Boone v. United States

• Decision Date: 27 December 1973
• Docket Number: Civ. No. 4629.
• Citation: 374 F. Supp. 115
• Parties: Ralph BOONE and Robert Boone, as Administrators C. T. A. of the Estate of Raymond Boone, Deceased, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of South Dakota

374 F. Supp. 115

Ralph BOONE and Robert Boone, as Administrators C. T. A. of the Estate of Raymond Boone, Deceased, Plaintiffs, v. UNITED STATES of America, Defendant.

Civ. No. 4629.

United States District Court, D. North Dakota, Northeastern Division.

December 27, 1973.

Garry A. Pearson, Grand Forks, N. D., for plaintiffs.

Harold O. Bullis, U. S. Atty., Fargo, N. D., for defendant.

MEMORANDUM OF DECISION

BENSON, Chief Judge.

Plaintiffs, as Administrators C.T.A. of the Estate of Raymond Boone, deceased, have sued to recover $13,219.91 in federal income taxes paid by Raymond Boone (Decedent), for the years 1964 and 1965. The dispute arose over the method Decedent used in reporting a 1965 purchase of a seed potato futures contract, and Decedent's deductions, as expenses, of intangible drilling and development costs incurred in connection with an interest in certain oil well operations. The parties have stipulated the facts. The burden is on the plaintiffs. New Colonial Ice Co., Inc., v. Helvering, Commissioner of Internal Revenue, 292 U.S. 435, 54 S.Ct. 788, 78 L.Ed. 1348 (1934); Wells-Lee v. C.I.R., 360 F.2d 665 (8th Cir. 1966).

POTATO FUTURES CONTRACT

The Decedent was an equal partner with his three brothers in a potato farming operation. In the fall of 1965, Decedent attempted to interest his partners in buying a potato futures contract to hedge the cost of the seed potatoes which would be required for the spring planting operations. The partners demurred, and the Decedent individually purchased a contract at a price of $13,387.50, on which he made a payment of $6,400.00. The contract was sold in March, 1966, at a loss of $304.00. The partnership acquired its seed potatoes from other sources. On his 1965 individual income tax return, the Decedent, on a cash basis, deducted from his individual share of partnership income, the futures contract price of $13,387.50 as an ordinary and necessary business expense, on the theory that the transaction was a hedge. The Internal Revenue Service (I.R.S.) treated the transaction as the purchase of a 26 U.S.C. § 1221 capital asset, and disallowed the deduction.

"A commodity future is a contract to purchase some fixed amount of a commodity at a future date for a fixed price". Corn Products Refining Co. v. C.I.R., 350 U.S. 46, 47, n. 1, 76 S.Ct. 20, 21, 100 L.Ed. 29 (1955).

There are three types of commodity exchanges when dealing in commodity futures.

(1) hedges — losses allowed in full.

(2) wagering contracts — losses allowed only to extent of gain thereon.

(3) legitimate capital investment — capital gains treatment of losses & gain. Futures are treated as capital asset. See C.I.R. v. Farmers & Ginners Cotton Oil Co., 120 F.2d 772 (5th Cir. 1941); 3B Mertens § 22.14 (1972).

"A hedge is regarded as a form of business insurance, directed to the factor of price of a commodity used in a business, and in its consequences is treated as an expenditure in the course of the business. . . . Losses from true hedges are allowable in full." 3B Mertens § 22.14 (1972).

To have a bona fide hedge, there must be: (1) a risk of loss by unfavorable changes in the prices of something expected to be used or marketed in one's business, (2) a possibility of shifting such risks to someone else, through purchase or sale of futures contracts; and (3) an intention and attempt to shift the risk.

Taxpayer Boone's potato seed transaction was not a legitimate hedge because he was not dealing with "something expected to be used or marketed in one's business".

"A thread that runs through all of the cases is that there must be a direct relation between the product that is the basis of the taxpayer's business and the commodity futures in which he deals for protection . . .. Transactions relating to inventories which are an integral part of taxpayer's business do not result in the realization of capital gains or losses, even though the commodity involved appears to come within the literal wording of the definition of capital assets." 3B Mertens § 22.14 (1972) (emphasis added). See Corn Products, the controlling authority.

Taxpayer Boone, as an individual, was not engaged in potato dealing as a business. It was the partnership that bought, sold and raised potatoes. One must look to the taxpayer's business. Kaltreider v. C.I.R., 255 F.2d 833 (3rd Cir. 1958); Hollywood Baseball Ass'n. v. C.I.R., 423 F.2d 494 (9th Cir. 1970).

There is no evidence before this Court that the individual partners, by agreement, were required to furnish their share of the seed potatoes, and there is no evidence that the partners, by practice and custom ever individually furnished their share of seed potatoes. The seed potato expense was a partnership expense and not allowable as a deduction on the individual income tax return of a partner. See Wilson v. United States, 376 F.2d 280, 179 Ct.Cl. 725 (1967).

The Court concludes that the Decedent's potato futures contract transaction was on his own behalf and not for the account of the partnership, and therefore no part of it was deductible on the Decedent's 1965 income tax return. See Faroll v. Jarecki, 231 F.2d 281 (7th Cir. 1956).

INTANGIBLE DRILLING AND DEVELOPMENT COSTS

During the calendar years 1964 and 1965, Decedent invested in several oil well ventures. The investments were made as a result of a long time friendship with a Donald Davis of Poneto, Indiana. Mr. Davis convinced Decedent and several other investors to help develop several oil well properties. Decedent never knew the names or addresses of the other investors. The venture was put together entirely by Davis, without divulging the identity of the other investors to one another. Decedent invested in four wells.

The wells were designated as Davis #1, Davis #2, in which Decedent invested in 1964, and J. D. Clark #1 and Lattas-Harrison, in which Decedent invested in 1965.

The dispute between I.R.S. and Decedent arose when I.R.S. disallowed Decedent's deduction of intangible drilling and development costs as expenses.

26 U.S.C. § 263(c) directs the promulgation of regulations granting an option to deduct as expenses intangible drilling and development costs in the case of oil and gas wells. 26 C.F.R. § 1.612-4 provides:

"(a) Option with respect to intangible drilling and development costs. In accordance with the provisions of § 263(a), intangible drilling and development costs incurred by an operator (one who holds a working or operating interest in any tract or parcel of land either as a fee owner or under a lease or any other form of contract granting working or operating rights) in the development of oil and gas properties may at his option be chargeable to capital or to expense."

The Decedent claimed the option provided in 26 C.F.R. § 1.612-4(a). The I.R.S. denied it, contending the relationship between Decedent, Davis, and other investors created a partnership; that only the partnership was entitled to elect the option and the individual may not elect even where no election was made by the partnership.

26 U.S.C. § 703 provides:

"(b) Election of Partnership; Any election affecting the computation of taxable income derived from a partnership shall be made by the partnership, . . ."

The Decedent contends a partnership was never created, and he was entitled to individually elect and deduct such expenses. He further contends that even if a partnership was formed, he was entitled to exercise the § 1.612-4(a) option where the partnership failed to elect.

Decedent cites Goodall v. Commissioner of Internal Revenue, 391 F.2d 775 (8th Cir. 1968), cert. den., 393 U.S. 829, 89 S.Ct. 96, 21 L.Ed.2d 100, as authority for the right of individual elections inconsistent with partnership elections regarding intangible drilling expenses. Goodall cannot be so broadly read, for it specifically concluded that the individual partner's election was consistent with the partnership return and that, therefore, the taxpayer was entitled to expense such costs. Goodall deals with partnership returns which, in technical form, did not meet I.R.S. requirements. The following language is pertinent:

"The very evidence which supports the conclusion that costs of this kind were incurred in 1949 demonstrates, without controversy, that Mr. Goodall intended that the costs be expensed rather than capitalized. . . ."

"There is nothing in any of the partnership returns indicative of a contrary intent. Intangible drilling costs were clearly and consistently asserted as deductions in 1950 and succeeding years and the only 1949 item, resembling that description, although unrelated, was also asserted as a deduction. Nothing of this kind was ever given a capital character on any of the returns."

"The partnership records are equally consistent. The costs were always expensed and not capitalized."

"There is an acceptable explanation for the failure of the 1949 costs to find their way into the partnership return for that year." at 804, 805 (emphasis added).

The Eighth Circuit in Goodall asserted "that the partnership election is controlling irrespective of any election made by the individuals with respect to their independent operations." at 802, citing Bentex Oil Corp., 20 T.C. 565 (1953).

Goodall is consistent with the rule that, if a partnership exists under the Codes, an election to expense intangible drilling development costs must be made by the partnership. As such, a failure to elect by the partnership precludes an election by individual members. 26 U. S.C. § 703(b). 26 C.F.R. § 1.703-1(b) states the general rule concerning the elections of the partnership as follows:

"Any elections . . . affecting the computation of income derived from a partnership shall be made by the partnership. For example, . . . the option to deduct as expenses intangible drilling and development costs shall be made by the partnership and not by the partners separately." (emphasis added). See also Morburger v. United States, 303 F. Supp. 42 (W.D.Ky.1969); 4

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