Brountas v. Comm'r of Internal Revenue , Docket Nos. 6255-78
| Decision Date | 26 December 1979 |
| Docket Number | 8497-76,Docket Nos. 6255-78,8698-77.1,8231-76 |
| Citation | 73 T.C. 491 |
| Parties | PAUL P. BROUNTAS and LYNN T. BROUNTAS, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENTCRC CORPORATION, PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner Brountas was a limited partner in an oil and gas drilling partnership, Coral I, while petitioner CRC was a general partner in Coral I, Coral II (another similar venture), and a direct investor in other drilling ventures. Each of these ventures used the following basic format, with variations. An exploratory drilling prospect would be presented to CRC by an operator. If the geology appeared favorable, CRC would purchase for itself, or cause a limited partnership such as Coral I or Coral II to purchase, the operator's leasehold interest and the operator's promise to drill to the hoped-for producing zone on a “no-out turnkey” basis. The operator would be paid in cash 40 percent of the nominal total price of the leasehold and drilling contract. The purchaser would execute a nonrecourse note to the operator or a “lender” for the 60 percent balance, payable solely from production, if any, from the prospect or from certain other prospects (usually two) with respect to which the note would be cross-collateralized. The operator would also receive a completion option, permitting it to pay the costs of completing the well if potential production was discovered and repay the purchaser's lease acquisition price and thereby regain a 40-percent interest in the well. The cash portion of the price for the drilling contract would have alone been a fair price for a “Gulf Coast Clause” or “standard turnkey” drilling contract, which, unlike the no-out turnkey, relieved the operator from his responsibility if certain unfavorable conditions were found in the course of drilling. The terms of the entire package were within a reasonable range of commercial practice.
Held, on the facts, the nonrecourse notes had value and commercial reality and were not shams. Held, further: The nonrecourse notes constituted oil or gas payments or the substantial economic equivalent within the meaning of sec. 636 and regulations sec. 1.636-3(a)(2), and must therefore be treated for tax purposes as loans from the lender or operator to the purchasers. Therefore, the face amount of the notes was fully includable, in the case of partnership purchases, in the basis of the partners' partnership interest, as liabilities under sec. 752, despite the contingent nature of the obligation. Held, further, the fact that the security for the notes was less than their face value does not prevent inclusion of the notes at face value for purposes of sec. 752(c). Tufts v. Commissioner, 70 T.C. 756 (1978), on appeal (5th Cir., Apr. 23, 1979), followed. Held, further, the partnerships were entitled to deductions for intangible drilling and development costs equal to the face value of the no-out turnkey drilling contract. Held, further, interest payable on the nonrecourse notes was deductible by the accrual-basis partnerships as it accrued, despite the contingent nature of the obligation, under regulations sec. 1.636-1(a)(3), example (1 ). Held, further: Respondent properly disallowed deductions to the partnership or CRC for the 60-percent note portion of the lease purchase price. On the facts, these were not advanced royalties, for the leasehold interests were acquired from the operators by purchase and not by lease. Held, further, respondent properly disallowed deductions claimed by the partnerships for management fees to the extent these fees in fact represented sales commission expenses paid by CRC and reimbursed by the partnerships to CRC. Held, further, respondent properly disallowed abandonment losses of capitalized leasehold acquisition expenses of unproductive leases for periods prior to acts of definitive abandonment (i.e., periods before delay rentals were permitted to fall due unpaid). A. T. Jergins Trust v. Commissioner, 22 B.T.A. 551 (1931), affd. on other issues 288 U.S. 508 (1933), revg. 61 F.2d 92 (9th Cir. 1932), followed. Held, further, fraud penalties against CRC are not sustained.
Reserved for further briefing and opinion is the issue of the timing and character of cancellation of indebtedness income generated in the case of nonrecourse indebtedness secured only by nonproductive leaseholds. Thomas B. Rutter, for the petitioners.
Bernard Nelson, M. Kevin Phalin, David Johnson, and Bob Hollohan, for the respondent.
Respondent determined deficiencies, plus additions to the tax for fraud under section 6653(b)2 and accumulated earnings tax under section 531, as follows:
+-----------------------------------------------------------------------------+
¦Petitioner ¦Year ¦Docket No. ¦Deficiency ¦Sec. 531 ¦Sec. 6653(b) ¦
+------------------+------+------------+------------+----------+--------------¦
¦ ¦ ¦ ¦ ¦ ¦ ¦
+------------------+------+------------+------------+----------+--------------¦
¦Paul and Lynn ¦1972 ¦8231-76 ¦$6,283.35 ¦none ¦none ¦
¦Brountas ¦ ¦ ¦ ¦ ¦ ¦
+------------------+------+------------+------------+----------+--------------¦
¦Paul and Lynn ¦1973 ¦6255-78 ¦19,006.43 ¦none ¦none ¦
¦Brountas ¦ ¦ ¦ ¦ ¦ ¦
+------------------+------+------------+------------+----------+--------------¦
¦CRC Corp. ¦1972 ¦8497-76 ¦238,826.00 ¦$152,485 ¦$195,656 ¦
+------------------+------+------------+------------+----------+--------------¦
¦CRC Corp. ¦1973 ¦8698-77 ¦272,821.00 ¦none ¦136,411 ¦
+-----------------------------------------------------------------------------+
Petitioner Paul Brountas was a limited partner in a “leveraged” oil and gas drilling venture (Coral I), and petitioner CRC Corp. (CRC) was both the general partner and a limited partner in Coral I and in another “leveraged” oil and gas drilling venture (Coral II). CRC also made direct investments for its own account in similar ventures. These ventures were “leveraged” in that they used nonrecourse notes as a portion of the consideration (in addition to cash contributed by CRC and various limited partners) in transactions with unrelated oil and gas operators. Coral I, Coral II, and CRC claimed deductions in 1972 and 1973 in excess of the amount of cash they expended in exploratory oil and gas drilling, giving rise to losses in both years, and petitioners Brountas and CRC reported their distributive shares of Coral I's and Coral II's claimed losses in 1972 and 1973. Other issues having been severed for trial at a later date,3 the issues for decision at this time are:
(1) Whether Coral I, Coral II, and CRC are entitled to deductions for intangible drilling and development costs in excess of the amount of cash spent in these transactions. Specifically, we must consider:
(a) Whether the nonrecourse notes were shams.
(b) If the nonrecourse notes were not shams, whether petitioners may include the face amount of these notes in their bases in their partnership interests. This issue involves consideration of (i) the applicability of section 636 (production payments) to these notes, and (ii) whether petitioners' bases are limited to the fair market value of the security for the nonrecourse notes.
(c) If these nonrecourse notes provide bases, the amount of the intangible development and drilling costs which Coral I, Coral II, and CRC are entitled to deduct.
(2) Whether Coral I, Coral II, and CRC are entitled to interest deductions relating to interest paid on the nonrecourse notes.
(3) Whether Coral I, Coral II, and CRC are entitled to claimed deductions for advanced royalties.
(4) Whether Coral I and Coral II are entitled to claimed deductions for management fees.
(5) Whether Coral I, Coral II, and CRC are entitled to claimed deductions for abandonment losses.
(6) With respect to 1973, whether petitioners realized ordinary income from discharge of the indebtedness on these notes.4
(7) Whether any part of petitioner CRC's underpayment of tax for 1972 was due to fraud.
Some of the facts have been stipulated by the parties and are found accordingly.
At the time they filed their petitions, Paul and Lynn Brountas were residents of Weston, Mass. Lynn Brountas is a party solely by virtue of the fact that she filed joint returns with her husband Paul Brountas (hereinafter Brountas) for the years in issue.
Petitioner CRC Corp. (CRC) is a Delaware corporation. At the time it filed its petitions, CRC's principal office was located in Jenkintown, Pa.
Brountas was a limited partner in Special Coral 1972 Drilling Venture I (Coral I) during the years in issue. During these years, CRC was both the general partner and a limited partner in Coral I and in Special Coral 1972 Drilling Venture II (Coral II). Coral I and Coral II are duly organized limited partnerships under the laws of the State of Texas. At all times pertinent hereto, Coral I, Coral II, and CRC used the accrual method of accounting.
Brountas is a lawyer. In 1972, he contributed $10,000 in cash to Coral I; in 1973, he contributed an additional $1,000 cash for an additional development program for Coral I. He had a 0.8811-percent capital and profits interest in Coral I during both years. CRC contributed $25,000 cash to Coral I in 1972, $25,000 cash to Coral II in 1972, and an additional $2,500 to each partnership in 1973 for additional development. CRC had a 2.2026-percent interest in Coral I during 1972 and 1973 and a 2.1872-percent interest in Coral II during those years. CRC made direct cash investments in various partnerships which engaged in leveraged drilling operations. Such investments totaled $359,000 in 1972.
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