*100 Decisions will be entered for the respondent.
The taxpayers, owners of gas and oil leases, assigned the leases to a corporation under a contract whereby they received a cash payment and the right to a fifth of the oil produced and to a fifth of the profits from the gas produced. If the assignee should organize a corporation to process the gas, 20 per cent of the stock was to be issued to the taxpayers. On the evidence, held, that under the terms of the assignment contracts the taxpayers retained an economic interest in the minerals in place and that payments received by them under the contracts are taxable as ordinary income, subject to depletion allowances.
*266 In these consolidated proceedings the Commissioner determined deficiencies in individual income taxes as follows:
| Deficiency | |||
| Petitioner | Docket No. | ||
| Cal. yr. 1943 | Cal. yr. 1944 | ||
| William D. Gray | 17952 | $ 5,298.16 | $ 1,049.42 |
| Fannie M. Gray | 17953 | 5,298.16 | 1,049.42 |
| Fiscal yr. | Fiscal yr. | ||
| 7/31/42 | 7/31/44 | ||
| R. J. Wolfe | 17954 | $ 4,585.76 | $ 997.41 |
| Nona Hobbs Wolfe | 17955 | 4,585.76 | 860.64 |
*101 The basic question is whether the respondent erred in holding that the amounts received by a partnership, of which the petitioner husbands were members, from the assignee of oil and gas leases are taxable as ordinary income. Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts we adopt and by this reference include herein. Petitioners are individuals and throughout the period here involved resided in Houston, Texas. During said period William D. Gray and Fannie M. Gray were living together as husband and wife, and R. J. Wolfe and Nona Hobbs Wolfe were likewise husband and wife, and each of them filed separate income tax returns with the collector of internal revenue for the first district of Texas. Gray and wife filed same for each of the calendar years 1943 and 1944 upon a cash receipts basis, as their books were kept. Wolfe and wife kept their books and filed their returns on the accrual basis of accounting, and filed same for each of the fiscal years ended July 31, 1942, to July 31, 1944, inclusive.
During the period involved and continuously after 1932, William D. Gray and R. J. Wolfe were equal copartners in a firm known as Gray & Wolfe, sometimes herein*102 called the partnership, whose office and principal place of business was in Houston, its business being drilling operations and oil and gas production. The transactions involved herein are treated generally as those of the partnership rather than *267 those of the individual partners. The partnership kept its books and filed its returns on the accrual basis of accounting, and for each of the fiscal years ended July 31, 1942, to July 31, 1944, inclusive, filed partnership returns with the collector of internal revenue for the first district of Texas.
In the fall of 1941 and the spring of 1942 and within the fiscal year ended July 31, 1942, Gray & Wolfe, after geophysical work, acquired certain oil and gas leases covering approximately 1,800 acres located in the Pinehurst field, 1Montgomery County, Texas, at a cost of $ 45,000, plus a drilling obligation as to certain of said leases. Most of the leases were on standard commercial lease forms, Producers 88, providing the usual one-eighth royalty to the landowner, but the leases from Grogan-Cochran Lumber Co. were in special form. One of the Grogan-Cochran leases contained a well-drilling obligation and both of the Grogan-Cochran*103 leases, over and above landowner's royalty, called for an oil payment of $ 100 per acre, payable out of one-sixteenth of the oil and gas production, which burdened more than half of the leasehold acreage involved in the purchase agreement.
Thereafter, on April 22, 1942, La Gloria Corporation, in a letter to Gray & Wolfe, made the following offer to purchase these leases:
We wish to submit to you the following offer for the purchase of your block of Oil and Gas Leases on approximately 1,800 acres of land located in, or in the vicinity of the Charles Frazier and A. Prather Surveys in Montgomery County, Texas, said Surveys being about three miles east of Magnolia and said leases being those indicated on the map you have heretofore furnished us.
We propose to acquire these leases on the following terms and conditions, to-wit:
1. We will pay you*104 $ 45,000.00 in cash on the delivery of proper assignments of the leases.
2. You will reserve the following:
(1) On oil produced from the first well to be drilled on said leases, you will retain an overriding royalty of 1/16 until we have recovered the drilling cost of said well from our working interest therein. After the drilling cost of the first well is recovered, your overriding royalty on oil will be increased from 1/16th to 1/5th. On oil produced from all wells except the first well, you will reserve to yourselves an overriding royalty of 1/5th without regard to drilling cost, provided, however, that when any well on said leases ceases to flow oil naturally, the overriding royalty will be reduced to 1/10th unless you pay your pro-rata share of the lifting cost.
(2) On gas, casinghead gas, natural gasoline, distillate and all other products that may be separated or extracted from gas produced from said leases, you will reserve a carried interest of 20%. If we elect to organize a corporation to erect and operate a processing and cycling plant to process the gas produced from said leases, you will have 20% of the common stock of the said corporation without cost to you. If *105 La Gloria Corporation elects to erect and operate the processing plant, you will have a carried interest of 20% in said products, or *268 in the value thereof, subject, of course, to the cost of the plant and the operating and managerial expense and subject to interest charges at the rate paid by La Gloria which shall not exceed 5%.
* * * *
4. We understand that the leases above mentioned are written on the Revised 88 Form and that the rentals are $ 1.00 per acre. We also understand that the Grogan-Cochran leases are encumbered with an oil payment of $ 100.00 per acre, payable out of 1/16th of the oil and gas production.
* * * *
On this letter Gray & Wolfe noted acceptance of the offer the same day.
This letter formed the basis of the contract between the parties, and in furtherance thereof, on May 25, 1942, four written instruments were executed, viz:
(1) Gray & Wolfe's assignment to La Gloria Corporation covering 1,640 acres of the oil and gas leases referred to in the letter.
(2) Gray & Wolfe's assignment to La Gloria of the oil and gas leases on the remaining 156.6 acres.
(3) Supplemental agreement (hereinafter called gas production contract) elaborating upon La Gloria's*106 obligation to transfer to Gray & Wolfe 20 per cent of the stock in a corporation contemplated to be formed to erect, own, maintain and operate a gas-processing and cycling plant, etc.
(4) Drilling contract.
Further description or such portions of each of said instruments as are deemed pertinent are set out below:
(1) The 1,640-acre assignment provides:
This writing evidences an assignment and contract by and between W. D. Gray and R. J. Wolfe of Harris County, Texas, hereinafter called Sellers and La Gloria Corporation, a Texas Corporation, hereinafter called Purchaser, as follows:
Sellers for and in consideration of the sum of $ 33,828.25 cash to it in hand paid by Purchaser, the receipt of which is hereby acknowledged, and in further consideration of the faithful performance by Purchaser of the agreements and covenants (which shall be covenants running with the land), and upon the terms and conditions and subject to the acceptances and reservations hereinafter set out, have granted, bargained, sold, conveyed and assigned, and by these presents do grant, bargain, sell, convey and assign to Purchaser those certain oil and gas mining leases a full list and description of which is attached*107 hereto marked "Exhibit A" 2 and made a part hereof.
To Have and To Hold, subject to the terms, agreements, covenants, conditions, acceptances and reservations set out, such oil and gas mining leases, together with all and singular the rights and appurtenances thereto and anywise belonging unto the said Purchaser, its successors and assigns in accordance with the terms and provisions of said leases and in so far as the said leases cover the lands described therein; and subject to the terms, agreements, covenants and reservations hereinafter set out, Sellers do hereby bind themselves, their heirs and assigns to warrant and forever defend all and singular the said oil and gas *269 leases unto said Purchaser, its successors and assigns, against every person whomsoever lawfully claiming or to claim the same or any part thereof, by, through and under them; * * *.
II.It is expressly understood and agreed that there is excepted from this transfer and conveyance and that there is reserved to Sellers, their heirs and assigns, the following: (1) On oil, an overriding royalty of 1/5 of all oil produced and saved from the leasehold estates herein conveyed. In the event any oil well ceases*108 to flow naturally, thereby necessitating the use of mechanical means to produce oil from such well, the said overriding royalty provided for herein shall be reduced to 1/10 of all oil produced from any such well or wells unless Sellers contribute their pro rata share of the lifting cost incurred in producing oil therefrom by mechanical means. (2) Purchaser will retain all proceeds derived from the sale of gas, casinghead gas, residue gas, as well as all natural gasoline, condensate and all other products extracted or separated from gas that is produced from said leasehold interests until such time as Purchaser shall have recovered a sum of money equal to the total of its Development and Operating costs. For the purposes of this Contract "Development and Operating Costs" shall include:
(1) The cash consideration paid Sellers for the leases herein assigned and such legal and recording expense as is incurred in connection therewith;
(2) The reasonable cost of all gas wells drilled on the leasehold estates herein assigned;
(3) The reasonable cost incurred by Purchaser in erecting any plant, appliance or facility that is used and is necessary for the recovery of natural gasoline, condensate*109 or any other product that may be extracted or separated from gas produced from said leases;
(4) Simple interest at the rate of 5% per annum on items (1), (2) and (3);
(5) Severance, sales and production taxes paid on gas and the products extracted therefrom, and all ad valorem taxes paid on the gas and gas rights in the leasehold estates assigned herein and also on such tangible property as is used for the production and processing of the gas produced from said leaseholds.
(6) All reasonable managerial, accounting, operating or maintenance costs necessarily incurred in connection with the operation of gas wells and the operation of any plant or facility used to process gas produced therefrom; and
(7) All gas royalty and production payments out of gas to which this assignment is subject.
From and after the time when Purchaser shall have recovered its said Development and Operating costs from funds derived from the sale of gas, casinghead gas and residue gas produced from the leases herein assigned and from the sale of natural gasoline, condensate and other products separated or extracted from gas produced from said leases, the balance of all funds so derived from said sources shall*110 be divided between Purchaser and Sellers on the basis of 4/5 to Purchaser and 1/5 to Sellers, and, from time to time thereafter, as additional or current Development and Operating costs are incurred and so recovered, the balance of said funds remaining in Purchaser's hands at the end of each and every month shall be divided between Purchaser and Sellers on the basis of 4/5 to Purchaser and 1/5 to Sellers. * * *
(2) The 156.6-acre assignment recited a cash consideration of $ 11,171.75 paid, and, except as to this difference in the amount of the cash consideration and the acreage covered, the 156.6-acre assignment *270 was substantially, in form and substance, the same as the assignment of the 1,640 acres.
(3) The instrument which we have termed the gas production contract reads:
Whereas, on the 25th day of May, 1942, W. D. Gray and R. J. Wolfe, as Sellers, and La Gloria Corporation, as Purchaser, entered into two certain contracts, *111 copies of which are hereto attached, marked Exhibit A and Exhibit B and made a part hereof; and
Whereas, the said parties contemplated that it may be desirable to form a separate corporation to erect, own, maintain and operate a Gas Processing and Cycling Plant to process the gas produced under and by virtue of the Oil and Gas leases assigned to Purchaser in said contracts; and
Whereas, the parties hereto have agreed, as a part of the consideration for said contracts that 20% of the stock in any corporation organized for the above mentioned purpose shall be assigned to Sellers by La Gloria Corporation; and
Whereas, it is agreed by and between the parties hereto, as a further consideration for the execution of said attached contracts, that all leasehold estates assigned to Purchaser by Sellers under and by virtue of said contracts shall be pooled and consolidated with any and all oil and gas leases now owned or hereafter acquired by Purchaser on the same geological structure as that on which the said assigned leases are located, and that Sellers are to have the same interest in the gas and gas rights in the leases contributed to said unit by Purchaser as they have retained in the leases*112 assigned by them to Purchaser in said attached contracts.
Therefore, it is agreed as follows:
1. That for and in consideration of the premises and of the sum of $ 10.00 cash to it in hand paid by Sellers, Purchaser hereby binds and obligates itself to properly assign and transfer to Sellers twenty per cent of the stock in any corporation it may form or cause to be formed for the purpose of erecting, owning and operating a gas processing and cycling plant through which the gas produced from the unitized leases above mentioned shall be processed, it being understood that said stock is to be so assigned to Sellers free of cost to them at the time such corporation is organized, if in fact it is organized.
2. It is further agreed that insofar, but only insofar, as gas and gas rights are concerned, the leasehold estates assigned to Purchaser in Exhibits A and B, and all other leaseholds (which shall be construed as any right to search for, produce and use gas) now owned or hereafter acquired by Purchaser from Sellers or from any other sources which are located in whole or in part on any gas producing structure that underlies all or a part of the leases so assigned to Purchaser by Sellers, *113 shall be regarded by the parties hereto as a unit for the development, production and utilization of gas. As a part of the consideration for said assignment, Purchaser hereby grants, sells and assigns to Sellers their heirs and assigns, the same and identical right to share in the proceeds of the sale of gas, residue gas, casing head gas, natural gasoline, condensate and other products that may be produced from the said leaseholds now owned or hereafter acquired by Purchaser in said unit, as are retained by Sellers in the gas, casinghead gas, residue gas and natural gasoline, condensate and other products that may be produced from the leases assigned by Sellers to Purchaser in Exhibits A and B aforesaid.
* * * *
*271 (4) In the drilling contract Gray & Wolfe contracted to drill a well, beginning within 45 days, for La Gloria, on the Grogan-Cochran Lumber Co. lease, to a maximum depth of 10,300 feet, at $ 5.30 per foot.
Within 45 days thereafter Gray & Wolfe commenced drilling a well which was continued to a depth below contract depth, and thereupon was completed as a small oil producer at a shallower depth. A second well drilled was a dry hole, but gas sands were encountered. *114 La Gloria eventually developed gas production in the Pinehurst field.
During the fiscal year ended July 31, 1943, and in accordance with the agreement of May 25, 1942, Gray & Wolfe acquired an additional lease in the Pinehurst area and incurred additional expenses in connection with the prior acquisition of and perfection of title to leases already assigned to La Gloria Corporation, representing additional costs thereof. The total of costs so incurred and paid by Gray & Wolfe during said fiscal year was $ 6,971.95, which was charged to La Gloria and paid by La Gloria to Gray & Wolfe. Of this amount, $ 3,318.50 represents the cost of an oil and gas lease from Hagan and Orr which was acquired by Gray & Wolfe, but taken directly in the name of La Gloria Corporation without any mention of Gray & Wolfe therein. The balance of such expenditures during said fiscal year, namely $ 3,653.45, consisted of additional costs relating to previously acquired leases which had been assigned to La Gloria Corporation. All leases assigned to La Gloria Corporation by Gray & Wolfe were transferred for the actual price Gray & Wolfe had paid for same.
On March 30, 1943, all leases here involved were *115 pooled and unitized by written agreement executed by La Gloria Corporation as "lessee" and six owners of royalty therein designated as "Royalty Owners." 3 As to oil, the participating area was unitized in 80-acre drilling units, while as to gas the entire area was considered as the participating area. Gray & Wolfe are not named as parties to this agreement and did not join in its execution.
When Gray & Wolfe acquired leases in Pinehurst, and also when they transferred same to La Gloria, there had been no drilling or development in the Pinehurst area. The nearby Lake Creek field had been determined to be a gas distillate field, there being nine producing wells therein in May 1942, Gray & Wolfe having drilled some of them. *116 Geological data, both subsurface and geophysical, in the Lake Creek field was available to and used by Gray & Wolfe in blocking up the leases of the unproven Pinehurst area, and all data indicated the presence of gas deposits there, and further indicated a sympathetic structural continuity between the Lake Creek and Pinehurst fields.
*272 The negotiations with La Gloria Corporation were instituted primarily because of that company's known interest in and success with cycling projects, and all conferences and negotiations concerned principally gas and gas rights, the oil royalty being largely incidental.
Occasional, temporary oil production from either the Lake Creek field or the Pinehurst field has been limited to small, isolated reserves encountered incidentally in drilling and developing gas distillate reserves, in most cases being exhausted before the payout of the cost of the wells. Geology, as such, is not an exact science in locating oil and gas, the only infallible test being the drilling of wells. Gas wells can also be found in the same strata of oil wells, and vice versa.
Neither the partnership returns for the fiscal years ended July 31, 1942 and 1943, nor the individual*117 returns of the petitioners and their wives for the same periods, reflected any part of the consideration received by them from La Gloria Corporation, $ 45,000 in 1942 and $ 6,971.95 in 1943, as income.
Respondent increased the partnership income for the fiscal year 1942 by $ 45,000 and for the fiscal year 1943 by $ 6,971.95, representing the cash consideration received from La Gloria Corporation.
As a result, on January 21, 1948, respondent issued statutory notices of deficiencies to petitioners and reflected therein the following additional income and allowance of statutory depletion of 27 1/2 per cent:
| Year 1942 | Year 1943 | |||
| Additional | Additional | |||
| income | Depletion | income | Depletion | |
| William D. Gray | $ 11,250 | $ 3,093.75 | $ 1,742.99 | $ 479.32 |
| Fannie M. Gray | 11,250 | 3,093.75 | 1,742.99 | 479.32 |
| R. J. Wolfe | 11,250 | 3,093.75 | 1,742.99 | 479.32 |
| Nona Hobbs Wolfe | 11,250 | 3,093.75 | 1,742.99 | 479.32 |
| Total | 45,000 | 12,375.00 | 6,971.96 | 1,917.28 |
Respondent's reason for so doing, as stated in his deficiency letter, was:
It is held that the transactions whereby the partnership Gray and Wolfe assigned certain oil and gas leases to La Gloria Corporation and retained*118 certain interests therein were in the nature of subleasing transactions and the cash amounts received by the partnership in consideration of the assignments are ordinary income of the partnership subject to depletion allowances of 27 1/2% thereof which have been allowed herein.
OPINION.
Petitioners contend that the assignments of the oil and gas leases by them through Gray & Wolfe to La Gloria Corporation were sales of such leases, and, since they were made for the *273 same cash consideration as Gray & Wolfe had paid for them, there was no gain or profit realized from the transactions, and hence no taxable income.
Respondent, on the other hand, contends that such transactions were not sales, but subleases, and that the cash consideration received therefor by Gray & Wolfe was in the nature of a bonus or advanced royalty and hence constitutes ordinary income, taxable as such and subject to the statutory depletion allowance.
In transactions of this kind for Federal income tax purposes the form of the instrument of transfer and its effect on the title to the oil and gas under local law are not decisive, but the determinative factor is whether or not the transferor has retained an*119 economic interest to the minerals in place. If so, the transaction will not be regarded as an outright sale, but in the nature of a sublease, and payments thereunder, both royalties and bonus payments for the lease, are to be considered in the nature of rentals or ordinary income, and taxable as such. ; ; ; .
The leases in question cover two minerals, oil and gas. As to these minerals, Gray & Wolfe in their assignments of the leases retained a different interest as to each. As to oil, there was excepted and reserved to Gray & Wolfe "one-fifth of all oil produced and saved from the premises." Under the authorities cited this reservation undoubtedly constituted a retention of an economic interest in the oil in place. But petitioners seek to eliminate oil from consideration of the issue here involved and predicate it alone upon the question of whether or not there was an economic interest*120 retained in the gas and gas rights. They contend that all of the cash consideration paid for the leases and all cash received for the transfer thereof are allocable to gas and gas rights alone, since the oil rights had no substantial or commercial value, and that the moving consideration, both in the purchase and transfer of the leases, was exclusively with reference to gas and gas rights.
While there is some evidence to this effect, we do not deem it necessary to discuss or pass thereon, since even if petitioners' contention in this regard be correct, under the holding in , and the cases there cited and reviewed, we think that Gray & Wolfe here retained an economic interest in the gas in place and hence the Commissioner's determination must be sustained.
Petitioners earnestly contend that as to gas there was no reservation of an economic interest. Instead of an economic interest they claim that after the assignment and contract the interest of the partnership in the gas was "a mere economic advantage derived from production" *274 which arose solely "through a contractual relation to the owner." The quoted language *121 sought here to be applied the petitioners took from a paragraph of a Treasury regulation, 4 wherein it is declared that under circumstances there detailed an economic interest in the mineral deposit would not exist.
The quoted sentence from the regulations relied upon by petitioners is inapplicable here. It provides that a person who has no capital investment in the mineral deposit does not possess an economic interest therein merely because through a contractual relation with the owner he possesses a mere economic advantage derived from production. Its meaning is illustrated in the next succeeding sentence of the regulations, which reads:
* * * Thus, an agreement between the owner of an economic interest and another entitling the latter to purchase the product upon production or to share in the net income derived from the interest of such owner does not convey a depletable economic interest.
An apt and concrete illustration of its meaning is found in ,*122 where the taxpayer, who received net income from an oil operation was a stranger to the lease who had contracted for a share of its net profits as consideration for his stock in a corporation which was the owner of the lease. 5 The Supreme Court said:
The question is whether respondent had an interest, that is, a capital investment, in the oil and gas in place. * * * As a mere owner of shares in the San Gabriel Company, respondent had no such interest.
In the instant case petitioners are not strangers to the leases; by investment they acquired ownership of them and the minerals covered thereby, including gas, and in their assignment of them a reservation was made as to gas which in effect was one-fifth of the net profits:
* * * derived from the sale of gas, casinghead gas and residue gas produced from the leases*123 herein assigned and from the sale of natural gasoline, condensate and other products separated or extracted from gas produced from said leases. * * *
This is substantially the same form of reservation as was made in , where the lessor in an oil and gas lease retained "20 per cent of the net money profits realized by the lessees from their operations under the lease," and also in , where the assignment of a mineral lease required the grantee to pay the grantor "50 per cent of the proceeds of the oil produced and sold from the land, deducting from the proceeds certain itemized expenses of the producer," which expenses the Supreme Court *275 said "are so general in character that it may be said fairly that the lessor was to receive 50 per cent of the net from operations."
In each of these cases the Supreme Court held that the reservation constituted a retention of an economic interest in the minerals in place. In the Kirby case depletion allowance was the issue, and it was held that the taxpayer was entitled to depletion on the 20 per cent profits paid him by*124 the lessees, the Court concluding its opinion thusly:
In our view, the "net profit" payments in these cases flow directly from the taxpayers' economic interest in the oil and partake of the quality of rent rather than of a sale price. Therefore, the capital investment of the lessors is reduced by the extraction of the oil and the lessors should have depletion.
In the Burton-Sutton case the issue was whether or not the transfer of the lease was a sale, and notwithstanding that the instrument recited the transaction to be a sale and contained the language usually incident thereto, the Supreme Court held that it could not be construed as a sale, but an assignment to exploit the property, with a reservation of an economic interest in the oil.
Petitioners contend that the Burton-Sutton Oil Co. case is not applicable because it was here agreed that if La Gloria Corporation (transferee of the leases) "elects to organize a corporation to erect and operate a processing and cycling plant to process the gas produced from said leases" petitioners were to have, without cost to them, 20 per cent of the common stock of the corporation. This, they say, removed it from the realm of subleasing*125 cases such as Burton-Sutton, and they quote from the Supreme Court's opinion therein this sentence:
It is the lessor's, lessee's or transferee's "possibility of profit" from the use of his rights over production, "dependent solely upon the extraction and sale of the oil," which marks an economic interest in the oil.
Petitioners, they say, took in return for the gas rights "a net profit interest in a business venture -- the business of erecting, operating and maintaining a recycling plant." The record reveals that there was no definite commitment on the part of either party to the contract to organize a corporation or to install a recycling plant. All reference thereto was contingent and purely optional, and there was nothing in the record which required the erection of such a plant.
The assignments of the leases here in question were not qualified or conditioned upon the erection of a recycling plant, and the retention of 20 per cent of the net profits from the gas and its products produced from the leases was definite and without regard thereto. It is not believed that this contingent and optional agreement will in any way affect the economic interest retained by petitioners*126 to the gas in place.
By alternative assignments of error, petitioners attack as insufficient the amounts of the depletion deductions allowed by respondent. They *276 also claim that he should have allowed "a loss due to the worthlessness of the partnership's interest in future profits to be derived from natural gas production." But, as these assignments are not discussed or mentioned in petitioners' opening or reply briefs, we assume that they are abandoned.
Decisions will be entered for the respondent.
Footnotes
1. Pinehurst field is about one mile southwest of Lake Creek field where earlier drilling and development occurred. Lake Creek is a gas distillate field rather than an oil field.↩
2. Exhibit A listed the oil and gas leases aggregating 1,640 acres therein assigned.↩
3. This instrument thus defines "Royalty Owners":
"The term 'Royalty Owners' includes a mineral owner, the owner of lands from which minerals have not been severed, the owners of overriding royalties, production payments, reversionary interests, and the owner of ordinary royalty retained by lessor."↩
4. Regulations 111, sec. 29.23 (m)-1.↩
5. This analysis of the facts in the O'Donnell↩ case is taken from the opinion of the Supreme Court in .