Wing v. Comm'r of Internal Revenue
| Decision Date | 11 July 1983 |
| Docket Number | Docket No. 11994–81. |
| Citation | 81 T.C. No. 3,81 T.C. 17 |
| Parties | SAMUEL E. WING, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
P owned a one-third interest in a coal mining joint venture which had made a valid election under section 761(a), I.R.C. 1954. P reported his income from the venture on the accrual method. On October 20, 1977, P entered into a 10-year sublease agreement for the extraction of coal, whereby the joint venture would pay a “minimum royalty” of $6,000 per year for the life of the sublease. The “minimum royalty” was recoupable out of production from the reserves. The $60,000 representing the total “minimum royalties” owing during the lease term was purportedly paid immediately in the form of $10,000 cash and by delivery of a $50,000 nonrecourse promissory note. The note was due ten years in the future and secured by the reserves subject to the sublease, whose value exceeded the note principal. No coal was mined in 1977. The entire transaction had economic substance and purpose other than the avoidance of taxes. Petitioner claimed the full $60,000 as a deduction in the first year of the lease, relying on section 1.612–3(b)(3), Income Tax Regs., prior to amendment.
Held: 1. (a) Section 1.612–3(b)(3), Income Tax Regs., (the regulation) is a “substantive rule” for purposes of the Administrative Procedure Act, (APA) 5 U.S.C. sec. 551 et seq., 60 Stat. 237.
(b) The amendment to the regulation in T.D. 7523, 1978–1 C.B. 192 (the amendment) was not in violation of the notice requirements of 5 U.S.C. sec. 553(d). Wendland v. Commissioner, 79 T.C. 355 (1982), followed.
(c) The amendment did not violate the APA requirement that a “basis and purpose” statement accompany the publishing of the final regulation. 5 U.S.C. sec. 553(c).
(d) The limited basis and purpose statement did not constitute a failure to respond to comments that were submitted pursuant to the proposal to amend the regulation. Therefore, 5 U.S.C. sec. 553(c) was not violated.
(e) Changes between the proposed and final regulation were not substantial and did not warrant an additional round of comment.
Held further: 2. (a) The amendment to the regulation did not violate the “legislative reenactment doctrine.”
(b) The decision by respondent to apply T.D. 7523 retroactive to October 29, 1976, did not constitute an abuse of discretion or violation of due process. Wendland v. Commissioner, supra.
(c) The terms of the lease agreement, which provide for a payment of a royalty equal to $6,000 per year for the life of the sublease, but paid through the issuance of a promissory note whose principal is due after termination of the lease, are insufficient to establish a minimum royalty provision under the regulation. Accordingly, the amounts payable are subject to the general rule of the regulation and are not deductible until coal is sold or produced. Theodore Z. Gelt, Lewis H. Mathis and Joseph B. Hurst, Jr., for the petitioner.
Glenn D. Wilkinson, William F. Garrow and James F. Podheiser, for the respondent.
Respondent determined a deficiency in petitioner's Federal income tax in the amount of $25,888 for the taxable year ended December 31, 1977.
The issues presented for decision are: (1) whether the amendment to section 1.612–3(b)(3), Income Tax Regs., by the T.D. 7523 is valid; (2) if so, whether any portion of the $60,000 amount paid 1 by petitioner in the form of cash plus a nonrecourse promissory note meets the requirements of the regulation and is deductible in the year paid or accrued.
This case was submitted fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts and attached exhibits are incorporated herein by reference. The pertinent facts are summarized below.
Petitioner resided in Denver, Colorado, when he filed the petition in this case. He timely filed his 1977 income tax return with the Internal Revenue Service Center in Ogden, Utah.
Petitioner joined with Messrs. Nelson E. Tamplin (Tamplin) and A.G. Foust (Foust) to form a joint venture called the Weston County Coal Project (hereinafter the project). The project's purpose was to engage in coal mining operations on approximately 1,500 acres of Weston and Crook counties in Wyoming. A joint operating agreement dated October 8, 1977 was signed by the parties to that effect, with Foust being designated as operating manager and Tamplin and petitioner designated as co-owners.2 Petitioner's share of the working interest in the project was 33– 1/3 percent. By provision of the joint operating agreement, all the parties agreed to make an election pursuant to section 761(a).3 Petitioner elected to report his income and losses with respect to the project in accordance with the accrual method of accounting.
A mining sublease (hereinafter the agreement) was signed by petitioner on behalf of the joint venture and Everett Wing on behalf of Everett Corporation on October 8, 1977. Everett Wing is petitioner's father and the sole shareholder of Everett Corporation. The agreement provided that Everett Corporation would sublease an undivided one-third interest in Wyoming State coal leases Nos. 0–32586 and 0–32587 () to petitioner for a period of 10 years. This agreement further provided for payment of an “advance minimum royalty” of $60,000 ($6,000 per year for 10 years) to be paid in the form of $10,000 cash plus a nonrecourse promissory note in the amount of $50,000 upon execution of the agreement.
On October 20, 1977 petitioner paid $10,000 to Everett Corporation by check and executed and delivered to Everett Corporation a nonrecourse promissory note in the amount of $50,000 (bearing interest at the rate of 7 percent per year) in satisfaction of the agreement. The note was collateralized by all the coal underlying the property leased from the Everett Corporation. Payment was to be made from all proceeds received by the project from the leased premises at the rate of 50¢ per ton sold. All payments were to apply to interest first, and the balance, if any, was to be applied to reduction of principal. The note is payable to the Everett Corporation, is secured by the leases, 3a bears interest, has a definite maturity date, and has a fixed amount of principal.
All outstanding sums were due and payable on December 31, 1987.4 In the event that petitioner failed to make payments in accordance with the terms of the note, the Everett Corporation could foreclose upon the entire mineral interest secured by the leases to satisfy payment, but no more. Such arrangements were not unusual in the mineral financing area.
Petitioner has made the following payments of interest on the note:
+-----------------------------+
¦Date ¦Amount of payment ¦
+--------+--------------------¦
¦ ¦ ¦
+--------+--------------------¦
¦12/27/78¦$534.93 ¦
+--------+--------------------¦
¦2/22/79 ¦300.00 ¦
+--------+--------------------¦
¦3/30/79 ¦1,000.00 ¦
+--------+--------------------¦
¦6/08/79 ¦250.00 ¦
+--------+--------------------¦
¦10/23/79¦1,000.00 ¦
+--------+--------------------¦
¦12/26/79¦1,500.00 ¦
+--------+--------------------¦
¦12/17/80¦1,200.07 ¦
+--------+--------------------¦
¦12/15/81¦500.00 ¦
+--------+--------------------¦
¦3/15/82 ¦500.00 ¦
+-----------------------------+
In the payment made on December 17, 1980, $234.93 was allocated by petitioner as advance minimum royalties and the remainder as interest.
Petitioner claimed a deduction for an advance minimum annual royalty payment accrued for the project on Schedule C of his 1977 individual Federal Income tax return in the amount of $50,000. This deduction corresponded to the promissory note payable to the Everett Corporation. Petitioner filed an amended return for 1977, alleging entitlement to an additional $10,000 deduction as an advance minimum royalty for the cash payment which was made to Everett Corporation on October 20, 1977. The entire deficiency amount results from respondent's disallowance of the $50,000 deduction. Respondent also contests petitioner's claimed deduction for the $10,000 cash payment.
The parties agree that the note and the $10,000 cash payment by petitioner had economic purpose and substance other than the avoidance of taxes and that the coal reserves subject to the leases are at least sufficient to permit recoupment of the advance minimum royalty payment over the term of the lease.
In disallowing the claimed deduction, respondent relies on section 1.612–3(b)(3), Income Tax Regs., T.D. 7523, 1978–1 C.B. 192. 5
The regulation prior to amendment indicated different treatment of the claimed deductions.6
On October 29, 1976, the Service issued News Release IR-1687 announcing that proposed regulations under section 612 would be published in the Federal Register which would modify the treatment of advanced royalties under mineral leases entered into as of that date. A copy of the proposed regulations accompanied the release. The supposed effect of the amendment was that lump-sum advanced royalties could now be deducted only in the year of sale of the mineral product with respect to which the royalty was paid. In the event that coal was sold before production, a taxpayer would now have to wait until the coal was actually mined before deducting advance royalties. In two earlier revenue rulings the Service had concluded that lump-sum royalties were deductible when paid or accrued. Rev. Rul. 70–20, 1970–1 C.B. 144, and Rev. Rul. 74–214, 1974–1 C.B. 148. The news release also announced the suspension of these rulings. In the November 2, 1976 Federal Register a notice of proposed rule making containing the same proposed regulation which...
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