Brown v. U.S.

• Decision Date: 27 February 1989
• Docket Number: No. 87-6333,87-6333
• Citation: 868 F.2d 859
• Parties: -779, 89-1 USTC P 9190 Clyde BROWN, Jr., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 859

868 F.2d 859

63 A.F.T.R.2d 89-779, 89-1 USTC P 9190

Clyde BROWN, Jr., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 87-6333.

United States Court of Appeals Sixth Circuit.

Argued Nov. 29, 1988.

Decided Feb. 27, 1989.

Jesse T. Mountjoy, Timothy O. Shelburne (argued), Holbrook, Wible, Sullivan & Helmers, P.S.C., Owensboro, Ky., for plaintiff-appellant.

Joseph Whittle, David Gray, U.S. Atty.'s Office, Suzanne M. Warner, Louisville, Ky., Gary R. Allen, Appellate Section, Tax Div., Dept. of Justice, William S. Rose, Jr., Gilbert S. Rothenberg, Francis M. Allegra (argued) Michael J. Salem, U.S. Dept. of Justice, Tax Div., Washington, D.C., for U.S.

Before: KEITH and KRUPANSKY, Circuit Judges, and CONTIE, Senior Circuit Judge.

CONTIE, Senior Circuit Judge.

Clyde Brown, Jr. appeals from the district court's judgment entered December 1, 1987, which denies in part his claim for a refund of taxes paid filed pursuant to 28 U.S.C. Sec. 1346(a)(1). For the following reasons, we affirm the district court's judgment in part, vacate the district court's judgment in part, reverse the district court's judgment in part, and remand this case for further proceedings.

I.

Appellant Clyde Brown, Jr. began mining and investing in coal in the early 1950's. He had conducted coal extraction activities in his own name as a proprietor in the 1950's and as late as 1966, but not thereafter. Nonetheless, he is an experienced coal operator with great knowledge of the coal propensities of the counties in western Kentucky.

During the years 1970-1977, Brown entered into the following six different coal mining leases, collection of leases, or subleases in his individual capacity or in cooperation with Brown Badgett, Inc., a corporation in which Brown holds a substantial interest. First, on June 10, 1970, Brown and Brown Badgett acquired as lessees a coal mining lease from Harrison and Pearl Cross (the Cross lease). Second, beginning on November 4, 1970, Brown acquired as lessee six lignite mining leases from Jackson Lignite Company, covering lignite deposits in Alabama, and acquired four leases from other individuals relating to these deposits (the Alabama lignite leases). Third, on October 7, 1973, Brown acquired as lessee a coal mining lease from Hayward Spinks, Jackie R. Spinks, and others (the Spinks lease). Fourth, on July 30, 1976, Brown and Brown Badgett acquired as lessees a coal mining lease from Henry Casebier and his wife (the Casebier lease). Fifth, on October 26, 1976, Brown and Brown Badgett acquired as lessees a coal mining lease from E.R. Wickliffe and his wife (the Wickliffe lease). Finally, on March 8, 1977, Brown entered into a coal mining sublease with Old Ben Coal Company (the Old Ben sublease). ¹

In each transaction, Brown acquired the mineral rights to particular tracts of land in exchange for a certain sum of money per month in advanced minimum coal royalties. These royalty payments were to be credited against future earned royalties.

This tax dispute arises out of Brown's treatment of the advanced minimum royalty payments made to his lessors in 1976. In that year, Brown deducted these payments, totalling $41,118.63, as trade or business expenses pursuant to I.R.C. Sec. 162(a)(3). ² Section 162(a)(3) permits a taxpayer to deduct "rentals or other payments required to be made as a condition to the continued use or possession, for purposes of trade or business, of property to which the taxpayer has not taken or is not taking title in or in which he has no equity."

After 1976, but before he had begun mining the tracts of land, Brown assigned or subleased each of the coal mining leases to various parties. The Commissioner of Internal Revenue audited Brown's return and assessed a deficiency of $57,397.86 plus statutory interest. Among other things, the Commissioner claimed that the proper treatment of Brown's 1976 advanced minimum royalty payments is governed by I.R.C. Sec. 631(c). Section 631(c) and related provisions require a taxpayer "who owns an economic interest in coal or iron ore in place, including a sublessor" to use such royalty payments to reduce I.R.C. Sec. 1231 gains, and then to deduct a loss under I.R.C. Sec. 165(a). See I.R.C. Sec. 272.

Brown paid the assessed income tax deficiency. He then filed timely claim for refund for the year 1976 in the amount of $26,624.31. The Commissioner disallowed Brown's claim for a refund.

Thereafter, on March 25, 1982, Brown filed a complaint in the United States District Court for the Western District of Kentucky for recovery of taxes and interest. In Brown v. United States, 600 F.Supp. 47 (W.D.Ky.1984), rev'd, 782 F.2d 559 (6th Cir.1986) (Brown I ), the district court granted the government's motion for summary judgment, holding that advanced minimum royalties paid by a sublessor cannot be deducted as a trade or business expense pursuant to section 162 even though the sublease arose in years after those royalties were paid. The court further held that section 631(c) mandates that these royalties must be taken into account in computing net royalty income.

This court vacated the district court's judgment in Brown I, relying on Davis v. Commissioner, 746 F.2d 357 (6th Cir.1984), a case decided by the Sixth Circuit subsequent to the district court's decision in Brown I. Davis approved the application of the step transaction doctrine to treat the acquisition of leases and subsequent execution of subleases as one transaction in certain instances, depending upon the taxpayer's intent at the outset. This court remanded the case for further proceedings, holding that a genuine question of material fact remained concerning whether Brown intended to mine the coal as a lessee under the original leases or whether he always intended to become a sublessor. Brown I elaborated on the importance of the step transaction doctrine to its holding as follows:

Application of the step transaction doctrine is necessary to a holding that Sec. 631(c) governs the tax treatment of the royalties paid by Brown as a lessee. If the step transaction doctrine applies, Brown will be considered a lessee who is also a sublessor and, pursuant to Treas.Reg. Sec. 1.631-3(b)(3)(ii)(a), he will be subject to the terms of Sec. 631(c) requiring the royalties paid to be offset against royalty income to compute capital gain. If the doctrine does not apply, the execution of the leases and subsequent execution of subleases should be viewed as separate transactions for the purposes of taxation. Under this view, Brown's original treatment of his royalty payments as deductible business expenses would be allowable, since Sec. 631(c) by its own terms does not apply to a taxpayer who is solely a lessee.

Brown I, 782 F.2d at 564.

After remand, the district court made the following relevant conclusions of law:

The advanced royalty payments made by the plaintiff for the Wickliffe, Casebier, Cross and Spinks leases during 1976 must be offset by the royalty payments received thereafter with respect to each property, inasmuch as the royalty payments received constituted component parts of overall plans to sublease those properties.

... The advanced royalty payments made by the plaintiff for the Old Ben and Alabama Lignite leases were properly claimed as deductions by the plaintiff on his 1976 federal income tax return inasmuch as he had no settled intention which would constitute plans to sublease those properties.

... The payment by the plaintiff of $10,000.00 for the Old Ben Option Agreement on June 18, 1976, was payment for the purchase of an option which may not be treated as an ordinary business expense under 26 U.S.C. Sec. 162 during the calendar year 1976.

Brown v. United States, 687 F.Supp. 288, 293 (W.D.Ky.1987) (Brown II ).

Brown appealed and the government cross-appealed from the district court's judgment. In accordance with the stipulation of the parties, this court dismissed the government's cross-appeal in an order filed June 16, 1988. Brown's appeal presents the following issues: (1) whether the district court erroneously applied the step transaction doctrine to the 1976 advanced royalty payments which Brown made for the Wickliffe, Casebier, Cross, and Spinks leases; and (2) whether the district court erroneously held that Brown's payment of $10,000 for the Old Ben option agreement may not be treated as an ordinary business expense under section 162 during the calendar year 1976.

II.

A.

A business transaction, like the rest of life, has no clearly defined beginning or end, but it is necessary in practice to cut it, usually chronologically, into segments for tax purposes. If the segment is too thin, however, the tax results may be unfair to the taxpayer or to the government, or to both. In viewing a dynamic whole, the courts often say that an integrated transaction must not be broken into independent steps or, conversely, that the separate steps must be taken together in attaching tax consequences.

B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders p 1.05 (5th ed. 1987).

As the Supreme Court has recognized, "[a] transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consumation ..., is relevant.... To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress." Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945).

"The step transaction doctrine is a ' "judicial device expressing the familiar principle that in applying the income tax laws, the substance rather than the form of the transaction is controlling." ' " Brown v. United States, 782 F.2d 559, 563 (6th Cir.1986) (Brown I ). See also McDonald's Restaurants v. Commissioner, 688 F.2d 520, 524 (7th Cir.1982) (stating that "[t]he step-transaction...