Brountas v. C. I. R.

• Citation: 692 F.2d 152
• Decision Date: 28 September 1982
• Docket Number: 81-1877,Nos. 81-1840,s. 81-1840
• Parties: 82-2 USTC P 9626 Paul P. BROUNTAS, et al., Petitioners, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellant. Paul P. and Lynn T. BROUNTAS, Petitioners, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (1st Circuit)

Page 152

692 F.2d 152

82-2 USTC P 9626

Paul P. BROUNTAS, et al., Petitioners, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellant.

Paul P. and Lynn T. BROUNTAS, Petitioners, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.

Nos. 81-1840, 81-1877.

United States Court of Appeals First Circuit.

Argued June 4, 1982.

Decided Sept. 28, 1982.

George L. Hastings, Jr., Atty., Tax Div., Dept. of Justice, Washington, D.C., with whom Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup and Ann Belanger Durney, Attys., Tax Div., Dept. of Justice, Washington, D.C., were on brief, for C.I.R.

Thomas B. Rutter, Philadelphia, Pa., for Paul P. Brountas, et al.

Before CAMPBELL and BREYER, Circuit Judges, and PETTINE, ^* Senior District Judge.

BREYER, Circuit Judge.

In this "tax shelter" case, we are asked to determine the propriety of certain deductions taken by a limited partner in an oil-and-gas drilling partnership. There is little question that subsequent changes in the law have made deductions similar to those at issue here improper for individual taxpayers. See 26 U.S.C. Sec. 465 (Supp. IV 1980) (the "at risk" provisions). But, under the law as it stood when the deductions were taken, which is the law we must apply, the propriety of the deductions is a complicated and unsettled question. The Tax Court's opinion from which this appeal was taken holds that the deductions were proper. See 73 T.C. 491 (1979). Yet, the Fifth Circuit, in a different case but on nearly identical facts, determined that they were not. Gibson Products Co. v. United States, 637 F.2d 1041 (5th Cir. 1981). Having reviewed both of these decisions, as well as the briefs filed and various cases and authorities, we find as did the Fifth Circuit (but for somewhat different reasons) that the deductions here were improper.

I

This case arises out of the activities of a Texas limited partnership known as "Coral I." The partnership was organized in 1972, and was set up to explore and develop "oil and gas" property. The case involves two investors in Coral I. One is CRC Corp., which was both a limited and general partner. The other is Paul Brountas, one of several limited partners in Coral I. Brountas contributed $10,000 in 1972 and $1,000 in 1973. He and his wife (who filed a joint return with her husband) filed a petition in the United States Tax Court contesting a notice of deficiency in their return for 1972. The Tax Court found in favor of the petitioners. The Commissioner has appealed. Brountas has also appealed from one part of the Tax Court's decision. The appeals in this circuit concern Brountas and his wife but not CRC.

The Coral I partnership worked in essentially the following manner: At the outset, partners would contribute money (as Brountas did in the amount of $10,000). This money would then be used to buy participations in what looked like promising "oil and gas" ventures. These ventures were invariably set up by CRC officials, and then sold in fractional interests to various CRC-managed partnerships (such as Coral I) and to CRC on its own account. In each case, a venture encompassed a package of several (typically three) oil and gas leasehold interests, or "prospects." These prospects (leaseholds) were owned by an "operator"--an entrepreneur unrelated to CRC who wanted to develop the prospects but lacked the money to do so. The investors had the money at a time when it was apparently difficult to obtain in the oil and gas industry; they were in a position to strike advantageous bargains.

The bargains followed a uniform pattern. The operator would agree to convey to the investors a set of "oil and gas" leaseholds and would agree to drill a test well on each. The test well was often an expensive undertaking because CRC officials insisted that the operator agree to complete the well no matter how difficult this proved to be. In return, the investors agreed to pay the operator a "total" contract price. This price consisted of a "lease purchase price" and a "drilling contract price," corresponding to the two parts of the operator's agreement. Each of these component prices was apparently negotiated separately with the operator by someone on CRC's behalf. The Tax Court found, and the government does not contest, that the two prices were each the result of arms-length bargaining and represented reasonable charges for the leaseholds and obligations in question.

The investors, however, did not pay the total price in cash. Rather, they paid the contract price with what the Tax Court found amounted to 40 percent in cash and 60 percent in a "nonrecourse" note. The "nonrecourse" note bore interest and was payable "on demand" after a certain time (usually about five years). It was "secured" by a percentage of oil and gas production from the underlying prospects, by a percentage of the leaseholds themselves, and by some of the equipment used. And, it provided that payment on the notes would be made out of production once production began. Despite these assurances, however, it was quite clear to all concerned that neither principal nor interest on a note would ever be paid if the prospects in a given venture all proved to be nonproducers. The investors were not personally liable on the notes; the operators could look to no property other than that securing the notes for payment; and all of that property would be essentially worthless if the wells proved to be dry. As a practical matter, the notes would be paid out of production or not paid at all.

The agreement between the investors and the operator provided the operator with one further potential source of compensation for drilling the test wells--a "development option." If a well proved successful, the agreement allowed the operator to gain an "equity" interest in its production by entering into a "completion joint venture" with the investors. To exercise this "development option," the operator would have to agree to "complete" the test well to obtain production and to reimburse the investors for certain previous expenses. The operator and investors would then share all future costs and production in a specified ratio (subject to certain additional restrictions and conditions not relevant here).

The limited partners believed they had invested in a leveraged "tax shelter." This type of shelter provides an investor with tax deductions greater in amount than the cash that he initially provides for the investment. These extra deductions can be subtracted from the investor's ordinary income, thus "sheltering" some of his ordinary income from tax. Of course, these extra deductions may some day be offset when the investor must recognize "income" though he receives no payment. But this day of reckoning is in the future, and in the meantime the government has provided the investor at least with what is effectively an interest-free loan of the dollars that it otherwise would have taxed away. See Harrell & Stricoff, Overview of an Oil and Gas Tax Shelter, 28 Oil & Gas Tax Q. 496, 496 (1980).

We can illustrate how the promoters and investors thought this shelter would work by using the facts of this case in simplified form. Assume the operator conveys a package of prospects to investors for $250,000 and agrees to drill test wells on each prospect for another $750,000. The investors, in turn, agree to pay the "total contract price" of $1,000,000 with $400,000 in cash and $600,000 in a nonrecourse note payable out of production and secured (as indicated above) by production, leaseholds, and equipment. The operator and the investors further agree to allocate $100,000 of the cash and $150,000 of the note to the "purchase price" of the prospects, and $300,000 of the cash and $450,000 of the note to the "drilling contract price." In short, they agree that the same note/cash ratio as applies to the total price shall also apply to the two component prices. For simplicity, assume that there is only one investor, a partnership called Coral I, and that a (hypothetical) limited partner called Brountas has contributed cash equal to one percent, or $4,000, of the partnership's initial cash capital. Assuming these numbers, Brountas' argument amounts to a claim that he is entitled to deduct $7,500 as expenses. This figure--$7,500--equals one percent (Brountas' share) of the total "drilling contract" price.

Brountas' argument begins with the fact that the cost of drilling an oil well is an immediately deductible expense. This is so because the Internal Revenue Code allows taxpayers (who make the proper election) to deduct all "intangible drilling and development costs" (or IDC's) in the year incurred. 26 U.S.C. Sec. 263(c) (Supp. IV 1980); Treas. Reg. Sec. 1.612-4(a) (1965). The Code treats other expenses less favorably. The cost of machinery and equipment must be capitalized and depreciated. The cost of acquiring leaseholds is not immediately deductible, but instead becomes part of the investor's tax "basis" and must be recovered gradually through the depletion allowance or on final disposition of the property as an offset against "amount realized." But unlike these costs, the "intangible" costs of drilling and developing a well, such as "wages, fuel, repairs, hauling, supplies ... [and] the cost to [the investors here] of any drilling or development work ... done for them by contractors under any form of contract," Treas. Reg. 1.612-4(a) (1965) are immediately deductible.

Brountas thus claims that the partnership incurred what (in our example) amounts to $750,000 in IDC's in its first year. This expense consists of its payment to the operator (in return for a promise to drill) of $300,000 cash and $450,000 in nonrecourse notes. Brountas believes that the partnership, an accrual base taxpayer, can accrue as an expense in 1972 the future obligation to pay money that the notes represent. And, as a one percent partner, Brountas seeks to deduct one percent of the...