United States v. Cocke

Decision Date16 October 1968
Docket NumberNo. 23963.,23963.
Citation399 F.2d 433
PartiesUNITED STATES of America, Appellant, v. W. H. COCKE et al., Appellees.
CourtU.S. Court of Appeals — Fifth Circuit

COPYRIGHT MATERIAL OMITTED

Mitchell Rogovin, Asst. Atty. Gen., Dept. of Justice, Lee A. Jackson, Melva M. Graney, Crombie J. E. Garrett, Richard C. Pugh, Grant W. Wiprud, Stephen H. Paley, Meyer Rothwacks, Stuart A. Smith, Attys., Dept. of Justice, Washington, D. C., Morton L. Susman, U. S. Atty., James R. Gough, Asst. U. S. Atty., Houston, Tex., for appellant.

Homer L. Bruce, William C. Griffith, Houston, Tex., for appellees.

Before JOHN R. BROWN, Chief Judge, and TUTTLE*, WISDOM, GEWIN, BELL, THORNBERRY, COLEMAN, GOLDBERG, AINSWORTH, GODBOLD, DYER, SIMPSON and CLAYTON, Circuit Judges.**

GOLDBERG, Circuit Judge:

This case — involving questions of oil and gas depletion, depreciation, and intangible drilling and development costs1 — provides a setting for our occasional departure from the doctrine of stare decisis. The taxpayer argues, and the government concedes, that the disposition of the present case depends upon whether the doctrine of Commissioner of Internal Revenue v. J. S. Abercrombie Co., 5 Cir. 1947, 162 F.2d 338, stands or falls. Because the Court believed the question to be one of exceptional importance to which uniformity of decision is vital, a hearing en banc was ordered pursuant to Fifth Circuit Court Rule 25(a).2 We now conclude that our decision in Abercrombie must be overruled.

I.

Abercrombie represents one form of a carried interest transaction in the field of oil and gas. In any carried interest transaction, one of the owners of the working interest in property is willing to advance the funds necessary for drilling of wells and development of production of oil or gas, and to look only to the other owner's share of production for the other owner's contribution to such costs. The party who puts up the money is called the carrying party because he risks his entire investment against the possibility that there will not be enough production to reimburse him for his costs. The other party is called the carried party because he takes no risks. The carried party agrees to wait until the carrying party has recouped his drilling and development costs out of production before he takes any payments on his share. The carried party is not personally liable for any costs and loses nothing if there is no production.

The courts and the commentators have recognized three types of carried interests. In the Manahan type,3 the carried party originally owns all of the working interest and assigns the entire interest to the carrying party, who is obligated to drill and develop a well or wells. This assignment is subject to a right of reversion of a portion (typically one-half) of the working interest to the carried party if and when the drilling and development costs are recouped by the carrying party. After this reversion, income and expenses are shared by carried and carrying parties according to their proportionate shares of the working interest.4

In the Herndon type,5 the carried party originally owns all of the working interest and assigns half (or some other share) of the working interest to the carrying party, who is obligated to drill and develop. The carried party also assigns to the carrying party an oil production payment covering his retained working interest. This assignment ends only when the carrying party has recouped his drilling and development costs.

It has been held that during the period of the recoupment the carried party in a Manahan or Herndon carried interest gets no income and no deductions for depletion or depreciation, and that all income and deductions go to the carrying party. See Weinert's Estate v. Commissioner of Internal Revenue, 5 Cir. 1961, 294 F.2d 750. See also Breeding, "The Trend in Carried Interest Cases," 17 Southwestern Law Journal 242 (1963); Galvin, "The `Ought' and `Is' of Oil-and-Gas Taxation," 73 Harvard Law Review 1441, 1492-94 (1960); Bullion, supra note 4, at 606-607.6

The third form of carried interest is represented by Commissioner of Internal Revenue v. J. S. Abercrombie Co., 5 Cir. 1947, 162 F.2d 338. In that case the carried party had assigned all but 1/16 of its working interest to the carrying party. The carrying party was to drill and operate the wells, to pay all costs and expenses out of production, and to pay to the carried party 1/16 of "operating profits" (income after the deductions for costs and expenses had been made). In the calendar year 1941 there was nothing to pay to the carried party under the agreement because deductions for costs and expenses exceeded income. The carrying party's tax return, however, did not include as income 1/16th of the gross proceeds, as the carrying party claimed that such income was attributable to the carried party. The Commissioner contended that the carried party had retained only a 1/16 interest in net profits, and that none of the gross profits used by the carrying party in recouping its outlays was income taxable to the carried party.

In reversing for the carrying party, we stated the following:

"In some instances the law may look through form to substance to get to the right of a controversy, but in ordinary cases tax consequences under federal law often depend upon property rights under local law, which in turn may be fixed by agreements between owners of the property. * * *
* * * "Our decision is controlled by the fundamental principle that income is taxable to the owner of the property producing the same, and that an assignment in anticipation of such income is ineffective to avoid taxation thereof to the real owner. The economic reality of the transaction was that the assigning co-owners mortgaged their interest to their operating co-owner; and by so doing they not only reaped the benefit of development but acquired an undivided one-sixteenth interest in valuable physical equipment placed on the property by the operators." 162 F.2d at 339, 340.

We held in Abercrombie that the carried party's retention of a 1/16 interest in "operating profits" meant that 1/16 of all gross income, no matter whether paid out to the carried party or retained and used by the carrying party for drilling or development costs or expenses, was income to the carried party. Twelve years later, in Prater v. Commissioner of Internal Revenue, 5 Cir. 1959, 273 F.2d 124, we "followed Abercrombie to its logical conclusion and allowed the carried party in an Abercrombie transaction to deduct his attributive fractional * * * share of the costs of development and operation." Weinert's Estate v. Commissioner, supra, 294 F.2d at 758.7

Although neither the Abercrombie nor the Prater opinion clearly explains the rational of Abercrombie, a two-pronged argument has since been advanced to support the result. First, as the appellee argues here, it may be argued that the Abercrombie transaction was a loan from the carried to the carrying party of 1/16 of the funds necessary to develop and operate the wells. The loan could be repaid only out of the carried party's share of production. The production which went towards repaying any of the loan would be income to the carried party on the familiar theory that the nondonative payment of a debt by a third party is income to the debtor. Int.Rev.Code of 1954, § 61(a) (12).

The second prong of this argument distinguishes an Abercrombie situation from other carried interest cases by the situs of title. Unlike Manahan and Herndon, in Abercrombie and Prater the carried party did not assign to the carrying party either title to, or oil production payments from,8 his retained portion of the working interest. Each gave the carrying party merely the right to recoup drilling and development costs out of production before making any payments to the carried party.9

Despite attempted distinctions, the Abercrombie and Prater holdings conflict with the view, taken in other carried interest transactions, that only income actually payable to the carried party is taxable to the carried party. Fundamental to both Manahan and Herndon is that no income which, under the carried interest agreement, is retained by the carrying party and used to recoup drilling and development costs (as opposed to operating expenses) is taxable to the carried party. Moreover, one year before Abercrombie the Supreme Court decided two cases, Burton-Sutton Oil Co. v. Commissioner of Internal Revenue, 1946, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062, 162 A.L.R. 827, and Kirby Petroleum Co. v. Commissioner of Internal Revenue, 1946, 326 U.S. 599, 66 S.Ct. 409, 90 L.Ed. 343, which cast further doubt on the loan-title rationale (although seemingly they were used for support in the Abercrombie opinion). These cases stated that for tax purposes an interest in net proceeds is a depletable interest in the oil; thus, receipt of such proceeds is taxable only to the recipient. Implicit in the Burton-Sutton opinion is the principle that before the break-even point is reached, gross income is reported by the one who, through the production contract, actually receives it.10

With this discussion of legal background, we turn to the facts of the present case.

II.

The taxpayers, William H. Cocke, Sr., and Tula Stokes Cocke, his wife, and William H. Cocke, Jr., and Bula H. Cocke, his wife, were residents of Houston. The Cockes were involved in two agreements for the drilling and production of oil. We describe each briefly.

In the first, Cocke, Sr., R. H. Goodrich, and Humble Oil and Refining Company owned working interests in mineral leases and unleased mineral interests in St. Martin Parish, Louisiana, known as the "Goodrich K" properties.11

On October 12, 1955, Humble, Goodrich, and Cocke, Sr., entered into a joint operating agreement among themselves to accomplish the drilling and development of the Goodrich K properties. Humble was designated...

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