Bush #1 C/O Stonestreet Lands Co. v. Comm'r of Internal Revenue

• Decision Date: 26 May 1967
• Docket Number: Docket No. 3686-64.
• Citation: 48 T.C. 218
• Parties: BUSH #1 C/O STONESTREET LANDS CO., PETITIONER V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

48 T.C. 218

BUSH #1 C/O STONESTREET LANDS CO., PETITIONER V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 3686-64.

Tax Court of the United States.

Filed May 26, 1967.

Philip O. North, for the petitioner.

John H. Menzel, for the respondent.

Held, petitioner, a producing oil and gas well, found to be a mining partnership which did not qualify as an association taxable as a corporation.

DRENNEN, Judge:

Respondent determined a deficiency in petitioner's income tax for the taxable year 1961 in the amount of $535.20.

The principal issue for decision is whether petitioner was an association taxable as a corporation during the years 1960 and 1961. Petitioner filed partnership returns of income for both of the years 1960 and 1961, on which it reported a net loss for 1960 and a net profit for 1961. In his notice of deficiency, respondent determined that petitioner was an association taxable as a corporation for both years, made certain adjustments in the net loss reported by petitioner for the year 1960, allowed the resulting reduced net loss as an operating loss carryover to petitioner in computing petitioner's corporate tax for 1961, and determined that the resulting corporate tax for 1961 was due from petitioner. The adjustments made to the net loss reported by petitioner for 1960 were reduction of the deduction claimed for intangible drilling expense to the amount actually paid by the promoter to have the well drilled rather than the amounts paid by the participants to the promoter for their interests in the well, disallowance of first-year additional depreciation, and capitalization of $600 of the amount claimed for drilling expense allocated by respondent to hauling expense. If we conclude that petitioner was not an association taxable as a corporation it will be unnecessary for us to decide the remaining issues because any losses incurred by petitioner would be deductible by the individual participants in the well, rather than petitioner, and none of them are parties to this proceeding.

FINDINGS OF FACT

Bush #1 is a producing oil and gas well located in Gilmer County, W. Va. The well is drilled to the Weir sand, about 1,900 feet deep. Drilling was started August 25, 1960, and was completed September 21, 1960. Federal partnership returns of income were filed for petitioner for the years 1960 and 1961 with the district director of internal revenue, Parkersburg, W. Va.

Stonestreet Oil & Gas Co. (hereinafter referred to as SOG) is a partnership composed of three brothers Denzil, O. Vance, and Bernard Stonestreet (hereinafter referred to as Denzil, Vance, and Bernard, respectively) as equal partners. The principal business of SOG is the promotion of oil and gas wells in the area of Spencer, W. Va. It maintains offices in Spencer and Charleston, W. va., and its business affairs are conducted primarily by Denzil. SOG promoted Bush #1 and Bush #2 wells.

Stonestreet Lands Co. (hereinafter referred to as Lands Co.) is a West Virginia corporation, the stock of which is equally owned by the three Stonestreet brothers. Lands Co. maintains its office at Spencer, W. Va., and its business activities are conducted primarily by Vance. Its business consists of acting as agent for and performing various necessary functions for numerous oil and gas wells in the Spencer area, as well as for SOG. At the time of this trial Lands Co. was acting as agent for and performing these same functions for about 70 oil and gas wells, of which about 55 had been promoted by SOG and about 15 had been promoted by others. These services consisted primarily of (a) keeping books of account; (b) causing Federal and State tax returns to be filed; (c) receiving and disbursing moneys; (d) furnishing regular accounting summaries to owners; (e) overseeing maintenance of wells; and (f) entering into contracts, including liability insurance contracts, for and in behalf of the owners of the wells. These functions were performed separately for each well; some of them were also performed for SOG.

Stonestreet Drilling Co. (hereinafter referred to as Drilling Co.) is a West Virginia corporation, the stock of which is equally owned by the three Stonestreet brothers. Its principal business is the drilling of oil and gas wells and its activities are conducted primarily by Bernard.

The activities of SOG, Lands Co., and Drilling Co. were conducted separately and the three organizations were separate entities, although the three Stonestreet brothers owned each of them.

On or before May 10, 1960, SOG negotiated with a large number of heirs of Hobart Bush a mineral lease on a 108 3/4-acre tract of land in Gilmer County, W. Va., and arranged to have Lands Co., as its agent, named as lessee therein. The lease was dated May 10, 1960. Under the terms of the lease, the lessee was not required to pay any rental but the lease was to be canceled if the lessee did not drill a well on the property within 9 months after the lease was signed; and the lessee was also obligated to drill a second well within another 9 months if the first well proved productive. The lessors were to receive a royalty of one-eighth of the oil and one-eighth of the value of the gas produced from the property. Neither SOG nor Lands Co. paid anything else for the lease. SOG originally agreed with the Bush heirs to drill a well to the Injun sand, which is not as deep as the Weir sand, and SOG was to receive $325 for each one thirty-second interest in the well. Before drilling was started, however, it was decided that SOG should drill the well to the Weir sand and receive $400 for each one thirty-second interest. SOG, acting through Denzil, thereupon set about to ‘stock out'¹ or promote the well by contacting various potential investors with a view to interesting them in investing in the well. Title to the Bush farm was examined by an attorney, who received for his services a one thirty-second interest in the oil and gas well which was to be drilled on the property.

It was understood by the persons whom Denzil contacted, in accordance with the usual terms of stocking-out agreements in this area, that they would obtain a one thirty-second interest in the well for each $400 they invested; that the $400 per one thirty-second interest was to be paid to SOG to drill a well on the Bush lease, on a ‘turnkey contract’ basis, to the Weir sand; that if the well was drilled for less than the amounts received by SOG from the investors, the excess would represent a profit to the promoter; that if it cost more to drill the well than was received by SOG, SOG would have to bear the additional cost; that if the well was a dry hole SOG would plug the hole at its own expense; and that if the well turned out to be productive each owner of an interest in the well would be assessed his proportionate share of the cost of equipping the well and would receive an assignment of his proportionate undivided interest in the leasehold estate and the well. They also understood that the well would be operated as a partnership. There was no written agreement entered into between the promoter and the investors at the time the well was ‘stocked out.’ The above terms, except as to the cost of participating interests and the depth of the well, which varied, were typical of the terms of most oil and gas promotion agreements in the Spencer area and were known to and relied on by most persons promoting and investing in oil and gas wells in the area.

Several of the potential investors contacted by Denzil, consisting of a group of Union Carbide employees who were not familiar with oil and gas operating agreements in West Virginia, took it upon themselves to find out about oil and gas wells generally and to travel to the site of the proposed well on the Bush property on August 13, 1960, prior to making any payment for an interest in the well. They considered that, as partners, they would have to make decisions about the drilling and operation of the well and that no other well could be drilled on the leased property without their consent. The participants also understood that they could sell their interests in the leasehold estate and in the well without the consent of SOG or of LANDS Co.² Shortly after talking to Denzil they made the requisite investment.

There was some discussion between several of the participants and Denzil about what driller should be chosen to drill Bush #1. Drilling Co. and Raines Drilling Co. were mentioned as possible drillers by Denzil but no decision was reached as to the driller when the participants were first contacted. The participants did not direct that any particular driller was to be chosen; the choice of a driller was later made by SOG as promoter.

Bush #1 well was ‘stocked out’ by SOG in a period of approximately 2 weeks during August of 1960. No advertising materials were used; interests in the well were sold primarily through personal contacts by Denzil. A total of 29 one thirty-second interests were sold to 21 other persons or partnerships, and oral agreements on the above terms were entered into between these investors and SOG, acting through Denzil. The Bush family heirs, who lived outside of West Virginia, acquired about one-third of the ownership interests in the well, the Union Carbide employees acquired about one-fourth of the ownership interests, and the remainder of the 29 one thirty-second interests were acquired by individuals or partnerships in Spencer, Parkersburg, and Charleston, W. Va. As previously mentioned, a one thirty-second interest was assigned to the attorney who checked the title of the Bush farm, and SOG received during 1960 the sum of $11,600 under these agreements for drilling the first well. The investors paid this amount to Lands Co., as agent for SOG.

SOG contracted with Drilling Co. to have the Bush #1 well drilled and Drilling Co. subcontracted the drilling to Raines Drilling Co., which actually drilled the well. SOG paid out $7,742 in 1960 for the...