CIR v. Estate of Donnell

• Decision Date: 10 October 1969
• Docket Number: No. 25835.,25835.
• Citation: 417 F.2d 106
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner-Respondent, v. The ESTATE of H. W. DONNELL, Deceased, Willie Hayden Donnell, Executrix and Willie Hayden Donnell, Respondents-Petitioners. The ESTATE of H. W. DONNELL, Deceased, Willie Hayden Donnell, Executrix and Willie Hayden Donnell, Respondents-Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Petitioner-Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

417 F.2d 106 (1969)

COMMISSIONER OF INTERNAL REVENUE, Petitioner-Respondent, v. The ESTATE of H. W. DONNELL, Deceased, Willie Hayden Donnell, Executrix and Willie Hayden Donnell, Respondents-Petitioners.

The ESTATE of H. W. DONNELL, Deceased, Willie Hayden Donnell, Executrix and Willie Hayden Donnell, Respondents-Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Petitioner-Respondent.

No. 25835.

United States Court of Appeals Fifth Circuit.

October 10, 1969.

Mitchell Rogovin, Asst. Atty. Gen., Dept. of Justice, Washington, D. C., Richard C. Pugh, Acting Asst. Atty. Gen., Tax Div., Dept. of Justice, Washington, D. C., Lee A. Jackson, Harris Weinstein, Stephen H. Paley, Grant W. Wiprud, Attys., Dept. of Justice, Washington, D. C., Lester R. Uretz, Chief Counsel, IRS, Washington, D. C., for petitioner-respondent.

Harold D. Rogers, Wichita Falls, Tex., for respondents-petitioners.

Before GOLDBERG and MORGAN, Circuit Judges, and LIEB, District Judge.

GOLDBERG, Circuit Judge:

In this case we engage the occult mysteries of oil and gas taxation regarding intangible drilling and development costs, depletion, and that alphabetical mystique, the ABC transaction. The taxpayers, H. W. Donnell and Willie H. Donnell, were husband and wife during the years 1959 through 1963. H. W. Donnell died in 1966, and Willie H. Donnell is the executrix of his estate. The taxpayers owned leasehold working interests in oil and gas properties and used the cash method of accounting and reporting their income and expenses from their oil and gas business. This case concerns the propriety of certain deductions and exclusions from taxable income taken by the taxpayers in computing their income from two of these leases during the years 1959 through 1963.

The Ephriam Lease

The taxpayers owned an undivided one-half of a 7/8ths working interest in the Ephriam Lease in Rusk County, Texas, operated by J. D. Laird. Eleven wells were surfaced on this lease. In October, 1962, the Texas Railroad Commission ordered four of these wells shut in because it was discovered that the wells were bottomed in producing oil sands which were outside the vertical extensions of the surface boundaries of the Ephriam leasehold.

I. Depletion. The taxpayers claimed percentage depletion deductions with respect to all the income received by them from all of the wells located on the surface of the Ephriam Lease. The Commissioner disallowed for the years 1961 and 1962 that portion of the claimed deductions which he alleged were attributable to the sales of oil produced by the wells bottomed outside of the taxpayers' leasehold. The Tax Court affirmed the Commissioner's disallowance, holding that the taxpayers should receive depletion deductions only from the seven non-deviated wells and not from the four deviated wells. The taxpayers seek reversal. Agreeing with the Tax Court, we affirm. We hold that the depletion deduction is not allowed with respect to income from the sale of oil extracted from property in which the taxpayers have no economic interest.

The taxpayers claimed the depletion deduction pursuant to Internal Revenue Code § 613(a)¹ which authorizes percentage depletion. In determining whether a person is entitled to depletion under this section the United States Supreme Court has consistently held that the taxpayer must have some economic interest in the minerals in place in order to apply the depletion deduction to income generated by the extraction of the minerals. Commissioner of Internal Revenue v. Southwest Exploration Co., 1956, 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347; Anderson v. Helvering, 1940, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277; Helvering v. Bankline Oil Co., 1938, 303 U.S. 362, 58 S.Ct. 616, 82 L.Ed. 897; Palmer v. Bender, 1933, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489. Absent this requirement the depletion allowance could not perform its obvious purpose of allowing the owner of minerals to recoup his capital investment as the minerals are mined. In Commissioner of Internal Revenue v. Southwest Exploration Co., supra, the court explained the purpose of the depletion allowance:

"An allowance for depletion has been recognized in our revenue laws since 1913. It is based on the theory that the extraction of minerals gradually exhausts the capital investment in the mineral deposit. Presently, the depletion allowance is a fixed percentage of gross income which Congress allows to be excluded; this exclusion is designed to permit a recoupment of the owner\'s capital investment in the minerals so that when the minerals are exhausted, the owner\'s capital is unimpaired." Id. 350 U.S. at 312, 76 S.Ct. at 397.

In accord with this purpose the treasury regulations provide that "Annual depletion deductions are allowed only to the owner of an economic interest in mineral deposits or standing timber." Treas. Reg. 1.611.1(b). Despite the difficulties often encountered in applying the somewhat elusive concept of "economic interest," we think it clear enough that one who reaches out underground to poach upon another's oil does not have the required interest in the purloined mineral to justify granting the depletion allowance. Furthermore, our recent case of Harrington v. Commissioner of Internal Revenue, 5 Cir. 1968, 404 F.2d 237, which also involved an illegally deviated well, unquestionably denies Donnell's quest for depletion. In Harrington we said:

"To qualify for the depletion allowance, a taxpayer must have `acquired, by investment, any interest in the oil in place,\' and secured, `by any form of legal relationship, income derived from the extraction of the oil, to which he might look for a return of his capital.\' Palmer v. Bender, 1933, 287 U.S. 551, 557, 53 S.Ct. 225, 226. Appellants do not have the required interest in the oil pumped from the slanted wells in order to take the depletion allowance because the income derived from the extraction of the oil was not `secured by any form of legal relationship.\' Rather, the income from the oil was derived from a tortious conversion of neighboring landowners\' oil case cited." Id. at 239.

The necessity for some economic interest in the minerals and Donnell's demonstrable lack of such an interest is so obvious that the taxpayers do not even argue that they are entitled to the depletion deduction under the statute. Rather, as we understand the taxpayers' argument, they assert that since they were required to report the entire income from the property as their income under the "claim of right" doctrine they were, therefore, entitled to the depletion deduction. They argue, apparently on the basis of Internal Revenue Code § 1341,² that the Commissioner can require a taxpayer to restore the amount of the depletion deduction only in the year he is required to restore the past oil sales to the rightful owner. Thus, the taxpayers would have us read § 1341 so that they are required to give back an illegal deduction only when they are required to restore the illegal income from which the deduction was taken. We do not read § 1341 to require such a result. That section is to provide a tax adjustment when income is declared and taxed in one year and in a subsequent year has to be returned. It operates upon a properly computed tax return which included as taxable income funds which later prove to be income attributable to and returned to another person. It has no application to the problem before us, which is whether a taxpayer, in computing the tax due for the year in which he claimed the funds as his own and was, therefore, required to include them as his taxable income, could properly take a depletion deduction on oil income when he had no economic interest in the oil. We hold that he could not. The Donnells had no economic interest in the oil extracted from the four wells bottomed off the Ephriam Lease. It was not their oil which was being depleted. They cannot, therefore, take a percentage depletion allowance in computing the tax due on the income from the sale of that oil.

Under the circumstances here the taxpayers are not entitled to depletion deduction based on § 1341, but we make no comment concerning their other rights under that section.

II. Intangible drilling and development costs. The taxpayers also elected to expense rather than capitalize all of their drilling and development costs for the wells on the Ephriam Lease. In 1959 and 1960 the taxpayers paid the operator of the Ephriam Lease their share of the intangible drilling and development costs for the wells which the Texas Railroad Commission later found to be bottomed off of the Ephriam Lease. The Commissioner disallowed the deductions for these development costs on the ground that they were incurred for drilling wells not completed on the taxpayers' property. The Tax Court upheld the taxpayers' contention that the option provided in Internal Revenue Code § 263 entitled them to deduct as expenses the intangible drilling and development costs of wells bottomed outside the Ephriam Lease. We agree with the Commissioner and reverse the Tax Court.

Internal Revenue Code § 263(a) contains the general rule that "any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate" must be capitalized and not expensed. Subsection c of § 263, however, provides an exception which allows an option to expense intangible drilling and development costs in the case of oil and gas wells subject to regulations to be prescribed by the Secretary of the Treasury or his delegate. The pertinent regulations are Treasury Regulation § 1.612-4(a) and § 1.614-1(a).

Section 1.612-4 provides:

"In accordance with the provisions of section 263(c), intangible drilling and development costs incurred by an operator (one who holds a working or operating interest in any tract or parcel of land either as a fee owner or under a lease or any other form of contract granting working or operating rights) in the

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