Engle v. Comm'r of Internal Revenue

• Citation: 76 T.C. 915
• Decision Date: 08 June 1981
• Docket Number: Docket No. 6219-79.
• Parties: FRED L. and MARY A. ENGLE, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

76 T.C. 915

FRED L. and MARY A. ENGLE, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 6219-79.

United States Tax Court

Filed June 8, 1981.

Petitioners made assignments in 1975 of two oil and gas leases held by them, retaining, however, overriding royalties of 4 percent from one lease and 5 percent from the other. As part of the consideration for the assignments, they received advance royalties totaling $7,600. There was no production of oil or gas from either of the leases during 1975. Held, under sec. 613A(c), I.R.C. 1954, petitioners are not entitled to deduct percentage depletion with respect to the advance royalties in 1975.

[76 T.C. 915]

Thomas J. Donnelly, for the petitioners.

Robert M. Fowler, for the respondent.

OPINION FEATHERSTON , Judge:

Respondent determined a deficiency in the amount of $4,957.65 in petitioners' Federal income tax for 1975. Petitioners failed to take exception to certain items of adjustment; therefore, the only issue for decision is whether a percentage depletion deduction is allowable under section 613A¹ with respect to $7,600 that petitioners received in 1975, as advance royalties, under the terms of their assignment of two oil and gas leases.

All of the facts have been stipulated.

At the time the petition was filed, petitioners, who are husband and wife, were legal residents of Hartland, Wis. They filed their joint Federal income tax return for 1975 with the Internal Revenue Service Center, Kansas City, Mo.

Effective July 1, 1975, petitioner Fred L. Engle (Fred) procured an oil and gas lease covering 80 acres of land in Campbell County, Wyo. On October 6, 1975, he assigned the lease to Getty Oil Co., retaining, however, a 5-percent overriding royalty.² As part of the consideration for the assignment, he received an advance royalty in the amount of $6,000.

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Fred was also the lessee under an oil and gas lease, effective beginning September 2, 1975, covering 160 acres of land in Carbon County, Wyo. On October 22, 1975, petitioners assigned this lease to Marshall & Winston, Inc.,³ retaining a 4-percent overriding royalty. As part of the consideration for the assignment, they received an advance royalty in the amount of $1,600.

The amounts received as consideration for the assignments of the leases constituted the only taxable income from the described properties in 1975. There were no related expenses. Prior to the end of 1975, no discovery or exploratory work had been done on the properties covered by the leases, and no oil or gas had been produced from the properties. During 1975, petitioners had no average daily production of domestic crude oil or natural gas and no average daily secondary or tertiary production of domestic crude oil or natural gas, within the meaning of section 613A(c), quoted in note 8 infra, which provides a limited deduction for percentage depletion in the case of oil and gas wells.

Section 611(a) provides in part that, in the case of mineral deposits (including oil and gas wells), “there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion.” In theory, this deduction is allowed in order to permit the holder of an “economic interest” in minerals in place to recover his capital investment in those minerals tax free. ⁴ See sec. 1.611-1(b)(1), Income Tax Regs.; Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 602-603 (1946); Palmer v. Bender, 287 U.S. 551, 557-558 (1933). For purposes of computing the deduction, Congress has provided two different methods, cost

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depletion⁵ and percentage depletion,⁶ and, where a taxpayer is entitled to use either method, the method allowing the greater deduction for any given tax year must be used to compute depletion for that year. Secs. 1.611-1(a), 1.613-1, Income Tax Regs.

Prior to 1975, it was well settled that the recipient of advance royalties (i.e., royalties paid in advance of the actual production of a mineral) under an oil and gas lease was entitled to compute depletion on the basis of both the cost method and the percentage method and to deduct the greater of the two amounts so computed. See, e.g., Herring v. Commissioner, 293 U.S. 322 (1934). Effective for taxable years beginning after December 31, 1974, however, the Tax Reduction Act of 1975 added a new section, section 613A, and related provisions which, with certain exceptions, generally eliminated percentage depletion in the case of oil and gas wells.⁷ One of the exceptions, on which petitioners rely, provides a limited exemption for independent producers and royalty owners. Sec. 613A(c).⁸ Under this

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exception, the deduction of percentage depletion continues to be permitted “with respect to * * * so much of the taxpayer's

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average daily production” of domestic crude oil or natural gas as does not exceed the taxpayer's “depletable quantities” of crude oil and natural gas.

A taxpayer's “average daily production” of domestic crude oil or natural gas is determined by dividing his aggregate production⁹ during the taxable year by the number of days in such taxable year. Sec. 613A(c)(2)(A). Under section 613A(c)(3), the taxpayer's depletable oil quantity is equivalent to a specified “tentative quantity,” stated in terms of a certain number of barrels of oil “production during the calendar year,” reduced by the taxpayer's average daily secondary or tertiary production of domestic crude oil and natural gas¹⁰ for the “taxable year.”¹¹ The taxpayer's depletable natural gas quantity is equal to the number of barrels of his depletable oil quantity that he elects to convert to depletable natural gas quantity,¹² and the taxpayer's depletable oil quantity is reduced by the number of barrels for which he has made such an election.¹³

The number of barrels constituting the taxpayer's tentative depletable oil quantity is set forth in a “Phase-out table” in

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section 613A(c)(3)(B). The number of barrels in this table is gradually reduced in the case of “production during the calendar year” from 2,000 barrels in 1975 to 1,000 barrels in 1980 and thereafter. In this connection, section 613A(c)(5) sets forth a table of percentages that are applicable in computing the percentage depletion allowance in the case of “production during the calendar year.” The percentage to be used gradually declines from 22 percent in 1975 to 15 percent in 1984 and thereafter.

Respondent, in this case and in proposed regulations under section 613A(c), has taken the position that the exemption for independent producers and royalty owners does not allow percentage depletion on advance royalties paid under an oil and gas lease except to the extent that they are earned or “recouped” through actual production of oil or gas during the taxable year in which the advance royalties are received.¹⁴ In support of his position, respondent emphasizes the language in section 613A(c)(1) stating that the allowance for depletion under section 611 shall be computed in accordance with section 613 only “with respect to * * * so much of the taxpayer's average daily production” of domestic crude oil or natural gas as does not exceed the depletable oil and natural gas quantities specified in section 613A(c)(3) and (4). Respondent reasons that petitioners, having no “average daily production” of oil or natural gas for 1975, have nothing with respect to which percentage depletion may be computed in accordance with section 613.

Petitioners, on the other hand, emphasize that percentage depletion was allowable with respect to advance royalties prior to the enactment of section 613A, notwithstanding the absence of production of oil or gas during the year of receipt of such payments. They point out that the depletion allowance has always been “based on the proceeds derived from the property” and argue that, therefore, “no quantity of oil or gas is required for purposes of the calculation.” Petitioners contend that the quantities of production specified in section 613A(c) were simply intended to limit the applicability of the exemption for independent

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producers and royalty owners to those producers and royalty owners with production levels below the ceiling quantities and that prior law was to be retained in full with respect to that class of persons.¹⁵ Thus, petitioners maintain that “zero [production] is within the limitation just as is one drop of oil or one cubic centimeter of natural gas” and that, therefore, they are entitled to compute percentage depletion on the advance royalties in 1975.

We hold that petitioners are not entitled to deduct in 1975, a year in which they had no production of oil or gas, percentage depletion computed with reference to their $7,600 in advance royalties. Petitioners may deduct only cost depletion with respect to that sum, and they have made no claim to such a deduction.

As petitioners point out, the amount of the percentage depletion allowance under section 613(a) was computed prior to the enactment of section 613A(c) on the basis of the “gross income from the property,” without regard to quantities of production. Nevertheless, section 613A(c) now imposes limitations on the percentage depletion allowance in terms of quantities of production and, as we read it, permits the computation of percentage depletion only with respect to gross income attributable to what might be called an exempt quantity of crude oil or natural gas production. Therefore, unless gross income can be identified as attributable to an exempt quantity of production (which, of course, can hardly be done in the case of payments received in advance of production), the computation of percentage depletion is not permitted.

In our view, the express language of section 613A(c) limiting the percentage depletion deduction to stated quantities of production is so clear that it permits no other reasonable interpretation. Section 613A(c)(1) allows percentage depletion

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only with respect...