stated sum for a finished job, leaving it to the contractor to make his own deal for the material, equipment, and labor. In disallowing the deduction, we pointed out that the relationship between the parties was not that of employer and employee but that of independent contractor.
On this point in the present case the respondent argues that the petitioners are not entitled to the deductions because they "made no expenditures" for intangible drilling and development costs. He contends that these expenditures were made by the Ross Drilling Co. While it is true that the contracts provided that the Ross Drilling Co. would "furnish" all machinery, tools, pipe, tubing, materials, and labor of every kind necessary for the drilling of the well, the remaining provisions of the contracts clearly show that the real arrangement was that the materials and labor, which included the intangible drilling costs, were to be procured by the Ross Drilling*877 Co. for the petitioners, subject to their approval, and were to be paid for by them. According to the contracts, the company agreed to use casing, tubing, and connections "approved by and acceptable" to the petitioners; that if the "materials" brought to the location should "not be satisfactory" to the petitioners, the company would replace same with materials which would meet the approval of the petitioners; that the contracts were entered into on a "cost-plus" basis; and that when the wells were completed, the petitioners would "be indebted" to the company for the "cost of drilling" the wells and its profit, said cost to be the amount shown by a statement furnished by the company, accompanied by supporting invoices showing all charges appearing in said statement. The company, acting as agent for the petitioners, kept their books and records and when any expenditures were made for materials and labor such items were charged to petitioners' account. From time to time the petitioners inspected these records, also the materials, invoices, payrolls, etc., and when the wells were completed they paid the cost of each and every such item, plus a bonus to the drilling company.
We think*878 these contracts are more in the nature of contracts of employment rather than that of an independent contractor. It seems unnecessary to point out all the differences between a contract entered into on a "cost-plus" basis and one on an independent contractor basis. It will suffice here to point out that the petitioners, in effect, employed the partnership to supervise the drilling of wells for them *1410 on their oil properties, agreeing to pay the costs thereof plus a bonus to the partnership for services rendered. We think those facts meet the test of the respondent's regulation and we hold that petitioners are entitled to the deductions claimed.
Decisions will be entered under Rule 50.
Footnotes
1. ART. 23(m)-16. Charges to capital and to expense in the case of oil and gas wells. - (a) Items chargeable to capital or to expense at taxpayer's option:
(1) Option with respect to intangible drilling and development costs in general: All expenditures for wages, fuel, repairs, hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas, may, at the option of the taxpayer, be deducted from gross income as an expense or charged to capital account. Such expenditures have for convenience been termed intangible drilling and development costs. * * * Drilling and development costs shall not be excepted from the option merely because they are incurred under a contract providing for the drilling of a well to an agreed depth, or depths, at an agreed price per foot or other unit of measurement. ↩