Berkshire Oil Co. v. Comm'r of Internal Revenue
| Decision Date | 06 November 1947 |
| Docket Number | Docket No. 9382. |
| Citation | 9 T.C. 903 |
| Parties | BERKSHIRE OIL COMPANY, PETITIONER. v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
1. The taxpayer corporation acquired leases on several properties in consideration of cash, the drilling of oil wells within a fixed time, and the payment of a royalty on oil or minerals extracted. It incurred intangible drilling and development costs which it deducted as expenses. Such costs held not deductible as expenses because part of the cost of the lease acquired and hence a capital investment.
2. The option given by section 19.23(m)-16, Regulations 103, to treat such costs as expense or capital, held inapplicable to costs incurred in drillings which are made in performance of a contract for acquisition of the mineral property, even although substantial cash consideration is also paid for the property.
3. The taxpayer corporation acquired by a single lease four lots in consideration of cash, the drilling of oil wells within a fixed time, and the payment of a royalty on oil or minerals extracted. Two lots had only one corner point in common with another of the group; two were contiguous on one side. The taxpayer drilled a dry hole on one of the two contiguous lots and released both to the lessor in 1942. Held:
(a) The two contiguous lots constitute ‘a property‘ different from the others, which, touching only at a corner point were separate tracts.
(b) Cost of the two lots, including intangible drilling cost of t e dry hole, is deductible as loss on ‘a property‘ in the year of release.
4. The taxpayer corporation paid salary to an officer absent in military service. The office had rendered services without compensation before induction into the Army and returned to the taxpayer's employ after release. The salary paid held deductible as a business expense. I.T. 3417, 1940-2 C.B. 64, approved. James H. Yeatman, Esq., for the petitioner.
Frank B. Schlosser, Esq., for the respondent.
The Commissioner determined the following deficiencies in petitioner's income and excess profits taxes:
+-------------------------------+
¦ ¦ ¦Excess profits ¦
+----+----------+---------------¦
¦Year¦Income tax¦tax ¦
+----+----------+---------------¦
¦1941¦$16,933.70¦$8,512.69 ¦
+----+----------+---------------¦
¦1942¦2,648.50 ¦37,202.05 ¦
+----+----------+---------------¦
¦1943¦101.86 ¦879.58 ¦
+-------------------------------+
Petitioner assails the disallowance for 1941 and 1942 of intangible drilling and development expenses incurred in drilling oil wells on property held under leases which it acquired in consideration of cash, its obligation to drill, and promise to pay royalties. In the alternative, it seeks to deduct a part of such expenses proportionate to the part of the leases acquired for cash. For 1942 it seeks further to deduct that part of the cash consideration applicable to two lots which it acquired under a lease of four lots and released in that year to the lessor after having drilled a dry hole on them. Having allowed deduction of the expense of drilling the dry hole, respondent by affirmative plea, alleges error in so doing, contending that the two lots were parts of ‘one property,‘ although they had only one corner point of contact with the other two lots. For 1942 and 1943 petitioner assails the disallowance of salaries paid to its vice president while serving in the United States Army. Other issues were settled by stipulation or abandoned.
Petitioner, a Texas corporation with principal office at Houston, Texas, is engaged in the production and sale of oil, gas, and kindred products. Its records are kept and its income tax returns are rendered on an accrual basis of accounting and its returns for 1941, 1942, and 1943 were filed with the collector of internal revenue for the first district of Texas.
On June 20, 1941, J. R. Frankel, petitioner's vice president, acquired from Albert J. Ward, an oil, gas, and mineral lease on 4 lots of land aggregating 350.61 acres in LaSalle Arish, Louisiana. On July 10, 1941, Frankel assigned the Ward lease to petitioner. This lease conveyed the right to explore, prospect, drill, mine, produce, treat, and store oil, gas, sulphur, and all other minerals on the property, and in consideration therefor petitioner paid $25,000 in cash (plus commissions and attorneys' fees of $3,864.35) and agreed to pay the lessor royalties of one-fourth of the oil, gas, and other minerals extracted and in addition $27,500 out of the proceeds of oil sold.
The seventh paragraph of the lease provided:
In order to maintain this lease and its rights in effect with respect to the leased premises, Lessee shall. on or before July 22, 1941, commence the actual drilling of a well in search of oil, gas or other mineral on some portion of the leased premises and shall, prior to the discovery and production of oil, gas or other mineral in paying quantities thereon, continue drilling operations thereon with not more than thirty (30) days elapsing between the date of completion or abandonment of one well and the date of commencement of actual drilling operations on another well * * * .
The lease covered lots 1, 7, 10, and 11, township 7 north, range 3 east except 40 acres of lot 1, Lots 10 and 11 were contiguous on one side; lots 1 and 7 touched another lot of the group only at one corner. But it was provided that: ‘For all of the purposes of this lease, the property above described shall be deemed to be one single, contiguous and continuous body or tract of land.‘
Frankel, acting for petitioner, became interested in the property covered by the lease after a well drilled about 1,100 feet from a part of it had produced oil. He regarded the 4 lots as of equal value, and in negotiations with Ward offered cash consideration on the basis of $70 an acre. The $25,000 was determined as reflecting approximately that price. When the lease was made, petitioner was already operating in another oil field; had a rig available to begin drilling without delay; and was not inconvenienced by the requirement that drilling be commenced on or before the fixed date. This requirement is commonly a condition of the lessee's rights in leases made in the area.
On August 6, 1941, petitioner acquired from W. F. Hyde another oil, gas, and mineral lease in LaSalle Parish, Louisiana, on 25 1/2 acres of land which adjoined a lot of the Ward lease on the north, and on November 12, 1941, it acquired from the Placid Oil Co. a lease on 3 acres of the same tract which had been reserved when the former assignment was made. The area acquired by these assignments was known as the Yule lease. Petitioner paid for it $6,000 cash, a commission of $837.41, and agreed to pay as a royalty to the assignors a fixed percentage of the oil or gas produced, and:
As a further consideration the Berkshire Oil Company binds and obligates itself to begin the drilling of a well for oil or gas on the above described property in six (6) months from the date of this assignment and to prosecute the drilling of the said well with due diligence until a depth of 4000 feet is reached * * * . Failure to comply * * * shall operate as a cancellation of this assignment.
In 1941 petitioner drilled two producing wells on lot 1 and one producing well on lot 7 of the Ward lease, and one producing well on the Yule lease. In 1942 it drilled one producing well on lot 7 of the Ward lease. In 1941 it incurred and paid intangible drilling and development costs of $46,025.27 and $15,223.95 on the Ward and Yule leases, respectively, and in 1942 such costs of $13,118.14 and $322.10, respectively. Petitioner elected to charge intangible drilling and development costs to expense under the provisions of section 29.23(m)-16, Regulations 111, and on its income tax returns for 1941 and 1942 deducted the amounts so expended in those years. The Commissioner disallowed the deductions because:
* * * Such charges arose in performance of your obligation under the contract by which you acquired the working interest rights in the leases involves. The drilling costs so incurred are held to represent capital charges and are therefore deemed unallowable.
On July 16, 1942, petitioner completed the drilling of a dry hole on lot 11 of the Ward lease at a cost of $11,354.93. No well was drilled on lot 10. On December 21, 1942, petitioner released to Albert J. Ward and others all of its right, title, and interest in and to lots 10 and 11, and deducted from gross income on its income tax return for 1942 the $11,354.93 representing intangible drilling and development costs and $16,035.75 as representing cash cost of the acreage surrendered. The release was made in accordance with the terms of the lease to petitioner. In determining petitioner's income tax for 1942, the Commissioner allowed deduction of the $11,354.93 and disallowed deduction of the $16,035.75.
Petitioner was organized in 1939; its stock is owned in equal parts by five members of the Frankel family, including J. R. Frankel; and four members of that family are its officers. J. R. Frankel, vice president, rendered services to petitioner from its inception, and was in charge of the procurement of leases on land until February 1942, when he was inducted into the United States Army. On his release from military service in October 1943, he returned to his position with petitioner. Prior to September 22, 1942, petitioner's officers worked without salaries or for only nominal amounts, to aid petitioner's financial position. On that date the board of directors by resolution directed that the officers be paid specified annual salaries from September 1, 1942, as follows:
+-----------------------------------------+
¦R.R. Frankel, president ¦$15,000¦
+---------------------------------+-------¦
¦M. Frankel, vice president ¦10,000 ¦
+---------------------------------+-------¦
¦J.R. Frankel, vice...To continue reading
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