Keller v. Comm'r of Internal Revenue , Docket No. 2656-79.

• Citation: 79 T.C. 7
• Decision Date: 08 July 1982
• Docket Number: Docket No. 2656-79.
• Parties: STEPHEN A. KELLER and ETHEL L. KELLER, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

79 T.C. 7

STEPHEN A. KELLER and ETHEL L. KELLER, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 2656-79.

United States Tax Court

Filed July 8, 1982.

In 1973, K acquired a $50,000 limited partnership interest in an oil and gas drilling program sponsored by Amarex, Inc.

Issue 1: The drilling partnership participated in the drilling of 182 wells, approximately two-thirds of which were drilled pursuant to pay-as-you-go contracts, and the balance, pursuant to contracts prepaid in December 1973. The drilling partnership elected to expense certain items as intangible drilling costs (IDC) under sec. 263(c), I.R.C. 1954. Respondent accepted the IDC classification. He also allowed deductions in 1973 for amounts paid in 1973 on the pay-as-you-go contracts. But he disallowed deductions in 1973 for amounts paid in 1973 on the prepaid contracts; i.e., he challenged the timing of the deductions for prepaid IDC. The prepaid IDC included amounts paid on footage and daywork drilling contracts, turnkey drilling contracts, third-party well-servicing contracts, and the “well charges” which the drilling agreement required the drilling partnership to pay its operator, Amarex Funds. The amount of the prepayments made on the footage and daywork drilling contracts and on the third-party well-servicing contracts was the best estimate of the amount which would become due on completion of the well on the footage or daywork basis and on the per unit of materials or services required basis contained in the respective contracts. If the actual contract cost on completion on the footage or daywork basis or on the per unit basis differed from the prepaid amount, then excess costs were to be billed and overpayments were to be refunded or applied to a different well. The prepayments made on the turnkey drilling contracts and the Amarex Funds well charges constituted full payments under the contracts. No possibility of refund existed for these prepayments. Some of the wells for which prepayments were made in 1973 were subsequently canceled. Of the 65 prepaid wells actually drilled, 16 were spudded in 1973. The balance were spudded in 1974. Held: A two-part test must be applied to determine the current deductibility of prepaid IDC for cash basis taxpayers, namely (1) whether the expenditure was a payment or a deposit, (2) whether the prepayment resulted in a material distortion of income. The business purpose for prepayment, or lack thereof, is an important consideration in the material distortion analysis. Deductibility of the prepayments in issue in this case is determined with reference to this test.

Issue 2: The drilling partnership sought to deduct a $137,200 payment to Amarex Funds in 1973 as a management fee. Held, the petitioners failed to prove the deductibility of the payment as an ordinary and necessary business expense under sec. 162(a), I.R.C. 1954. Cagle v. Commissioner, 63 T.C. 86 (1974), affd. 539 F.2d 409 (5th Cir. 1976), followed. Thomas G. Parrott, Julian P. Kornfeld, and Gilbert L. Tierce, Jr., for the petitioners.

Osmun P. Latrobe, for the respondent.

NIMS , Judge:

Respondent determined a deficiency in petitioners' income tax of $14,202 for 1973. The issue for decision is whether petitioners are entitled to deduct $50,000 in 1973 as their distributive share of the Amarex Drilling Program, Ltd.- 72/73 partnership losses. The resolution of this question depends upon the resolution of the following underlying issues: (1) Whether Amarex Drilling Partnership No. 72/73-D is entitled to deduct $635,560.71 in 1973 for prepaid intangible drilling and development costs; and (2) whether Amarex Drilling Partnership No. 72/73-D is entitled to deduct $137,200¹ in 1973 for management fee expenses.

This case concerns petitioner Stephen A. Keller's investment in an oil and gas program. Ethel L. Keller is a party to this proceeding solely because she filed a joint income tax return with her husband, Stephen A. Keller. Consequently, Stephen A. Keller will be referred to hereafter as the petitioner.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation and the attached exhibits are incorporated herein by reference.

Petitioners resided in Minneapolis, Minn., at the time the petition in this case was filed.

Petitioners maintained their books and records and filed their income tax returns on a calendar year basis using the cash receipts and disbursements method of accounting.

The oil and gas program involved a set of related entities. Amarex, Inc. (hereinafter Amarex), is a Delaware corporation which was incorporated in December 1968. Its stock is publicly traded in the over-the-counter market. Amarex has been actively engaged in the exploration, development, and production of oil and gas since its formation. In August 1970, Amarex began organizing and promoting oil and gas limited partnerships.

Amarex Funds of Delaware, Inc. (hereinafter Amarex Funds), is a Delaware corporation which was incorporated in January 1970. Amarex Funds is a wholly owned subsidiary of Amarex. Both corporations had their principal place of business in Oklahoma City, Okla.

The oil and gas program had two tiers of limited partnerships. Amarex Drilling Program, Ltd.- 72/73 (hereinafter the program partnership) was formed on October 11, 1972, as an Oklahoma limited partnership. It invested, as a limited partner, in four drilling partnerships which engaged in the exploration for, and production of, oil and gas.

Amarex and Amarex Funds were the general partners of the program partnership and of the drilling partnerships. Amarex Funds also served as the program partnership's manager and as the drilling partnerships' operator.

Investors who purchased a minimum of five $1,000 units of participation became limited partners in the program partnership. Fifteen thousand $1,000 units of participation ($15 million) were registered with the Securities and Exchange Commission² and were offered for sale on a “best efforts” basis by securities brokers and dealers.

The program partnership did not acquire oil or gas properties or actively engage in exploratory or developmental operations. Instead, the amounts invested in the program partnership by its limited partners were reinvested by the program partnership in four drilling partnerships (Amarex Drilling Partnership: No. 72/73-A, No. 72/73-B, No. 72/73-C, and No. 72/73-D). The program partnership participated as a limited partner in each of the four drilling partnerships. The drilling partnerships conducted the oil and gas operations.

An investor's subscription in the program partnership was allocated to the program partnership's investment in one of the four drilling partnerships. The investor's subscription was allocated to the drilling partnership which was accepting subscriptions at the time of the individual's investment. The program partnership's distributive share of a particular drilling partnership's profit and loss was allocated to the individual investors whose subscriptions had been allocated to that particular drilling partnership. The investors' distributive shares of the profit and loss were determined by the ratios of their subscriptions in the program partnership.

Each limited partner in the program partnership entered into a limited partnership agreement (hereinafter the program partnership agreement) with the general partners, Amarex and Amarex Funds. As each drilling partnership was activated, the program partnership, as limited partner, entered into a limited partnership agreement (hereinafter the drilling agreement) with the general partners, Amarex and Amarex Funds. Thus, the program partnership agreement and the drilling agreement governed the rights and obligations of the participants in this oil and gas program.

On July 31, 1973, petitioner subscribed to invest $50,000 as a limited partner in the program partnership. Petitioner's entire investment was allocated, at the time he became a limited partner, to the program partnership's investment in Amarex Drilling Partnership No. 72/73-D (hereinafter the drilling partnership). This case focuses on certain of this drilling partnership's transactions.

The drilling partnership's closing date for accepting subscriptions was August 1, 1973. It was formed as an Oklahoma limited partnership on August 14, 1973. It commenced operations shortly thereafter. A total $1,372,000, invested by 98 limited partners in the program partnership, constituted the program partnership's investment in the drilling partnership. The drilling agreement required Amarex to contribute certain oil and gas leases, mineral rights, equipment, and cash to the drilling partnership's capital.

The drilling agreement vested Amarex Funds, as operator of the drilling partnership, with full and exclusive authority to do all things necessary or desirable in conducting the business of the drilling partnership. These powers included: determining the wells and operations in which the drilling partnership would participate; making expenditures and incurring obligations necessary for the conduct of partnership activities; and determining the leases to be developed, abandoned, sold, or assigned to other parties. The program partnership was expressly excluded from sharing the power to manage or control the operations of the drilling partnership.

All revenues of the drilling partnership were split on a 50-50 basis between Amarex and the program partnership. The drilling agreement allocated deductions and credits to the party whose account had been charged with the expenditure associated with the deduction or credit. Generally, expenditures which could be deducted currently were charged to the program partnership's account, whereas costs which had to be capitalized were charged to Amarex's account.

The drilling partnership began its drilling program in August 1973. A total of 182 wells in 14 States were drilled under the program: 63 wells were completed in...