*1086 Held, under authority of Sterling Oil & Gas Co. v. Lucas, 62 Fed.(2d) 951, the taxpayers' contentions respecting classification of drilling expenses under the optional provisions of articles 223 and 225, respectively, of Regulations 62 and 65, are sustained.
*636 These proceedings, which were consolidated for hearing, involve disputed income tax deficiencies for the years and amounts indicated as follows:
| Docket No. | 1923 | 1924 | 1925 |
| 42496 | $245.72 | $10,207.73 | $1,076.97 |
| 42497 | 245.72 | 10,278.23 | 1,076.47 |
The issues submitted for determination relate to (1) certain drilling expenses connected with oil properties; (2) expenditures made to procure the cancellation of a production sale contract; (3) expenditures claimed to be part cost of an oil lease; (4) disallowed portion of cost of oil properties sold in 1924; and (5) erroneous determination of income unidentified sources in 1924.
FINDINGS OF FACT.
The petitioners are*1087 husband and wife and, at all times material, lived together at Wichita Falls, Texas. For the years under review they filed separate income tax returns and reported their income under the community property laws of the State of Texas.
In and during the years in review the petitioner R. R. Robertson owned a one-third interest in a partnership known as the Wilmut Farm Oil Co. of Wichita Falls, Texas, and a one-half interest in the copartnership of Muse & Robertson, of the same city. The last named firm kept its books and reported its income tax returns on the basis of a fiscal year ending at August 31.
During 1923 the first named partnership incurred drilling expenses other than for physical equipment and fixtures, on a partnership lease, amounting to $12,565.48, and in 1924 incurred similar expenses of $24,569.34 upon the same property and $18,127.96 upon one other partnership lease. During these years the Wilmut Farm Oil Co. and R. R. Robertson regarded their relationship in these developments as that of coadventurers, and for that reason filed no partnership return relating to them.
In August 1925, the Wilmut Farm Oil Co. filed a belated partnership return for 1923, for*1088 itself and petitioner R. R. Robertson as partners, in which it reported and claimed the item of $12,565.48 as an expense deduction from gross income. At or about the same date it filed a similar return for 1924 and claimed the other two items above mentioned as expense deductions.
*637 After the filing of the partnership returns, as aforesaid, these petitioners respectively filed income tax returns for 1924 and amended returns for 1923, in which they claimed as deductions from their respective incomes their ratable portions of the expense items hereinbefore mentioned, as determined by the partnership returns filed by the Wilmut Farm Oil Co.
The respondent has denied these deductions upon the ground that the petitioners' failure to claim them as deductions in the original returns amounted to an election to capitalize them under article 223 of Regulations 62.
During the fiscal year ended August 31, 1925, the partnership of Muse & Robertson expended, in gross, $12,266.35, in drilling oil and gas wells on three leases which it acquired under assignments requiring it to make explorations as provided in the lease. The petitioners charged out one half of these expenditures*1089 from their gross income as expenses in that period.
In April 1923, the petitioner R. R. Robertson acquired at a cost of $3,000 an undivided one-fifth interest in an oil and gas lease designated as the Wilson D. Lease. On October 26, 1923, before development of the lease had begun, the Camp Oil & Gas Co., a cotenant and four-fifths owner of the lease, entered into a contract with the Texhoma Oil & Gas Co., undertaking to sell all oil thereafter produced from the property to the last named company at the rate of $1 per barrel. Thereafter, the Camp Oil & Gas Co. sold its four-fifths interest in the lease, and R. R. Robertson and his new cotenant developed the property to the point of production in January 1924. Soon after production had begun on the aforesaid lease the Texhoma Oil & Gas Co. claimed its right under its contract. The petitioner R. R. Robertson refused to recognize the agreed price of $1 per barrel fixed in the contract as applying to his one-fifth interest and his one-fifth interest in oil impounded pending negotiations for settlement by the parties. These negotiations resulted in the owners of the lease purchasing from the Texhoma Oil & Gas Co. a release of their*1090 contract, for a cash consideration of $40,000, of which Robertson contributed the sum of $8,000. Following this release of the Texhoma Oil & Gas Co. contract, the owners, on April 28, 1924, sold the lease to the Prairie Oil & Gas Co. for a cash consideration which netted R. R. Robertson $225,000 for his one-fifth interest.
Some time prior to 1924, R. R. Robertson acquired an interest in an oil lease known as the Wilson B. lease at a cost of $7,833, plus other properties whose values are not shown. The respondent has excluded this item from the basis for computing gain from the sale of such lease in 1924. In his audit of petitioners' return for 1924 *638 the respondent added to petitioners' identified income the amount of $8,533.24 as other income from undisclosed sources. Excepting the item of $8,000 paid to the Texhoma Oil & Gas Co., the petitioners have stipulated that (1) the petitioners' income in 1924 from the sale of oil from the Wilson D. lease was $48,022.35; (2) that the petitioners sustained deductible losses on account of worthless leases abandoned in 1924, amounting to $7,600; that deduction for the losses indicated should be made from the petitioners' gross*1091 income for 1924 and a corresponding sum added to their income for 1925, such deduction having been theretofore erroneously claimed and allowed in the latter year; and (3) that the partnership of Muse & Robertson sustained losses in 1925 amounting to $8,325 on account of two properties known as the J. B. Routon lease and the W. B. Mills lease.
OPINION.
LANSDON: The petitioners claim their right to deduct from their incomes in 1923 and 1924, respectively, ratable parts of the so-called "intangible" drilling expenses referred to in our findings of fact. The respondent contends that the petitioners, having elected under article 223 of Regulations 62 and article 225 of Regulations 65 to charge such expenditures against capital, are now precluded from claiming them as development expenses. The portion of the regulation invoked by respondent as relating to drilling expenses reads as follows:
Such incidental expenses as are paid for wages, fuel, repairs, hauling, etc., in connection with the exploration of the property, drilling of wells, building of pipe lines, and development of the property may at the option of the taxpayer be deducted as a development expense or charged to the*1092 capital account returnable through depletion. * * *
It will be noted that the regulation gives the taxpayer the option to deduct expenditures of the kind here considered as development expenses or to charge them to capital, but does not restrict him as to time or manner by which he is bound to indicate his election. Obviously a reasonable time, according to the circumstances in each case, and some definite commitment, are implied.
In the case considered nothing was done by the partnership or these petitioners to classify the items here considered in the initial year of their operations. At that time, according to the record, these petitioners were under the impression that the relationship between petitioner R. R. Robertson and the other members of the partnership was that of coadventurers in the two oil projects, and that no accounting was to be made until the leases were developed or sold. A choice was made, however, in 1925, when the partnership filed regular and *639 delinquent returns for 1924 and 1923, respectively. In each of these returns the partnership deducted the amount of such items as expense. In harmony with this classification of expenditures the petitioners*1093 thereafter filed their amended returns for 1923 and current returns for 1924, in which they claimed ratable deductions of the items from their gross income as expenses. These acts, we hold, were the only commitments made by the petitioners respecting their choice in the premises considered after adequate knowledge was had upon which they could exercise judgment in respect thereto, and, under the circumstances, must be considered as their election. We, therefore, sustain the contentions of the petitioners respecting this issue. Cf. ; affd., .
The next issue relates to expenditures amounting to $12,266.35 which the partnership of Muse & Robertson made during the fiscal year ended August 31, 1925, in carrying out conditions assumed in the acquisition of lease interests. There is nothing in the record to show the character of these expenditures, except the stipulation that they were made "in connection with the drilling of oil and gas wells on the leases named." These leases, however, call for drilling and exploration expenditures which, in their nature, must be regarded as capital expenditures*1094 and, the partnership having assumed such obligations, we assume that the amounts in dispute relate thereto. In the absence of proof to show that the respondent committed error in denying these deductions, his determination in regard thereto must be affirmed.
The petitioners paid $8,000 as their one-fifth interest in the $40,000 paid to the Texhoma Oil & Gas Co. to secure the release of a production purchase contract. The respondent holds that this expenditure must be attributed to the cost of selling the oil released by that contract. The record shows that, in so far as the petitioners' one-fifth interest in the oil was concerned, the sale contract in no way encumbered it and that the petitioners refused to recognize it. The contract, however, did constitute a cloud upon the lease, in that it affected four fifths of the entire production and while outstanding was an obstacle to a sale for which they were negotiating with the Prairie Oil & Gas Co. Petitioner R. R. Robertson testified that the purchasing company refused to buy the lease so long as the contract was outstanding, and that they were compelled to purchase it from the Texhoma Oil & Gas Co. in order to clear their title*1095 and consummate the sale. This testimony is not contradicted and we must accept it as true. We, therefore, hold this $8,000 item to have been a capital expenditure and not an expense deductible from 1925 income as determined by the respondent.
*640 In computing the gain resulting from the sale of oil leases by the petitioners in 1924, the respondent has disallowed the amount of $7,833 as a part of the cost of the property sold because petitioners were unable to produce the canceled check in evidence. At the hearing petitioner R. R. Robertson testified that he made the payment by cashier's check in the amount claimed and entered the same in the investment account on his books. The canceled cashier's check was not produced. If it is now in existence it is in the files of the bank which issued it and, therefore, not available for production by petitioner. We think the testimony of Robertson that he paid this amount and duly entered it on his books is sufficient to overcome the presumption of correctness that attaches to the determination of the respondent. Accordingly, we hold that petitioners' income for the year 1924 should be reduced in the amount of $7,833.
Resulting*1096 from his analysis of petitioners' capital account for 1924, the respondent determined additional income from unidentified sources in the amount of $8,533.24. Since we have found above that the respondent erroneously excluded $7,833 from petitioners' investment or capital account in 1924, it follows that the income from undisclosed sources in that year must be reduced to that extent.
Decision will be entered under Rule 50.