7 T.C. 685 (1946), 7253, Porter Royalty Pool, Inc. v. C. I. R.

Docket Nº:7253.
Citation:7 T.C. 685
Opinion Judge:VAN FOSSAN, Judge:
Party Name:PORTER ROYALTY POOL, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Attorney:John C. Evans, Esq., and George L. Cassidy, Esq., for the petitioner. Philip M. Clark, Esq., for the respondent.
Case Date:September 06, 1946
Court:United States Tax Court

Page 685

7 T.C. 685 (1946)

PORTER ROYALTY POOL, INC., PETITIONER,

v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

No. 7253.

United States Tax Court.

September 6, 1946

1. Prior to the taxable year, certain land owners entered into oil and gas leases with various oil companies, reserving to themselves a one-eighth royalty interest in the oil produced. Subsequently a pooling agreement was devised whereby, in 1933, one-half of the royalty interest of each land owner was transferred to the petitioner in exchange for shares of stock in a number based on the number of acres pooled. In addition, the promoters of the pool received 25 per cent of the petitioner's stock. Under the pooling agreement, the royalties paid on the interests thus pooled were to be collected by the petitioner and distributed monthly to the stockholders on the basis of their stockholdings. Thereafter, certain of the landowners instituted proceedings to have the pooling agreement canceled, alleging fraud and a violation of the blue sky laws of Michigan in the sale of petitioner's stock. The litigation lasted eight years, during which time the oil royalties were impounded by the oil companies. In 1941 the Supreme Court of Michigan decreed that there was no fraud; that the sale of stock did not violate the blue sky laws; that the petitioner was the owner of the pooled royalty interests and entitled to the royalty payments. Pursuant to such decree, the oil companies in 1941 paid over the impounded royalties and subsequent royalties to the petitioner. Held, such royalties constitute taxable income to the petitioner.

2. Held, attorney's fees and legal expenses paid in connection with the litigation in the Michigan courts are capital expenditures and not deductible from gross income as ordinary and necessary business expenses.

Page 686

John C. Evans, Esq., and George L. Cassidy, Esq., for the petitioner.

Philip M. Clark, Esq., for the respondent.

The respondent determined deficiencies in income tax for the years 1940 and 1941 and a deficiency in excess profits tax for the year 1941 against Porter Royalty Pool., as follows:

Year Income tax Excess profits tax
1940 $70.81
1941 45,975.12 $3,461.60

The petitioner claims an overpayment in income tax for the year 1941 in the amount of $128,021.98 and an overpayment in excess profits tax for the same year in the amount of $9,338.63. It is stipulated that there is no deficiency due in excess profits tax; that the petitioner has overpaid its excess profits tax and is entitled to relief under section 722 of the Internal Revenue Code. The parties agree that the amount of such overpayment can be determined in the recomputation under Rule 50. The issues in controversy are: (1) whether royalties paid to the petitioner in 1940 and 1941 constitute taxable income to it; and (2) if the first issue is answered adversely to the petitioner, whether amounts representing legal expenses and attorneys' fees incurred and paid by the petitioner in 1940 and 1941 are properly deductible from gross income for those years as expenses under section 23(a) of the Internal Revenue Code. Page 687 FINDINGS OF FACT. The facts are all contained in a stipulation, together with exhibits attached thereto. The facts essential to a proper presentation of the issues may be summarized as follows: The petitioner is a corporation, organized and existing under the laws of Michigan, with principal office at Breckenridge, Michigan. The returns for the years in controversy were filed with the collector of internal revenue at Detroit, Michigan. At various dates prior to December 31, 1933, certain fee owners of land located in the Township of Porter, County of Midland, State of Michigan, each executed an oil and gas lease as lessor, with certain persons or corporations as lessee. Under such lease, the lessor conveyed to the lessee for a term of years, and for so long thereafter as operated for oil and gas, all the oil and gas in and under the described land, as well as certain surface rights incident to the oil and gas operations, in consideration of the lessee agreeing to drill and sell within a stipulated period of time, and ‘ to deliver to first party (lessor) in the pipe line with which it may connect the well or wells, the one-eighth part of the oil produced and saved from said premises‘ and for other considerations. The leases were recorded by the register of deeds of the County of Midland, State of Michigan. At various dates prior to December 1, 1933, each of the fee owner-lessors entered into a so-called pooling agreement with certain promoters and trustees whereby they assigned to the trustees certain royalty interests derived from the property or properties subject to the leases. These contracts provided in pertinent part as follows: WHEREAS, The parties of the first part (fee owner-lessor) are now the owners of a * * * royalty interest in and to all the oil and/or gas produced from or contained in the following real estate in the township of Porter, county of Midland and state of Michigan, described as follows: to-wit: (Here followed a description of the property so owned.) WHEREAS, the first parties desire to enter into a pool or combination with certain other owners of land in the township of Porter, Midland county, Michigan, providing for an assignment of one-half of each of their royalties of oil and/or gas to second parties, and to be by the said second parties (trustees) later assigned to a corporation to be formed, each owner of land to own a number of shares in said corporation equal to the number of acres owned by him and placed in said pool, so as to insure to each stockholder of said corporation a certain participation in the revenue to be derived from the production of oil and/or gas in said territory, irrespective of whether or not oil and/or gas is produced on his land; and WHEREAS, The said first parties desire to assign a one-half of their royalty interest in and to all oil and/or gas produced from the lands aforesaid to a corporation to be formed of all owners of oil and/or gas royalties who enter into similar contracts hereto with second parties; and Page 688 WHEREAS, The third parties (promoters) intend to do all the work necessary to be done in getting the owners of royalty interests to join in such pool, and become stockholders in the corporation provided for herein, for the mutual profit, advantage and protection of said parties, and as a consideration for such services, the said third parties are to receive a share in the capital stock of said corporation as hereinafter provided; and WHEREAS, Said third parties intend to pay all charges and expenses of second parties, and all costs, charges and expenses of drafting this contract, and all costs, charges and expenses of forming this pool and incorporating said corporation; and WHEREAS, The said first parties desire to appoint the second parties as trustees for the uses and purposes hereinafter set forth; and WHEREAS, The second parties desire to act as said trustees: NOW, THEREFORE, In consideration of the premises and the mutual contracts of other owners of royalty interests as enter into similar contracts hereto with second and third parties, and the sum of one dollar mutually paid, it is hereby agreed as follows: 1. The first parties hereby irrevocably appoint the second parties as their trustees upon the trusts and for the purposes hereinafter set forth, and the second parties do hereby accept and agree to perform said trusts and conditions and to look to, and settle with, said third parties for their, and each of their, remuneration. 2. The first parties do hereby transfer, assign and set over to the said second parties, as trustees, all the right, title, interest, claim or demand of the first parties in and to all royalty interest in oil and/or gas now or hereafter discovered and/or produced from the real estate hereinbefore described, to the extent, however, of a one-half of the royalty interest of the first parties only, that is to say, to the extent of an undivided one-sixteenth interest in and to all the oil and/or gas produced from the aforesaid lands, to be held by said trustees until a corporation is organized as hereinafter set forth or for a period of five years from the date hereof, when said trustees are to transfer this contract, and all other such contracts as herein provided for, to such corporation, and in the event a corporation is not so organized within said five year period said trustees agree to cancel, surrender and deliver over this contract to first parties. First parties also agree to convey a good merchantable title to said oil and gas. 3. In the event that oil and/or gas is discovered and/or produced in commercial quantities upon any of the lands affected by this agreement, including similar agreements executed by other owners of oil and gas lands, in the territory hereinbefore mentioned, the said second parties shall forthwith after such discovery and/or production, and within at least ninety days thereafter, draft articles of incorporation for the signature of first parties and such others as are hereinbefore mentioned, and upon obtaining such signatures, or sufficient signatures as will comply with the laws of the state of Michigan, and present such articles of incorporation to the Secretary of State of the State of Michigan for the organization and incorporation of a Michigan corporation to be known as Porter Royalty Pool, Inc., or such other name as may be hereafter be agreed upon. 4. The corporation to be formed as foresaid shall have a capital stock of no par value common shares only and each share shall have equal voting and participating rights and be non-assessable. The amount of capital stock to be issued and outstanding, and the manner of its issue, shall be determined as follows: If there be six hundred acres of land represented in this agreement...

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