Collums v. United States

• Decision Date: 04 December 1979
• Docket Number: No. C79-035K.,C79-035K.
• Citation: 45 AFTR 2d 80,480 F. Supp. 864
• Parties: James D. COLLUMS and Mira M. Collums, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of Wyoming

480 F. Supp. 864

45 AFTR 2d 80

James D. COLLUMS and Mira M. Collums, Plaintiffs, v. UNITED STATES of America, Defendant.

No. C79-035K.

United States District Court, D. Wyoming.

December 4, 1979.

William H. Brown and Claude W. Martin, of Brown, Drew, Apostolos, Massey & Sullivan, Casper, Wyo., for plaintiffs.

Jeffrey A. King and Barry L. Lieberman, Tax Div., Dept. of Justice, Washington, D. C., for defendant.

MEMORANDUM OPINION

KERR, District Judge.

Taxpayers instituted this action seeking to obtain a refund of principal and interest on Federal income taxes alleged by them to have been assessed and collected illegally. The jurisdiction of this Court is invoked under 28 U.S.C. § 1346(a)(1).

The essential facts are not in dispute. James D. Collums and Mira M. Collums are husband and wife. Mira M. Collums is a plaintiff by reason of her filing a joint return as James D. Collums' wife. James D. Collums will hereinafter be referred to as "Taxpayer".

For the year 1975, taxpayers filed a joint return at the United States Internal Revenue Service Office in Ogden, Utah and paid the taxes shown therein to be due.

On November 13, 1978, the District Director of the United States Internal Revenue Service at Cheyenne, Wyoming issued a letter to taxpayers transmitting a copy of an IRS report of examination which disallowed the cost depletion deduction in their 1975 tax return and advised them that they had been assessed additional taxes plus interest for the year 1975 by reason thereof.

On December 29, 1978, taxpayers paid the additional taxes plus interest and on January 8, 1979 filed an appropriate claim for refund (Form 1040X) with the Director of the United States Internal Revenue Service Office at Ogden, Utah.

On January 23, 1979, Taxpayer's claim for refund was rejected and disallowed as evidenced by a letter on Form 906(DO) (7-77) issued by Bob G. Hughes, District Director of the United States Internal Revenue Service at Cheyenne, Wyoming.

All of the transactions in question consist of the purchase by Taxpayer of oil and gas leases and the subsequent assignment of said leases for a cash bonus in excess of his cost with the retention by him of an overriding royalty in each of said leases.

The United States Supreme Court held in Burnet v. Harmel, 287 U.S. 103, 53 S.Ct. 74, 77 L.Ed. 199 (1932) that for tax purposes the assignment of an oil and gas lease for value with the retention of an overriding royalty in the lease is a "sublease" and not a sale.

In every such transaction, as was conceded by the examining agent in his report of examination, the oil and gas lease covered lands that were "wildcat." A wildcat oil and gas lease is one that is unproven and that has no geological, geophysical, or other evidence indicating conditions favorable to the discovery of oil or gas thereon.

In each such transaction, Taxpayer received a cash price (bonus) for the assignment of a lease and retained an overriding royalty out of oil and gas, if any, which might be produced from said lease in the future during the term of such lease, which overriding royalty interests were in the range of three to five percent. If oil and gas were produced, the lease and the overriding royalty would continue as long as oil and gas were produced.

Infrequently, Taxpayer purchased lease interests in proximity to production but these were not wildcat leases. One block of such leases was inadvertently included in the claim for refund but was removed from the case during the trial and plaintiffs' claim was reduced by amendment to reflect the elimination of any claim for refund related to these leases.

The parties agreed that the primary business activity of Taxpayer was that of buying and selling wildcat oil and gas leases as a dealer in such properties. With respect to every wildcat lease purchased by Taxpayer, it was his intention and expectation to sell the lease and obtain a cash price in excess of his total basis therein so as to yield a cash profit at the time of sale without expecting royalties to be received from the lease.

The retention of overriding royalties by persons dealing in wildcat oil and gas leases has been a common practice in the oil and gas business for many years. In negotiating the price for the sale of such leases, the retention of such overriding royalty does not ordinarily cause a reduction in the price which the buyer is willing to pay, nor would a waiver of the right to retain the same result in a significantly higher price for the lease. In essence, such overriding royalty interests in this case were reserved and held by Taxpayer without actual cost. Ordinarily, persons dealing in such leases by virtue of a long prevailing practice in the industry are able to retain such overriding royalty interests without actual cost.

In the initial income tax return for 1975, Taxpayer allocated a basis to each retained overriding royalty in an amount proportionate to the ratio which the percentage of overriding royalty bore to the entire one hundred percent interest in the assigned lease. The Internal Revenue Service rejected this allocation. In his amended return, being also the claim for refund, Taxpayer eliminated this apportionment of basis to the retained overriding royalty for the reasons hereinafter stated.

The agent's report of examination of the 1975 income tax return discloses a contention by the Internal Revenue Service that where an overriding royalty is retained upon the assignment of a mineral lease, the transaction is a leasing transaction and not the sale of an asset. The agent's report concedes that cost depletion is available to the Taxpayer under U. S. Treasury Regulation § 1.612-3(a)(1). That regulation provides in relevant part:

If a bonus in addition to royalties is received upon the grant of an economic interest in a mineral deposit, or standing timber, there shall be allowed to the payee as a cost depletion deduction in respect of the bonus an amount equal to that proportion of his basis for depletion as provided in section 612 and § 1.612-1 which the amount of the bonus bears to the sum of the bonus and the royalties expected to be received.

U. S. Treasury Regulation § 1.612-3(a)(1) provides a formula for the calculation of such cost depletion which may be expressed as follows:

Cost Depletion = adjusted basis × a , where ---- in lease a+b a = bonus b = royalties expected to be received in the future.

The issue presented for the consideration of the Court is whether Taxpayer is entitled to deduct his entire basis in the wildcat oil and gas leases as cost depletion on the purchase and sale of said wildcat oil and gas leases where there is no basis to support a reasonable expectation that any oil or gas production will occur during the term of the lease and accordingly no revenue will accrue to the overriding royalty.

Section 611 of the Internal Revenue Code of 1954 (26 U.S.C. § 611) provides for a reasonable allowance for depletion, to be made in accordance with regulations issued by the Secretary of the Treasury. U. S. Treasury Regulation § 1.612-3(a) was first issued in 1920 and amended in 1926. The Supreme Court considered the amended regulation in the case of Murphy Oil Co. v. Burnet, 287 U.S. 299, 53 S.Ct. 161, 77 L.Ed. 318 (1932). The Court held that the estimates of "royalties expected to be received" must be reasonable, saying:

Where the estimates are reasonable, the formula affords a fair and convenient method of avoiding the present taxation of the bonus, when received, as income, in the face of the probability that it will ultimately prove not to be such.

In this case, the Taxpayer is not attempting to avoid taxation on the bonus as ordinary income to the extent that it exceeds his cost of the lease. The Court stated in Murphy that the taxpayer is not required to make estimates that are unreasonable, saying:

But the regulation does not require him to make estimates which are unreasonable . . .

The Regulation considered by the Court in Murphy has not been substantially changed.

In F.-K. Land Company v. Commissioner of Internal Revenue, 34 B.T.A. 87 (1936), aff'd 90 F.2d 484 (9th Cir. 1937), the Board of Tax Appeals (now the Tax Court of the United States) found that, although the only income of the lessor from the leased property in the year in question was the lease bonus, there was a reasonable expectation of substantial income in the future from royalties because the lease was in a producing oil field. In F.-K. Land Company, neither the taxpayer nor the Commissioner introduced proof as to the amount of royalties which could be reasonably expected from the property in the future. The taxpayer's position was that since the Commissioner failed to determine the expected royalties, the taxpayer should be entitled to treat the entire bonus as a return of capital. The Board disagreed, holding that the taxpayer had the burden of proof with respect to the correct amount of depletion, stating:

The sole condition which would entitle . . . (taxpayer) . . . to deduct the entire cost of this property is that the only probable return anticipated from the property is that represented by the bonus.

That condition has been satisfied in the case at bar. The Board concluded that the taxpayer did not establish this fact by merely pointing out that there had been no determination of the amount of anticipated royalties. The lease in question was in an oil field which had been in production for nearly 20 years, although the particular leased tract had not been operated. The Board indicated that the comparatively large bonus, together with the fact that the property lay in the Belridge Field, a proven field which had been producing for nearly twenty years, strongly indicated that substantial royalty payments would result from operation of the lease. The Board concluded:

It is only upon a reasonably justified anticipation of no future royalties that allowance of the . . . deduction in the entire

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