Cox v. United States

• Decision Date: 22 May 1974
• Docket Number: No. 73-2322.,73-2322.
• Citation: Cox v. United States, 497 F.2d 348 (4th Cir. 1974)
• Parties: James T. COX, Appellee, v. UNITED STATES of America, Appellant.
• Court: U.S. Court of Appeals — Fourth Circuit

497 F.2d 348 (1974)

James T. COX, Appellee, v.UNITED STATES of America, Appellant.

No. 73-2322.

United States Court of Appeals, Fourth Circuit.

Argued March 6, 1974.

Decided May 22, 1974.

William S. Estabrook, III, Atty., Tax Div., U. S. Dept. of Justice(Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks and Grant W. Wiprud, Attys., Tax Div., U. S. Dept. of Justice, James F. Companion, U. S. Atty. on brief) for appellant.

Boyd L. Warner, Clarksburg, W. Va. (Stathers & Cantrall, Clarksburg, W. Va., on brief) for appellee.

Before WINTER, BUTZNER and FIELD, Circuit Judges.

FIELD, Circuit Judge:

This appeal presents the question whether the retention of an overriding royalty interest incident to the assignment of certain oil and gas leases constitutes an "economic interest" which subjects the initial lump sum payments to ordinary income treatment rather than capital gains consideration.

In 1959 A. T. Carr leased 1,194 acres of oil and gas lands in Doddridge County, West Virginia, for one dollar per acre.In 1960the appellee, James T. Cox, entered into an informal agreement with Carr under which he would contribute $2,000 for the development of a well in exchange for a half interest in all of the leases.Spurred by successful drilling operations on adjacent land, the partnership assigned ten leases to various companies for $180,125 in 1963 and $115,000 in 1964.Cox and Carr shared the proceeds equally, and the partnership retained a 1/16th overriding royalty interest¹ of the 7/8th working interest² in each of the ten leasehold assignments.Additionally, the partnership retained a ¼th working interest, subject to the reserved overriding royalty interest, in one lease.

Cox treated his share of the profits as a long-term capital gain on his 1963 and 1964 tax returns.The Commissioner of Internal Revenue viewed the profits as ordinary income subject to a depletion allowance and assessed deficiencies of $12,156.17 plus $1,776.72 interest for 1963 and $5,556.63 plus $478.70 interest for 1964.Cox paid the deficiencies and sought a refund which was denied.He then instituted this action pursuant to 28 U.S.C. § 1346(a)(1) for recovery of the alleged overpayment.The district court granted judgment in favor of Cox and the government appeals.

The test for determining what is an economic interest first appeared in Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489(1933), and is now found in Treas.Reg. § 1.611-1(b)(1)(1960):

"An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place * * * and secures, by any form of legal relationship, income derived from the extraction of the mineral * * * to which he must look for a return of his capital."

The district court held the lump sum payments were subject to capital gains treatment because they were not dependent upon the extraction or production of oil and therefore did not fall within the scope of the treasury regulation.The record, however, does not support this bifurcated view of the transaction.Each of the ten leases assigned by the partnership is inextricably bound by a reserve clause which grants the partnership a 1/16th overriding royalty interest, and in one of the ten leases, a ¼th working interest, subject to the reserved overriding royalty interest of the 7/8th working interest.Accordingly, income from the royalty interests is tied directly to oil and gas production.

Assuming, however, that the two lump sum payments here in question were independent of the retained royalty interests, substantial authority denies them the benefit of capital gain treatment.In Burnet v. Harmel, 287 U.S. 103, 53 S.Ct. 74, 77 L.Ed. 199(1932), the issue was whether a lump sum bonus paid the lessor under an oil and gas lease, which reserved the usual royalty, was to be treated as capital gain or ordinary income.The Court put all portions of the transaction into one category, viewing the bonus as anticipatory royalty which should be treated as ordinary income.In Herring v. Commissioner, 293 U.S. 322, 55 S.Ct. 179, 79 L.Ed. 389(1934), the Court held that the depletion allowance was applicable to advance royalties and bonuses received by a lessor upon the execution of an oil and gas lease even though there were no wells on the property and no production during the taxable year.Finally, in Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 78 S. Ct. 691, 2 L.Ed.2d 743(1958), the Court decided that the consideration received for the assignment of an "oil payment right" carved out of a larger mineral interest (whether a royalty interest or a working interest) was taxable as ordinary income, subject to a depletion deduction, and not as a capital gain.The Court reasoned that "the lump sum consideration seems essentially a substitute for what would otherwise be received at a future time as ordinary income."356 U.S., supra, at 265.

In reaching the conclusion that Cox did not retain an economic interest the court below made no reference to the foregoing decisions, but relied primarily on Helvering v. Elbe Oil Land Co., 303 U.S. 372, 58 S.Ct. 621, 82 L.Ed. 904(1938), andCommissioner v. Remer, 260 F.2d 337(8 Cir.1958).We find, however, that Elbe has been considerably diluted by subsequent decisions and is of little precedential persuasiveness.In Elbe, the taxpayer sold all of its interest in certain oil and gas properties in consideration of a large initial lump sum payment, four substantial deferred payments which were payable without regard to production, and a residual interest in the net profits from production and operation of the properties.³The Court denied the taxpayer a depletion deduction computed on the cash payments, holding that the transaction was an absolute sale of the taxpayer's interest in the property.With reference to the taxpayer's participation in the net profits, the Court stated that it was "unable to conclude that the provision for this additional payment qualified in any way the effect of the transaction as an absolute sale or was other than a personal covenant of the purchaser."303 U.S., supra, at 375.

Eight years after Elbe, in Burton-Sutton Oil Co., Inc. v. Commissioner of Internal Revenue, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062(1946), the Court concluded that where the assignor of certain oil rights retained an interest in the net operating profits, the transaction was not a sale but rather an assignment "with a reservation in the assignor of an economic interest in the oil."Id., at 37.The Court attempted to distinguish rather than overrule its decision in Elbe, concluding that "the holding of Elbe should not be extended to the facts of this agreement."Id., at 36.⁴In Commissioner of Internal Revenue v. Southwest Exploration Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347(1956), the Court again declined to follow Elbe, holding that the retention of a share of net profits was an economic interest in the oil in place which entitled the taxpayer to the depletion allowance.The moribund state of Elbe was recognized by the Tenth Circuit in Commissioner of Internal Revenue v....