Capek v. Comm'r of Internal Revenue
| Decision Date | 21 January 1986 |
| Docket Number | 6754-84.,479-84,25003-83,Docket nos. 27834-82 |
| Parties | RICHARD C. CAPEK and JOY ANN CAPEK, ET AL.,1Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Ps were investors in the Price Coal leasing program. The program promised investors a royalty deduction of $4 for every $1 of cash invested. Ps entered into a mining lease with Price Coal which required the payment of one-quarter of the annual royalty in cash and the remaining three-quarters by means of a nonrecourse or a recourse note. Ps also entered into contracts with a related corporation, Price Ltd., for the mining and sale of coal, and, for program years 1979 and thereafter, that corporation agreed to make certain payments to an investor in the event that coal was not mined. HELD: (1) Ps Capek and Reaume did not engage in the Price Coal leasing programs with the actual and honest objective of making a profit. (2) Advanced royalties ‘paid‘ by Ps Capek and Reaume were not paid pursuant to a valid minimum royalty provision as required by sec. 1.612-3 (b)(3), Income Tax Regs. (3) Ps Croci and Spiller were not at risk for the amounts that they allegedly borrowed under recourse notes to pay the advanced royalties because no funds were actually borrowed within the meaning of sec. 465(b)(2), I.R.C. 1954, and because the alleged loans were protected against loss through a ‘stop loss agreement, or other similar arrangement‘ within the meaning of sec. 465(b)(4), I.R.C. 1954. Thomas C. Borders and William E. Bogner, for the respondent.
Robert Weber, for the petitioners.
The Commissioner determined the following deficiencies in the petitioners' Federal income taxes:
+-------------------------------------------------+
¦Petitioners ¦Taxable year¦Deficiency¦
+-------------------------+------------+----------¦
¦Richard C. Capek ¦1978 ¦$22,471.00¦
+-------------------------+------------+----------¦
¦and Joy Ann Capek ¦ ¦ ¦
+-------------------------+------------+----------¦
¦Gene Croci and Mary Croci¦1981 ¦14,323.00 ¦
+-------------------------+------------+----------¦
¦Paul A. Reaume ¦1979 ¦11,695.57 ¦
+-------------------------+------------+----------¦
¦and Alice May Reaume ¦1980 ¦25,114.23 ¦
+-------------------------+------------+----------¦
¦Arthur J. Spiller ¦1980 ¦8,440.00 ¦
+-------------------------+------------+----------¦
¦and Margie R. Spiller ¦1981 ¦10,748.00 ¦
+-------------------------------------------------+
The issues for decision are: (1) Whether petitioners Capek and Reaume engaged in their coal mining activities with a profit objective within the meaning of section 183 of the Internal Revenue Code of 19542; (2) whether advanced royalties ‘paid‘ by petitioners Capek and Reaume constitute advanced minimum royalties within the meaning of section 1.612-3(b)(3), Income Tax Regs.; and (3) whether petitioners Croci and Spiller were at risk within the meaning of section 465(b) with respect to their investments in the Price Coal leasing program.
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found.
Petitioners Richard C. and Joy Ann Capek are husband and wife, who maintained their legal residence in Downers Grove, Ill., at the time of the filing of their petition herein. Petitioners Paul A. and Alice Mae Reaume are husband and wife, who maintained their legal residence in Lake Forest, Ill., at the time of the filing of their petition herein. Petitioners Gene and Mary Croci are husband and wife, who maintained their legal residence in Highland Park, Ill., at the time of the filing of their petition herein. Petitioners Arthur J. and Margie R. Spiller are husband and wife, who maintained their legal residence in Waukegan, Ill., at the time of the filing of their petition herein. All of the petitioners filed timely joint Federal income tax returns for the taxable years involved with the Internal Revenue Service Center, Kansas City, Mo.
Price Coal and Energy, Inc. (Price Coal), an Illinois corporation, was incorporated on November 23, 1977. For all times relevant to these cases, its outstanding capital stock has been owned by Rodman G. Price (Mr. Price) and his wife, Diane Price. From its date of incorporation and for all times relevant to these cases, Mr. Price has been the president and a director of Price Coal, and Mrs. Price has been the secretary and a director of such corporation. Mr. Price graduated in 1949 from Hobart College with a degree in economics and is a ‘private investment banker, specializing in tax shelters.‘
Great American Royalties, Inc. (Great American), a North Dakota corporation, was incorporated in 1957. The articles of incorporation of Great American provide in part that it was formed for the ‘purchasing and leasing of lands, and royalty and mineral interests therein, believed to contain oil, gas and other minerals, the improving, mortgaging, leasing, assigning and otherwise disposing of the same.‘ In 1977, and for all times relevant to these cases, the officers of Great American were president, Melvin (Pat) Ballantyne, vice president, Russell Ballantyne, and secretary, Todd Ballantyne.
Rodman G. Price, Ltd. (Price Ltd.), a North Dakota corporation, was incorporated on January 24, 1979. The incorporators and directors listed on the articles of incorporation were Mr. Price, Diane R. Price, and Rodman M. Price.
Price Coal entered into a coal purchase agreement dated November 1, 1977, with Great American. This agreement gave Price Coal an option to acquire up to 100 million tons of in place strippable lignite coal located in western North Dakota ‘out of leases and acreage selected by‘ Great American for 29.97 cents per ton. As consideration for the option, the agreement required Price Coal to pay Great American $5,000.
Sometime late in 1977, Mr. Price, with the assistance of Melvin and Todd Ballantyne, prepared a promotional booklet describing the 1977 Price Coal coal leasing program (the 1977 program). The booklet contains copies of the following documents: lease instructions, mining lease, addendum to mining lease, contract for sale of coal, non-recourse promissory note, promissory note, and an authorization to negotiate. The booklet also contains a summary of the program, a legal opinion, and a geologist's report. The 1977 booklet contains no projections of profit that an investor might be expected to realize.
The 1977 booklet explained that an investor subleasing lands warranted to contain 300,000 tons of coal was entitled to deduct the $45,000 ‘advance royalties‘ as a business expense on Schedule C of his 1977 Federal income tax return. A sample Schedule C illustrating the mechanics of this deduction was included in the booklet. The summary of the 1977 program contained in the booklet described the anticipated deduction as follows: ‘For 1977, Lessee will report on his Federal Income Tax Return, as a business expense, a deductible royalty payment of $4.00 for every $1.00 of personal investment funds.‘
The 1977 booklet states that Price Coal is the ‘owner of one hundred (100) million tons of coal in North Dakota.‘ Although Price Coal had an option to acquire up to 100 million tons of strippable lignite coal reserves from Great American, it never obtained any coal lands under this option until February 25, 1978, when it received an assignment of a lease of 94.88 coal acres, known as the Knox lease. There is no indication in the assignment of how many tons of coal were estimated to be contained in such leased land. Most of the investors in the 1977 program were assigned subleases in the Knox lease, extending for 10 calendar years plus the remainder of 1977. However, in February 1984, Price Coal filed a release of the Knox lease with the Recorder of Deeds in Williams County, North Dakota, thereby releasing any claim to such property. Price Coal had a right of substitution, but there is no credible evidence that other property was substituted for the Knox lease.
The legal opinion in the 1977 program booklet is signed by Richard B. Thomas, an attorney with offices in Minot, North Dakota. The first paragraph of this opinion letter states as follows: ‘You have informed us that Price Coal & Energy, Inc. owns a lease on land containing coal resources and wishes to sub-lease the land to others under terms and conditions set forth below. ‘ Mr. Price provided Mr. Thomas with the information relied upon in preparing the legal opinion.
The geologist's report in the 1977 booklet was prepared by Ira M. Tillotson, an engineer registered in the State of Montana, and begins as follows: ‘This letter report attempts to evaluate and summarize certain of your coal leases in Dunn, McLean, Grant, Hettinger, McKenzie, Stark, Burke, Williams, Ward, and Morton Counties, North Dakota, attached hereto as Appendix A, by leases.‘ Price Coal has never owned any leases in Grant, Hettinger, McKenzie, Stark, Burke, Ward, or Morton Counties.
The booklet prepared for prospective investors in the 1978 coal leasing program (the 1978 program) is substantially similar to the 1977 program booklet. It, too, contains a one-page summary as to how the coal leasing program is intended to operate, which concludes with the statement that the investor will be entitled to a deduction of $4 for every $1 of personal investment funds. It, too, contains no projections of profit that an investor might be expected to realize.
In 1978, petitioner Richard Capek was one of 33 investors who entered the 1978 program. He holds an MBA degree from Northwestern University and is president of his own civil engineering firm. The letter of intent and lease instructions executed by Mr. Capek were dated December 29, 1978.
The lease instructions for the 1978 program contained the following schedule to aid investors in determining the amount to invest:
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