*1355 1. Petitioner held to be an association taxable as a corporation for the years 1925, 1926 and 1927.
2. The reasonable allowance for depletion authorized as a deduction under the 1926 Act, in the case of oil and gas wells, is required to be equitably apportioned between lessor and lessee in case of leases. The basis for determining such reasonable allowance, prescribed in section 204(c)(2), is 27 1/2 per cent of gross income from the property, and such reasonable allowance so determined is required to be apportioned equitably between lessor and lessee.
3. Total cost of oil wells drilled under contract represents cost of improvement subject to depreciation allowance.
*172 This proceeding is for the redetermination of deficiencies in income tax of the petitioner, as follows:
| 1925 | $54,287.68 |
| 1926 | 10,403.29 |
| 1927 | 3,760.80 |
| Total | 68,451.77 |
The errors assigned for all years are that the Commissioner (1) has classified petitioner as*1356 an association taxable as a corporation; (2) has not allowed a sufficient amount of depletion; and (3) has not allowed a sufficient amount of depreciation. The first error assigned was also raised by this petitioner as to the years 1922 and *173 1923 in Docket No. 29518, decided this day, which proceeding was heard with this case. By agreement of the parties, the stipulations in each docket filed at the hearing and the evidence introduced were to be considered as applicable to each case in so far as they are pertinent to the issues involved.
FINDINGS OF FACT.
The original declaration of trust creating the petitioner, which was executed on February 11, 1922, and amended on April 25, 1922, was further amended on March 14, 1925. The provisions of the trust as amended on April 25, 1922, and the method of operating under the trust are set forth in our findings of fact in Docket No. 29518, decided this day, and are incorporated herein by reference.
The amendment of March 14, 1925, made the following changes: The minimum number of trustees was made 3, and the maximum 5. Such salaries or compensation to the officers or trustees as might be agreed upon by unanimous consent*1357 of all the trustees, were authorized. Paragraph twelfth was amended by substituting "may" for "shall," so that the first sentence thereof reads: "The trustees may call meetings of the unitholders annually * * *." A paragraph designated "Seventeenth-A" was added, which allowed the trustees to amend the trust by any resolution, minute or motion passed by unanimous vote of all the trustees, without further formality, "the intent of this paragraph being to permit the Trustees by unanimous vote to make such changes from time to time in the Declaration of Trust and the various Amended Declarations of Trust as the conditions of the trust estate may be to them deemed advisable without the necessity of executing any additional instruments or documents." Paragraph eighteenth was so amended as to permit in effect the purchase of additional property and sales by the trustees, but such acts could be done only by unanimous consent of all of the trustees at a meeting called for that purpose.
The two wells drilled on petitioner's property in 1922 were drilled under contracts with the Keck Drilling Corporation for a fixed sum. Costs of labor and materials were not segregated. The two wells*1358 drilled in 1922 were deepened in 1923, also under contracts. The total well costs of petitioner under the contracts were as follows:
| Item | Amount | Cumulative total |
| Cost to December 31, 1922 | $256,632.00 | $256,632.00 |
| Additions during 1923 | 135,290.88 | 391,922.88 |
| Additions during 1924 | 391,922.08 | |
| Additions during 1925 | 391,922.88 | |
| Additions during 1926 | 391,922.88 | |
| Decrease during 1927 | 3,543.78 | 388,379.10 |
*174 The amounts paid to the contractors under the contracts were charged on petitioner's books as "Well Cost, No. 1 Well," and "Well Cost, No. 2 Well." The amounts paid to the contractors for drilling the wells include the total cost of the wells and nowhere on petitioner's books was any segregation made for the portion of the cost which represented materials going into the wells and the portion which represented labor and fuel incident to the drilling.
The respondent, in the determination of the deficiencies here in question, allocated 40 per cent of the total cost of the wells to tangible equipment cost and allowed depreciation on the same. He determined that 60 per cent of the cost of the wells represented intangible drilling costs, such*1359 as labor, wages, fuel, etc., and added such 60 per cent of the well costs to the lease account returnable to the petitioner through depletion. Respondent denied the petitioner the right to charge or be allowed depreciation deductions with respect to 60 per cent of the well costs.
The parties have stipulated and agreed that if the Board should determine that the petitioner is not entitled to depreciation on the total well cost, then the determination of the respondent is correct. But if the Board should determine that the petitioner is entitled to charge the total well cost to its well account and be allowed depreciation on the same, it is stipulated that petitioner is entitled to an additional depreciation deduction for the several years as follows:
| 1925 | $11,172.04 |
| 1926 | 8,953.04 |
| 1927 | 8,364.40 |
The one-sixth royalty paid to Batson and the one-twelfth royalty paid to Andrews, during the taxable years, were as follows:
| Year | Batson royalties | Andrews royalities |
| 1925 | $159,853.20 | $79,926.60 |
| 1926 | 143,253.02 | 71,626.51 |
| 1927 | 70,946.34 | 35,473.17 |
The parties stipulated and agreed as follows:
* * * The respondent has for purposes of computing*1360 the 27 1/2% depletion allowance to which petitioner is entitled, reduced petitioner's gross income for each of the years 1925, 1926, and 1927 by the respective amounts of the above mentioned royalties. Should the Board determine that petitioner's gross income should be reduced by the sums aforesaid in computing its depletion allowance then the amount of depletion allowed by the respondent is Should the Board determine that petitioner's gross income should not be reduced by said royalties in computing its depletion allowance, then said sums shall be added to the petitioner's gross income as determined by the respondent, for the purpose of determining the depletion allowance of 27 1/2%.
*175 The petitioner has never acquired any property other than the lease assigned to it by Lipps, and has never sold any part of such lease. The petitioner had a contract under which it sold all the oil produced to the Associated Oil Company and was under contract with the Norwalk Gas Company to sell it all the gas produced, some being produced. The petitioner entered on its books the payments received from the purchase of its oil in an "Oil Runs Account," and charged against such account*1361 the royalties to Batson and Andrews.
In 1925 and thereafter the trustees voted themselves salaries.
In 1926 some of the funds of the petitioner were used to purchase Julian Petroleum stock which was sold in the same year at a profit.
The return for 1925 was filed on Form 1041, a fiduciary trust form, and the returns for 1926 and 1927 were filed on Form 1120, corporation income-tax return. On the corporation returns, the kind of business is stated to be "Oil Producers."
OPINION.
MATTHEWS: 1. The first question is whether in 1925, 1926 and 1927 the petitioner must be regarded as a trust or as an association. For the years here involved petitioner may not avail itself of section 704(a) of the Revenue Act of 1928 as it did in the proceeding for the prior years 1922 and 1923, Docket No. 29518, and the tests to be applied in distinguishing a trust from an association must be those which this Board and the courts have found applicable in 1925 and subsequent years.
The Commissioner amended article 1504 in his Regulations 65 (Revenue Act of 1924), distinguishing a trust from an association in accordance with the test laid down in the Supreme Court's decision in *1362 Hecht v. Malley,265 U.S. 144. The explanation of this volte-face is given in G.C.M. 6517, C.B. VIII-1, p. 152, at pp. 153, 154 (June 24, 1929).
The Hecht case has been so fully discussed in our prior decisions that it is unnecessary to consider it in detail here. As we pointed out in our decision in the Morris Realty Trust,23 B.T.A. 1076, the Supreme Court put aside, apparently, the "control" test and substituted therefor business purpose, business operations and quasi-corporate structure.
A business enterprise, such as the petitioner's, created to drill for oil, and carrying on such operations, falls within the category of associations. The petitioner's organization was accomplished by Lipps and his cotrustees with a definite business purpose in mind, and the drilling of oil wells by the petitioner on its leased land, although by contract, was clearly a business operation. In the taxable *176 years the petitioner was under the exclusive control of the trustees, but that is beside the point. It did not have in some respects a quasi-corporate form. The trust declaration had been amended again on March 14, 1925, and*1363 the annual meeting of the unitholders was left to the trustees to call at their discretion, by the substitution of "may" for "shall" in paragraph twelfth. Paragraph eighteenth prohibited the trustees, except by their unanimous consent, from acquiring new property or selling the old. But the unitholders held transferable certificates which might be transferred like corporation stock. Under paragraph fifth the trustees and unitholders disclaimed any liability beyond the trust corpus. Petitioner was empowered to act under a common seal. The trustees assumed the style of "officers," although Lipps testified their duties remained undifferentiated. The trustees received salaries during the years here involved. Aside from the received salaries resident in the trustees, petitioner's organization resembles in purpose and in form that of a corporation.
The instant case is very similar to that of Little Four Oil & Gas Co. v. Lewellyn, 29 Fed.(2d) 137; affd., 35 Fed.(2d) 149; certiorari denied, 280 U.S. 613, in which the court held the taxpayer an association taxable as a corporation, saying, "The real test is whether the stockholders or*1364 trustees, or both combined, carry on business for profit * * *." White v. Hornblower, 27 Fed.(2d) 777.
Petitioner relies strongly upon Extension Oil Co.,16 B.T.A. 1028; affd., 47 Fed.(2d) 65, in which under facts somewhat similar to those of the instant case we held a body to be a trust and not an association. But that case can be easily distinguished. There, the organizers combined for the sole and restricted purpose of drilling a single oil well for test purposes, and as soon as the value of the leased land was thus learned, of selling the lease. This purpose was promptly carried through in eleven months time. Here, the original trust agreement ran for twenty years and as amended for fifty, and the trustees were given full powers to develop the lease as they saw fit. They did, it is true, distribute the profits when made, but this fact of distribution does not, in our opinion, negative the petitioner's obvious business purpose. It was carrying on a business enterprise and was fearful, as one of its trustees confessed, all the time of being treated for Federal tax purposes as an association. This fact accounts for the*1365 excessive circumspection apparent in the amendment of its trust declaration on March 14, 1925.
Quasi-corporate form is not an indispensable element of an "association." Sears, Roebuck & Co., etc., Fund v. Commissioner, 45 Fed.(2d) 506. But business purpose and activities are criteria which clearly bring the petitioner within the category of associations. *177 Willis v. Commissioner, 58 Fed.(2d) 121, affirming 22 B.T.A. 564. Cf. Russell Tyson et al., Trustees,25 B.T.A. 520.
We are of the opinion that petitioner was an association in 1925, 1926 and 1927 and taxable, therefore, as a corporation.
2. The authority for a deduction by a corporation for depletion in the case of oil and gas wells for the taxable years is contained in section 234(a)(8) of the Revenue Act of 1926, which reads as follows:
SEC. 234. (a) In computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
* * *
(8) In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, *1366 according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner with the approval of the Secretary. In the case of leases the deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee;
* * *
The above provision is mandatory in two respects; first, that there shall be allowed as a deduction a reasonable allowance for depletion, and, second, that such deduction shall, in the case of leases, be equitably apportioned between the lessor and the lessee.
The basis for determining depletion under the 1926 Act is prescribed in section 204(c), paragraph 2, which reads as follows:
SEC. 204. (c) The basis upon which depletion, exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the same as is provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the sale or other disposition of such property, except that -
* * *
(2) In the case of oil and gas wells the allowance for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year. *1367 Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance be less than it would be if computed without reference to this paragraph.
The basis of a depletion allowance, computed without reference to the above paragraph, would be cost or March 1, 1913, value. Sec. 204(a) and (b).
Reading the two sections together, that is, the one authorizing a deduction for depletion and the other prescribing the basis, it is clear that the reasonable allowance for depletion in the case of oil and gas wells on leased property, which is to be equitably apportioned between the lessor and the lessee, is 27 1/2 per cent of the gross income from the property during the taxable year. If the portion of such allowance which is equitably apportioned to the taxpayer (lessor or lessee) is more than 50 per cent of the net income *178 of such taxpayer, it is required to be reduced to an amount not in excess of 50 per cent of such net income, and if the amount apportioned to the taxpayer (the lessor or lessee) is less than it would be if computed without reference*1368 to paragraph 2, the allowance is to be based on the cost or the March 1, 1913, value.
The petitioner, as lessee, had a three-fourths interest in the oil produced from the wells, the other one-fourth interest being in Batson, the lessor, and Andrews, the original lessee. The depletion allowance with respect to the oil and gas wells is 27 1/2 per cent of the gross income from the wells, equitably apportioned between petitioner, Batson, and Andrews.
The depletion allowance determined by the Commissioner is 27 1/2 per cent of the petitioner's share of the gross income from the oil and gas wells, which amount is exactly the same as would have been determined if the Commissioner had taken 27 1/2 per cent of the total gross income from the property and apportioned three-fourths of such amount to the petitioner. The amount determined by the Commissioner is not in excess of 50 per cent of the net income of the taxpayer and is not less than the deduction would be if computed without reference to the provision in section 204(c)(2). The determination of the Commissioner as to the amount of depletion allowable is therefore approved.
3. The third issue is whether the petitioner should*1369 be allowed to take deductions for depreciation upon the total cost of its wells, or whether the respondent is correct in determining that 60 per cent of the well costs should be charged to the capital account, returnable through allowances for depletion. The amount of additional deductions for depreciation to be allowed, if petitioner is correct, is stipulated. Section 234(a)(8), Revenue Act of 1926, already quoted, provides in the case of mines, oil and gas wells, for "a reasonable allowance for depletion and for depreciation of improvements."
Respondent relies on article 223 of Regulations 69, which provides that incidental expenses such as wages, fuel for engines, repairs, and hauling may be charged to capital account, returnable through depletion, while the expense of physical property (such as derricks, machines, etc.) may be subject to depreciation.
It is admitted that petitioner drilled its wells on what is known in the trade as a "turnkey contract," that is, for a lump sum payable to the contractor, and that the petitioner, therefore, had no interest or concern with the apportionment of the costs of drilling, simply charging the whole to the well cost account. The question*1370 is whether the total cost of the wells represents an investment in an improvement which is subject to depreciation.
Since the hearing in the instant case, the same question was presented and decided in A. T. Jergins Trust,22 B.T.A. 551. The *179 same argument was there urged by the Commissioner, but we said, with respect to amounts expended for wages, fuel, repairs and hauling in connection with development and drilling, that "amounts expended in development and drilling operations convey to us the impression of expenditures for improvement of the property upon which the statute permits the taxpayer to duduct depreciation."
On this issue, therefore, we hold that the petitioner is entitled to the additional depreciation allowable for 1925, 1926 and 1927, in the sums stipulated.
Judgment will be entered under Rule 50.