Davis v. C.I.R.

• Decision Date: 24 October 1984
• Docket Number: 81-1127 and 81-1187,Nos. 81-1126,s. 81-1126
• Citation: 746 F.2d 357
• Parties: , 84-2 USTC P 9877 Joe C. DAVIS, Estate of Rascoe B. Davis, Third National Bank, Executor and Delta C. Davis, Petitioners-Appellants, Cross Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee (81-1127), Cross Appellant (81-1187). Joe C. DAVIS, Petitioner-Appellant, Cross Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee (81-1126), Cross Appellant (81-1187).
• Court: U.S. Court of Appeals — Sixth Circuit

Page 357

746 F.2d 357

53 USLW 2264, 84-2 USTC P 9877

Joe C. DAVIS, Estate of Rascoe B. Davis, Third National

Bank, Executor and Delta C. Davis, Petitioners-Appellants, Cross Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee

(81-1127), Cross Appellant (81-1187).

Joe C. DAVIS, Petitioner-Appellant, Cross Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee

(81-1126), Cross Appellant (81-1187).

Nos. 81-1126, 81-1127 and 81-1187.

United States Court of Appeals Sixth Circuit.

Argued Oct. 3, 1983.

Decided Oct. 24, 1984.

William Waller, Lawrence Dortch, Charles A. Trost (argued), Nashville, Tenn., for petitioners-appellants, cross appellees.

N. Jerold Cohen, Chief Counsel, I.R.S., M. Carr Ferguson, Asst. Atty. Gen., John F. Murray, Michael L. Paup, Richard Farber, James A. Riedy, Gilbert S. Rothenberg (argued), Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee, cross appellant.

Before ENGEL and KEITH, Circuit Judges, and WEICK, Senior Circuit Judge.

WEICK, Senior Circuit Judge.

These consolidated appeals by the taxpayers and the Commissioner of Internal Revenue are from decisions of the United States Tax Court, rendered by a sharply divided court.

There are two issues involved. The principal issue is whether section 631(c) of the Internal Revenue Code (Code), 26 U.S.C. Sec. 631(c), which permits a sublessor of coal mining rights to treat the royalties he receives from a sublessee of those rights as capital gains, also permits him, as a taxpayer, to deduct from his ordinary income the royalties paid to the lessor for the coal mining rights in this case. The second issue is whether Diedrich v. Commissioner, 457 U.S. 191, 102 S.Ct. 2414, 72 L.Ed.2d 777 (1982), should be applied retroactively to a transaction completed by Joe Davis in 1972.

I.

A.

The facts are undisputed, having been established by stipulation. While we summarize the facts here, a more thorough statement of the facts may be found in the opinion of the Tax Court in Davis v. Commissioner, 74 T.C. 881 (1980). Joe C. Davis and Rascoe B. Davis were originally partners in Cumberland Land Co. (Cumberland), a joint venture involved in the leasing of coal mining rights. Cumberland leased coal mining rights in Kentucky from land owners, and then subleased those rights to another entity, Webster Coal Corp. (Webster), which actually mined the coal. All of Webster's stock was owned, either directly or indirectly, by partners of Cumberland.

When Cumberland leased mining rights, it agreed to pay the lessor a royalty of ten cents for each ton of coal mined under the lease. These payments are called "earned royalties." Furthermore, Cumberland was required to pay a minimum royalty each year, even if no coal was mined. These payments are called "advanced minimum royalties." In any year in which Cumberland did not mine enough coal to cover the advanced minimum royalties, the balance of the minimum royalties paid was treated as a credit against future earned royalties.

When Cumberland leased mining rights, it would sometimes sublease the rights to Webster immediately. At other times, it would accumulate several leases, and sublease them together. While waiting to sublease mining rights to Webster, Cumberland paid the advanced minimum royalties required by the lease. Whatever the delay between lease and sublease, Cumberland subleased all of the coal mining rights it acquired and never mined coal itself.

Cumberland's royalty payments, therefore, can be separated into three categories: first, earned royalty payments, which Cumberland made on coal which its sublessee, Webster, actually mined; second, advanced minimum royalty payments which Cumberland made after it had subleased the rights to Webster; and third, advanced minimum royalty payments which Cumberland made before it had subleased the rights to Webster.

Cumberland received royalties from its sublessee, Webster. Under the subleases, Cumberland received either advanced minimum royalties, or earned royalties on the coal extracted. The earned royalties were 30 cents a ton or 8 1/2 percent of the gross sales price of the coal mined, whichever was greater. Thus, for coal actually mined by Webster, Cumberland was insured a profit of at least 20 cents per ton over the ten cents per ton earned royalty Cumberland was obligated to pay the lessor.

Cumberland's partners treated all of the royalties that Cumberland paid as business expenses, deductible from ordinary income under section 162(a) of the Code. At the same time, the partners treated all of the royalties Cumberland received from Webster as capital gains under section 631(c) of the Code. ¹ After examining the tax returns of Joe and Rascoe Davis for the years 1967 to 1975, in which the partners deducted from ordinary income the royalties Cumberland paid, the Commissioner disallowed these deductions and declared a deficiency, determining that Treas.Reg. Sec. 1.631-(3)(b)(3)(ii)(a) required total royalties paid, both earned and advanced, to be subtracted from royalties received, with the difference reported as long-term capital gain or loss. ²

The majority of the Tax Court held that earned royalties paid by a sublessor of coal mining rights are not deductible from ordinary income. This holding was based on the court's view that section 631(c) of the Code requires that the sublessor's gain or loss be determined by subtracting the adjusted depletion basis of the coal from the royalties the sublessor receives and that, for a sublessor, "the adjusted depletion basis or cost per unit of coal extracted must be interpreted to include earned royalties paid." 74 T.C. at 896. In addition, the majority concluded that "[t]he language in the statute which provides that the lessee's deductions are not affected by section 631(c) cannot be read as applying to a sublessor," because based on the legislative history, "it is reasonably clear that the sentence excluding 'the lessee' was added when the statute was enacted only to ensure that those not benefiting from section 631(c) would not be adversely affected either." Id. at 897.

The Tax Court applied the same analysis to the advanced minimum royalties paid on nonoperating leases that had been subleased to Webster Coal, noting that these payments were made by Cumberland as a sublessor, and therefore could not be deducted from ordinary income because the advanced minimum royalties Cumberland received from Websterwere entitled to capital gain treatment under section 631(c). The Tax Court further held that Cumberland could not deduct from ordinary income advanced minimum royalties it paid on leases before it subleased them to Webster, even though the royalties were paid while Cumberland was only a lessee and not a sublessor. The court treated these royalties as having been paid by a sublessor, because "Cumberland, in every case, subleased to Webster Coal the leases it acquired" and "never intended to nor did it ever engage in any mining operations." Id. at 899, citing, e.g., Commissioner v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981 (1945).

We agree with the Tax Court that the Commissioner's application of Treas.Reg. Sec. 1.631-3(b)(3)(ii)(a) to the facts of this case is reasonable and consistent with the statutory scheme, and therefore affirm its judgment as to this first issue.

B.

"[I]t is fundamental ... that as 'contemporaneous constructions by those charged with administration of' the Code, [Treasury] Regulations 'must be sustained unless unreasonable and plainly inconsistent with the revenue statutes,' and 'should not be overruled except for weighty reasons.' " Fulman v. United States, 434 U.S. 528, 533, 98 S.Ct. 841, 845, 55 L.Ed.2d 1 (1978) (quoting Bingler v. Johnson, 394 U.S. 741, 749-50, 89 S.Ct. 1439, 1444-45, 22 L.Ed.2d 695 (1969); Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501, 68 S.Ct. 695, 698, 92 L.Ed. 831 (1948)); accord United States v. Correll, 389 U.S. 299, 306-07, 88 S.Ct. 445, 449-50, 19 L.Ed.2d 537 (1967). According to the taxpayers, section 631(c) clearly allows them as sublessors to treat royalties received as capital gains, and as lessees to deduct royalties paid from ordinary income. Treas.Reg. Sec. 1.631-3(b)(3)(ii)(a), however, generally denies sublessors deductions from ordinary income for royalties paid with respect to coal disposed of under Sec. 631(c) by requiring such royalties to be added to the adjusted depletion basis of such coal, notwithstanding language in section 631(c), supra, that:

In determining the gross income, the adjusted gross income, or the taxable income of the lessee, the deductions allowable with respect to ... royalties shall be determined without regard to the provisions of this subsection.

Because a sublessor by definition is also a lessee, we are faced in section 631(c) with an ambiguous statute. "[T]he issue before us is not how we might resolve the statutory ambiguity in the first instance, but whether there is any reasonable basis for the resolution embodied in the Commissioner's Regulation." Fulman, supra, 434 U.S. at 536, 98 S.Ct. at 846. We agree with the Tax Court that the language in the statute, supra, which provides that the lessee's deductions shall be determined without regard to section 631(c), cannot be read to apply to sublessor. The legislative history cited by the Tax Court, 74 T.C. at 897, makes it clear that Congress included this language to exclude lessees from the operation of section 631(c), and not to provide lessees who are also sublessors and therefore "owners" under the statute with the double benefit of capital gains treatment on royalties received from sublessees but deductions from ordinary income under section 162(a) for royalties paid to the lessors, as is argued by the taxpayers. ³ In effect, the taxpayers argue that Congress simultaneously intended to include and exclude sublessors from the provisions of section 631(c), an intent we are unwilling to...