Jahn v. Comm'r of Internal Revenue , Docket No. 5276-69.

• Citation: 58 T.C. 452
• Decision Date: 12 June 1972
• Docket Number: Docket No. 5276-69.
• Parties: HAROLD E. JAHN AND MARY JAHN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

58 T.C. 452

HAROLD E. JAHN AND MARY JAHN, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 5276-69.

United States Tax Court

Filed June 12, 1972.

Leonard J. Simasko, for the petitioners.

Patrick R. McKenzie, for the respondent.

Petitioners owned a farm in Michigan, and on January 2, 1964, entered into an ‘agreement’ with two individuals, Neyer and Andres, with respect to such property whereby the latter agreed to drill oil and gas wells thereon at their sole risk and expense and to market the production therefrom. Petitioners retained the rights to five-eighths of all production to be realized from the property and Neyer and Andres were to receive three-eighths of the proceeds. On the same day that petitioners signed the ‘agreement’ and in conjunction therewith, petitioners received $50,000 from Andres. Petitioners reported the $50,000 as the proceeds from the sale of a capital asset. In 1964, eminent domain proceedings were brought by Michigan Consolidated Gas Co. against the land in question whereby Consolidated took over the use of the property. During 1964 and 1965 Consolidated took gas from the property and impounded the money payable to petitioners. On May 6, 1966, a settlement was finalized whereby petitioners received $935,000 in settlement of their claims against Consolidated. Petitioners reported this entire amount as long-term capital gain in 1966. Held:

1. The $50,000 payment in dispute was an inducement in the form of a bonus or advance royalty for entering into an oil and gas lease under which the petitioners retained an economic interest in the oil and gas production and, therefore, was ordinary income to petitioners in 1964.

2. As part of the settlement with Consolidated, the petitioners received at least $159,718.95 as their share in production for the period from 1964 through July 6, 1965, and such sum was ordinary income to them in 1966.

WITHEY, Judge:

Respondent determined deficiencies against petitioners for the taxable years 1964 and 1966 in the amounts of $3,164.56 and $21,141.16, respectively.

The principal issues presented for our consideration are (1) whether a $50,000 payment was the proceeds of a sale of a three-eighths interest in all the minerals lying beneath petitioners' farm to Neyer and Andres or whether it represented a bonus or advance royalty under a lease, and (2) whether the petitioners received as part of a settlement in 1966 of their claims against Michigan Consolidated Gas Co. royalty payments amounting to $159,718.95.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found and incorporated herein by reference.

Petitioners Harold E. Jahn and Mary Jahn are husband and wife whose residence was in St. Clair, Mich., at the time the petition herein was filed.

The petitioners filed their income tax returns for the calendar years 1964 and 1966 with the district director of internal revenue, Detroit, Mich.

Petitioners owned real property in St. Clair County, Mich., and on January 2, 1964, entered into an agreement with John Neyer and Ray Andres with respect to such property whereby Neyer and Andres agreed to ‘commence to drill on the permitted location * * * and shall proceed with all due diligence to drill such well to completion at their sole risk and expense.’

Neyer and Andres were to ‘operate, or arrange for operation, of all wells on the premises covered hereby, and shall market the production therefrom at not less than going field prices.’

Petitioners retained the rights to five-eighths of all production realized from the property and Neyer and Andres were to receive three-eighths of the production.

Neyer and Andres were obliged to drill and complete all wells at their own risk and expense but petitioners were obliged to pay their five-eighths share of operating such wells after completion.

Neyer and Andres were obliged to carry workmen's compensation insurance as required by the laws of the State of Michigan and public liability and property damage insurance with respect to the premises covered by the agreement and they were to hold petitioners harmless from all claims, demands, and causes of action arising directly or indirectly out of their operations on the premises.

The agreement also stated that ‘no mining partnership or joint undertaking shall be considered as created’ between petitioners and Neyer and Andres by reason of the latter's operations.

On the same day that petitioners signed the oil and gas drilling agreement and in conjunction therewith the petitioners received $50,000 from Andres.

In 1964, eminent domain proceedings were brought by Michigan Consolidated Gas. Co., hereinafter sometimes called Consolidated, against the land owned by petitioner's and covered by the oil and gas drilling agreement whereby Consolidated took over the use of the property as an underground storage facility for gas.

Pursuant to a condemnation order issued by the Probate Court for St. Clair County, Mich., Consolidated was given the right to occupy the land of the petitioners as of July 6, 1965.

During the period from 1964 until July 6, 1965, 854,427,000 cubic feet of gas was withdrawn from the property by Consolidated.

Consolidated was paying $0.3136 per 1,000 cubic feet of gas during the period of 1964 and 1965.

The total value of the production of gas from 1964 until July 6, 1965, was $271,084.31 and petitioners were to receive five-eighths of this amount, or $169,427.69.

The value of the petitioners' share in the production of gas as determined by Consolidated was $159,719.29.¹

During 1964 and 1965, Consolidated took gas from Jahn No. 1 and Jahn No. 3 wells and paid for a portion of it to Neyer and Andres, owners of a three-eighths interest, and impounded the balance of money due to petitioners. The balance of the money involved was impounded because petitioner had not signed a division order agreeing to the division of the interest in the gas involved.

On May 6, 1966, a settlement was finalized between petitioners and Consolidated whereby petitioners received $935,000 in settlement of their claims against Consolidated.

On May 19, 1966, petitioners and Consolidated executed a closing statement with respect to the ‘Sale of Properties and Interests, Belle River Mills Field’ in which the ‘contract price’ was set forth as $935,000. This closing agreement stated, in part, that:

Purchase price includes payment for all production from the Jahn #1 well located in the SE/4, NE/4, NW/4, Section 11, T4N, R16E, China Township, St. Clair County, Michigan and the Jahn #3 well located in the SW/4, NW/4, NE/4, Section 11, T4N, R16E, China Township, St. Clair County, Michigan, from and after the respective dates of initial production therefrom.

By the execution hereof and in consideration of said purchase price, Sellers, for themselves, their heirs, personal representatives and assigns, remise, release and forever discharge Buyer, its successors and assigns, of and from any and all claims for damages, compensation or otherwise, relating to the Belle River Mills Field located in China Township, St. Clair County, Michigan, including but not limited to any and all claims growing out of or resulting from the production, purchase, processing, storage or transmission of gas in or from said Field.

ULTIMATE FINDINGS OF FACT

The $50,000 payment received by petitioners was an inducement in the form of a bonus or advance royalty for entering into the oil and gas lease under which the petitioners retained an economic interest in the oil and gas production and, accordingly, was ordinary income to the petitioners in 1964.

As part of the settlement with Michigan Consolidated Gas Co., the petitioners received at least $159,718.95 as their share of production for the period from 1964 through July 6, 1965, and such sum was ordinary income to the petitioners in the taxable year 1966.

OPINION

Issue 1. $50,000 Bonus or Advance Royalty

Respondent determined that the $50,000 payment which petitioners received during the taxable year 1964 upon executing an oil and gas drilling agreement was a bonus or advance royalty and hence ordinary income to them, subject to depletion during that year. Petitioners, in opposition, contend that the payment in dispute was the proceeds of the outright sale of a capital asset which was subject to the preferential capital gain treatment as reported by them.

In our opinion, the transaction under consideration is an example of the classical form of oil and gas lease and for purposes of the Federal income tax is not a sale or conveyance of a property interest giving rise to capital gain or loss, and this, irrespective of the laws of the various States. Burnet v. Harmel, 287 U.S. 103(1932). Under such an oil and gas lease, the cash and other consideration paid the lessor upon execution of the lease and before actual production is treated as an advance royalty or bonus and is ordinary income subject to percentage depletion in the year received. Herring v. Commissioner, 293 U.S. 322, 324(1934).

Ordinarily a gas and oil transaction involves the owner of land leasing to another the right to explore and drill for oil, if found, on the property. The owner-lessor of the land retains a right to a portion of any resulting production and ‘The payment of an initial bonus (or advance royalty) alters the character of the transaction no more than an unusually large rental for the first year alters the character of any other lease.’ Burnet v. Harmel, supra at 106.² The two factors of having an investment interest in the oil in place, together with the right to income from the extraction of oil or gas, is what is referred to as having an ‘economic interest’ in the oil and gas. Commissioner v. Southwest Expl. Co., 350 U.S. 308(1956).

In numerous cases, the granting clause under the agreement for exploration and drilling of oil and gas is written in language which normally, if standing alone, denotes a sale. Where, however, other language in the...