Campbell v. Fields

• Decision Date: 27 January 1956
• Docket Number: No. 15686.,15686.
• Citation: 229 F.2d 197
• Parties: Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. Bert FIELDS and Alyne Fields, Appellees.
• Court: U.S. Court of Appeals — Fifth Circuit

229 F.2d 197 (1956)

Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. Bert FIELDS and Alyne Fields, Appellees.

No. 15686.

United States Court of Appeals Fifth Circuit.

January 27, 1956.

COPYRIGHT MATERIAL OMITTED

Elmer J. Kelsey, Atty., Dept. of Justice, Washington, D. C., H. Brian Holland, Asst. Atty. Gen., Ellis N. Slack, Sp. Asst. to the Atty. Gen., John C. Ford, Asst. U. S. Atty., Dallas, Tex., for appellant.

Robert J. Hobby, Wentworth T. Durant, Earle B. Mayfield, Jr., Dallas, Tex., Mayfield & Durant, Dallas, Tex., for appellees.

Before TUTTLE, CAMERON and JONES, Circuit Judges.

JONES, Circuit Judge.

The appellees, herein called the taxpayers, were lessees, prior to 1948, of 86 oil and gas leases in the Waskom Field, Harrison and Panola Counties, Texas. There were producing gas wells on these leases or some of them.

By an amendment to its Constitution made in 1917, the State of Texas declared that the conservation and development of the natural resources of the State were public rights and duties, and directed the Legislature to pass all such laws as may be appropriate thereto. Tex. Const. Art. 16, § 59, Vernon's Ann.St. Pursuant to this directive the Texas Legislature has enacted comprehensive regulatory measures. Administration is placed in the Railroad Commission of Texas. Vernon's Tex.Civ.Stat.Ann. Title 102, § 6004 et seq; Railroad Commission of Texas v. Rowan & Nichols Oil Co., 310 U.S. 573, 60 S.Ct. 1021, 84 L.Ed. 1368.

On April 16, 1947, the Railroad Commission of the State of Texas issued an order regulating production of oil and gas in the producing zones in the Waskon Field where taxpayers' leases were located. The drilling of new wells was restricted. Proration units of a standard area of 640 acres, with a ten per cent. tolerance area, were authorized. We need not here discuss the details of the Texas law relating to pooling and unitization. See 31 A Tex.Jur. 641, Oil and Gas, § 382, et seq. But a better understanding of the problem might be had by a consideration of the meaning of the terms "pooling" and "unitization". For this we turn to an article by Dean A. Allen King of the University of Tulsa, where it is said:

"In recent years two terms have become rather firmly established in the nomenclature of the oil and gas industry, `pooling\' and `unitization\'. Both refer to methods of achieving cooperative development, to a degree, of oil and gas properties, and while to the uninitiated they may seem to be synonymous such is not the case and it is important to distinguish them carefully. The term `pooling\' is used, and will be so used throughout this paper, to refer to the bringing together of two or more small or irregularly shaped tracts of land to form a drill site in connection with a program of uniform well spacing. The arrangement is essentially a species of joint venture whereby the various owners of the tracts pooled join to drill a well and to share in the benefits to be expected. It may be a pooling of either the working interests alone, or both the working interests and royalty interests. In the former, it is probable that compensatory or offset royalty may have to be paid to the owners of royalty under the tracts not drilled, hence, the latter is the preferred form. The drill site formed is sometimes referred to as a drilling unit; thus, confusion is introduced as statutes requiring pooling are often referred to as `unitization\' statutes. This is the case with the so-called compulsory unitization statute of Louisiana.

"`Unitization' or `unit operation,' as distinguished from `pooling', represents development and operation of an oil pool as a unit. It involves the consolidation or merger of all of the interests in the pool and designation of one or more of the parties as operator. Here the combining of all of the overlying tracts into a single unit has nothing to do with establishing a given drill site, but it does facilitate proper spacing as all surface lines are ignored. Obviously, this method of development will permit the location of wells on the structure so as to secure the most scientific use of the natural reservoir energy in the production of oil and gas by primary recovery methods." King, Pooling and Unitization of Oil and Gas Leases, (1948) 46 Mich.L.Rev. 311, 312.

The taxpayers' leases did not cover a sufficient area to permit them to put all of them into proration units. To accomplish full unitization they acquired, in 1948, 13 additional leases making 99 in all. During the year 1948, five Gas Units were formed in which the taxpayers participated. They owned all of the leases comprising three of these units. The taxpayers, owning leases on 597.02 acres, and Gulf Oil Corporation, with leases on 106.98 acres, formed a unit called the Woolworth Unit. The taxpayers put leases of 468.52 acres and Stanolind Corporation furnished leases of 235.48 acres to form a unit known as the George Unit.

As an incident to the unitization arrangements and agreements, surveys were required and these were procured at a cost to the taxpayers of $3,200.00. A Pooling and Operating Agreement between the taxpayers and Gulf Oil Corporation and another between the taxpayers and Stanolind Corporation were prepared and executed. Instruments were prepared and filed with the Clerks of the two counties describing each of the Units. Agreements between the owners of royalty interests and the lessees approving proration and unitization were prepared and executed. Attorneys' fees in the amount of $13,932.43 were paid by the taxpayers in connection with the formation of the Gas Units and the preparation of instruments in connection therewith.

In their joint income tax return for 1948, the taxpayers took deductions of the attorneys' fees and surveying charges as expense charges. These were disallowed, a tax deficiency was assessed and paid, suit was brought against the District Director of Internal Revenue, judgment was for the taxpayers and the Government has taken an appeal. The taxpayers contend and the District Court held that the legal and surveying charges were deductible under that portion of the Internal Revenue Code of 1939 providing as follows:

"In computing net income there shall be allowed as deductions:

"(a) Expenses.

"(1) Trade or business expenses.

"(A) In general. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. * * *

"(2) Non-trade or non-business expenses. In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income." Section 23(a) (1) (A), 23(a) (2), Internal Revenue Code of 1939 as amended.

The Government takes the position that the controverted items were non-deductible capital expenditures. To qualify for the deduction the expenditure must be ordinary, it must be necessary, and it must be an expense. The disbursement must have been made in carrying on a trade or business, or, in the case of an individual, for the management, conservation or maintenance of property held for the production of income.

There seems to be no dispute as to the facts. The Government controverts the District Court's finding that the taxpayers were required "under the Railroad Commission's Order to unitize, or, pool before they could produce gas on the leases which they owned." The Government points out that under the law of Texas the formation of proration units through pooling agreements shall be voluntary. The Government concedes, however, that the restrictions with respect to the spacing of wells impose an economic burden on operating except under pooling agreements, and that economic advantages are made possible by unitization. Economic pressures can exert controls as compelling as legal sanctions, and such, it seems, was the requirement to which the District Court's finding related.

The Government, citing Bailey v. Commissioner, 1954, 21 T.C. 678, notes that the leases originally held by the taxpayers represented a capital investment since they held the leases, as producers, for investment purposes. It is then urged that by the pooling and unitization there was a modification of the leases resulting in their conversion into unitized proration units calculated to increase their capital value. This approach gives too much consideration to form and too little to substance. Let us examine the nature of the property right as was evidenced by the leases and the extent to which that right was changed by the pooling and unitization.

In seeking a solution to the problem presented, light is shed by the Texas Supreme Court in the following language:

"The rule in Texas recognizes the ownership of oil and gas in place, and gives to the lessee a determinable fee therein. Citing cases.

"Owing to the peculiar characteristics of oil and gas, the foregoing rule of ownership of oil and gas in place should be considered in connection with the law of capture. This rule gives the right to produce all of the oil and gas that will flow out of the well on one\'s land; and this is a property right. And it is limited only by the physical possibility of the adjoining landowner diminishing the oil and gas under one\'s land by the exercise of the same right of capture. The following decisions discuss the law of capture as applied in this state: Citing c

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