Bernuth v. CIR, 209
| Decision Date | 12 December 1972 |
| Docket Number | Docket 72-1736.,No. 209,209 |
| Citation | 470 F.2d 710 |
| Parties | Charles M. BERNUTH and Shirley P. Bernuth, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. ESTATE of Carl VON BERNUTH, Deceased, Elizabeth von Bernuth, Executrix, et al., and Elizabeth von Bernuth, Surviving Wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. |
| Court | U.S. Court of Appeals — Second Circuit |
Alvin D. Lurie, New York City (Richard N. Gray, New York City, of counsel), for appellants.
Grant W. Wiprud, Atty., Tax Div., Dept. of Justice, Washington, D. C. (Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks and Richard Farber, Attys., Tax Div., Dept of Justice, Washington, D. C., of counsel), for appellee.
Before SMITH, KAUFMAN and MULLIGAN, Circuit Judges.
Charles M. Bernuth, Shirley P. Bernuth, Elizabeth von Bernuth, and the Estate of Carl von Bernuth have appealed from a decision of the Tax Court, 57 T.C. 225 (1971), sustaining the Commissioner's determination of deficiencies in their income taxes for the year 1959. The question presented for review is whether appellants were entitled to claimed deductions for "intangible drilling and development costs" for several oil and gas wells in which they had fractional interests. For the reasons stated below, we answer that question in the negative, and affirm the decision of the Tax Court.
The facts below, while complex, were stipulated. Since they are outlined exhaustively in the opinion of the Tax Court, we shall summarize them but briefly here. Three of the appellants, Charles M. Bernuth and Carl and Elizabeth von Bernuth, entered into oil and gas ventures promoted by Barnwell Production Company, a Louisiana partnership.1 Each taxpayer acquired from Barnwell fractional working interests (ownership) in oil and gas leases in Pike County, Mississippi, and agreed to participate in the drilling of wells on the leaseholds. The agreements provided that each taxpayer would pay Barnwell a fixed sum for his participation in the drilling of a well at a specified location to a particular depth. In addition, each taxpayer agreed to pay his share of the costs of completing and readying for commercial production any well which proved successful.
The agreements set out the price of a full 100 per cent working interest in each well, the percentage participation of each taxpayer, the full "turnkey to casing point" drilling cost,2 the cost to each taxpayer of his fractional working interest, and the taxpayer's fractional share of the drilling costs. For the four wells in controversy, the figures in the participation agreements can be summarized by the following table:
Fred Bacot Eugene W Eugene W Eugene W
#1 #1 #2 #3
100 Percent Working
Interest $ 15,000 $ 15,000 $ 15,000 $ 15,000
Full Turnkey Drilling
Cost* $205,000 $205,000 $205,000 $205,000
CHARLES BERNUTH
Percentage Participation 4.00 4.00 3.732 3.00
Working Interest $ 600.00 $ 600.00 $ 559.80 $ 450.00
Drilling Cost $8,200.00 $8,200.00 $7,650.60 $6,150.00
CARL VON BERNUTH
Percentage Participation 2.00 2.00 1.866 -
Working Interest $ 300.00 $ 300.00 $ 279.90 -
Drilling Cost $4,100.00 $4,100.00 $3,825.30 -
ELIZABETH VON BERNUTH
Percentage Participation 2.00 2.00 1.866 3.00
Working Interest $ 300.00 $ 300.00 $ 279.90 $ 450.00
Drilling Cost $4,100.00 $4,100.00 $3,825.30 $6,150.00
Each of the participation agreements was subject to an operating agreement between Barnwell Production and Barnwell Drilling Co., Inc., covering the development and operation of the wells. Barnwell Drilling is a corporation, the stock of which is owned by R. S. Barnwell, Sr. and R. S. Barnwell, Jr., who are, not coincidentally, the partners in Barnwell Production. Each agreement authorized Barnwell Production to enter into a drilling contract suitable to it with Barnwell Drilling. Although no such contracts were entered into here, the actual drilling of the wells was done by Barnwell Drilling.
Barnwell Production retained a major fractional working interest in each of the wells in issue.3 It also paid a portion of the drilling and completion costs to Barnwell Drilling although the record shows these payments to be less than Barnwell Production's proportional share.4 No records of the amounts actually expended on drilling were maintained by Barnwell Drilling.
Prior to 1943, amounts paid for drilling under turnkey contracts were considered to be capital in nature, on the theory that when a taxpayer bought a completed well, he had acquired a capital asset. See Commissioner v. Ambrose, 127 F.2d 47 (5th Cir. 1942); J. K. Hughes Oil Co. v. Bass, 62 F.2d 176 (5th Cir. 1932), cert. denied, 289 U.S. 726, 53 S.Ct. 523, 77 L.Ed. 1475 (1933). In 1943, the applicable regulations, Treas. Reg. 103, § 19.23(m)-19(a)(1) (1939), were amended to give the taxpayer the option to either capitalize or expense turnkey drilling costs. T.D. 5276, 1943 Cum.Bull. 151. At present, section 263(c) of the Internal Revenue Code of 1954, 26 U.S.C. § 263(c), authorizes the promulgation of regulations granting the option to deduct as expenses "intangible drilling and development costs." The pertinent regulation, 26 C.F.R. § 1.612-4, extends the option to those holding a working or operating interest in oil wells, either on a fee or leaseholder basis. The term "intangible drilling and development costs," is something of a misnomer, since the regulation defines such expenses to include sums spent for fuel, wages, repairs, hauling, etc., all of which are quite tangible.
For the taxable year 1959, each appellant made a timely election to claim in his tax return deductions for oil venture losses. These included, inter alia, intangible drilling and development costs incurred in the Pike County ventures sponsored by Barnwell. In all but one instance, each taxpayer claimed a deduction for intangible drilling expenses in the exact amount of the drilling costs set out in the participation agreements, plus intangible completion expenses.5
The Commissioner filed a notice of deficiency in each case, contending that the deductions were excessive, and that not more than $116,993.50 was the proper turnkey drilling cost for each well in question. This determination was based upon recommendations made in an "Engineering and Valuation Report" prepared separately with respect to each of the cases here, which were eventually consolidated for trial. Those reports based their recommendations on the average costs of drilling under straight footage contracts, adding a 30% increment to allow for the generally higher price of turnkey contracts. Thus, the $116,993.50 figure was arrived at by multiplying the going rate for drilling by a factor of 1.3, and applying that to the footages in the instant case. The Engineering Reports were received into evidence by the Tax Court for the limited purpose of showing how the Commissioner arrived at the deficiency assessment. See Clark v. Commissioner, 266 F.2d 698 (9th Cir. 1959).
It is black-letter law that deficiency determinations by the Commissioner of Internal Revenue carry with them a presumption of correctness. Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 78 L.Ed. 212 (1933); Helvering v. Taylor, 293 U.S. 507, 515, 55 S.Ct. 287, 79 L.Ed. 623 (1935); Tax Court Rule 32. Cf. United States v. Lease, 346 F.2d 696 (2d Cir. 1965). The burden is on the taxpayer to show that the Commissioner is wrong, Lucas v. Structural Steel Co., 281 U.S. 264, 271, 50 S.Ct. 263, 74 L.Ed. 848 (1930); although he need not prove what the correct tax would be, Taylor, supra, 293 U.S. at 515-516, 55 S.Ct. 287. See generally 9 J. Mertens, Law of Federal Income Taxation (1965) § 50.61 et seq. Once the taxpayer shows that the deficiency assessment is wrong, the burden shifts back to the Commissioner to show the existence and amount of the deficiency. Cohen v. Commissioner, 266 F.2d 5 (9th Cir. 1959).
Appellants recognize the general existence of this burden, but seek to avoid it here, arguing that the Commissioner's notices of deficiencies did not fairly warn them of his theories of law and fact. See Helvering v. Tex-Penn Co., 300 U.S. 481, 498, 57 S.Ct. 569, 81 L.Ed. 755 (1937). While it is true that the presumption of correctness does not extend to bases of deficiency not raised in the statutory notice, Taylor v. Commissioner, 70 F.2d 619, 621 (2d Cir. 1934), aff'd 293 U.S. 507, 55 S.Ct. 287, 79 L.Ed. 623 (1935), that rule is of little avail to appellants here. The statutory notice clearly identified the Commissioner's basic theory, that the challenged deductions represented capital expenditures, not intangible drilling and development costs. That general theory was made quite specific by the Engineering and Valuation Reports, which appellants received before the trial below, and which taxpayers themselves entered into evidence. These reports, received for the limited purpose of explaining the deficiency determination, see Clark v. Commissioner, supra, make the Commissioner's theory crystal clear — the excess of the deduction claimed over the going rate is so great as to require explanation by the taxpayers. In view of these reports, it can hardly be said that the taxpayers were confronted with a cryptic or arbitrary deficiency determination; indeed, they were apprised of the precise...
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