Deskins v. Comm'r of Internal Revenue

• Decision Date: 11 August 1986
• Docket Number: Docket No. 4302-84.
• Citation: 87 T.C. 305,87 T.C. No. 19
• Parties: HAZEL DESKINS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

87 T.C. 305

87 T.C. No. 19

HAZEL DESKINS, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4302-84.

United States Tax Court

Filed August 11, 1986.

P disposed of coal by a contract entitled ‘Coal Lease‘ under which she will receive a tonnage royalty of $1 per ton of coal mined. However, P will not receive more than $4.3 million even if more than 4.3 million tons of coal are mined. Under the contract, P will receive an annual minimum royalty of $430,000 per year for 10 years. Any tonnage royalty P receives during a year is credited against the annual minimum royalty for the year. If the tonnage royalty due during a year exceeds the annual minimum royalty for the year, the excess is recouped against any annual minimum royalty paid in any prior year and any remaining excess is applied as a prepayment of any annual minimum royalty due in any future year. P will receive $4.3 million, no more and no less. No portion of the payments to be made under the contract is designated as interest. Petitioner has no reversionary interest in the coal so long as she receives the payments required by the contract.

HELD, because P will receive tonnage and/or annual minimum royalties of $4.3 million, no more and no less, regardless of whether any coal is ever actually mined, P need not look to the extraction of the coal for the return of her capital, and, therefore, has not retained an economic interest in the coal. Thus, the payments she receives under the contract do not qualify for capital gain treatment under secs. 631(c) and 1231(b)(2), I.R.C. 1954.

HELD FURTHER, since sec. 631(c), I.R.C. 1954, does not apply, payments received under the contract are subject to the imputed interest rules of sec. 483, I.R.C. 1954. Thus, a portion of each such payment is ordinary interest income under secs. 483 and 61(a)(4), I.R.C. 1954, and only the balance is capital gain from P's sale of a capital asset. John G. Rocovich, Jr., Joseph L. Anthony, and John T. Arnold, for the petitioner.

Edwina L. Wilson, for the respondent.

PARKER, JUDGE:

Respondent determined a deficiency in petitioner's 1980 Federal income taxes in the amount of $54,469.32. The issues for decision are (1) whether under the contract petitioner retained an economic interest in the coal so that payments she receives for the disposition of the coal qualify for capital gain treatment under sections 631(c)¹ and 1231(b)(2), and(2) if section 631(c) does not apply, whether the payments she receives for the coal are subject to the imputed interest rules of section 483.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.

Petitioner resided in Belfry, Kentucky, at the time she filed the petition in this case. Petitioner filed her 1980 Federal income tax return (Form 1040) with the Internal Revenue Service Center in Memphis, Tennessee.

Petitioner acquired legal title to two tracts of real property (the property) situated on the Fifty-Eight Mile Branch of Racoon Creek, a tributary of Johns Creek, in Pike County, Kentucky, by a deed from Troy T. Deskins dated June 24, 1964. Petitioner held the property for over 12 years prior to the transaction involved herein.

Wellmore Coal Corporation (Wellmore), through its parent corporation, United Coal Companies, obtained a Reserve Estimate (the estimate report) dated February 25, 1977, from Thompson & Litton, Inc., Professional Engineers, on certain seams of coal in the property. Included in the estimate report is a survey map of the property that shows the topography of the property and the coal seams therein. The estimate report concludes that there are 6.8 million tons of coal in place and 4.3 million tons of recoverable coal in the property. ² The 4.3 million tons of recoverable coal in the property could easily be mined in four years.

On February 25, 1977, petitioner ³ and Wellmore entered into a contract (the contract) entitled ‘Coal Lease,‘ the purpose of which was to dispose of coal in place in the property. The contract grants to Wellmore mining rights to all coal in, and complete and absolute surface rights over, the property. The contract remains in effect for such period of time necessary to mine the merchantable and recoverable coal. The contract states that the parties agree that there are 4.3 million tons of mineable and merchantable coal in the property that can be recovered in a 10-year period. ⁴ The contract requires Wellmore to pay petitioner a tonnage royalty of $1 per ton mined, payable monthly not later than the 25th day of the month following the month the coal is mined. However, the contract provides that Wellmore's obligation to pay tonnage and/or annual minimum royalties to petitioner ceases after it pays her a total of $4.3 million, even if Wellmore mines more than 4.3 million tons of coal. ⁵ Thus, the maximum amount petitioner will receive under the contract is $4.3 million.

Wellmore is obligated by the contract to pay petitioner an annual minimum royalty of $430,000 each year for 10 years, not later than the 25th day of the month following the end of each year. Thus, the minimum amount petitioner will receive is also $4.3 million. See note 5, supra.

Any tonnage royalty petitioner receives during a year is credited against the annual minimum royalty due for that year. If the tonnage royalty due during a year exceeds the annual minimum royalty for the year, Wellmore may recoup the excess against any annual minimum royalty paid during any prior years and may apply any remaining excess tonnage royalty as a prepayment of any annual minimum royalty due in any future year or years. ⁶ Tonnage royalties are payable as coal is mined so that if Wellmore mines 4.3 million tons of coal before the 10-year contract period expires, petitioner will receive the $4.3 million over the shorter period of time. Thus, under the contract, petitioner will receive tonnage and/or annual minimum royalties of $4.3 million, no more and no less, over 10 years or less, regardless of whether any coal is ever actually mined. See notes 4, 5, 6, supra.

No portion of the payments to be made under the contract is designated as interest.

The contract states that ‘the economic interest in and to the coal in, on and under the (property) for income tax and all other purposes shall be deemed, construed and shall be in (Wellmore).‘ The contract contains a ‘diligent mining provision‘ that requires Wellmore to diligently mine the coal as expeditiously as possible using modern and efficient mining machinery, equipment, and methods, so as to mine the largest feasible tonnage in the shortest feasible time. ⁷ If Wellmore fails to make the payments required by the contract, petitioner can accelerate the as yet unpaid annual minimum royalties ($4,300,000 less any actual tonnage and/or annual minimum royalties paid to such date), and unless Wellmore cures the default, the contract terminates and petitioner can retake possession of the property and all fixtures, machinery, equipment, and other property placed thereon by Wellmore free and clear of any claim by Wellmore. If Wellmore makes the required payments ($4,300,000), petitioner has no reversionary interest in the coal and Wellmore retains the right to mine the coal after the 10-year contract period free of any further royalty payment.

The contract is a typical coal lease in that it contains the essential provisions of a coal lease. It is atypical, however, in several respects. Most coal leases do not specify a maximum amount of royalties payable. In those coal leases that specify a maximum, the maximum and minimum amount of royalties payable are rarely equal, as they are in the instant contract. A maximum is usually stated only when the parties have a third-party estimate of the approximate tonnage of coal in place. The contract's recoupment provision is unusual in that it does not state a cutoff period after which tonnage royalties due cannot be recouped from previously paid or future annual minimum royalties. See notes 4, 5, 6, supra. The annual minimum royalties of $430,000 can be applied to reduce any tonnage royalties at any time during the 10-year period, and after payment of a total sum of $4,300,000 of annual minimum royalties and/or tonnage royalties, no further royalties are payable to petitioner. See notes 4, 5, 6, supra.

At the time the parties entered into the contract, the typical tonnage royalty for deep mine coal was about eight percent of gross sales which amounted to about $2 per ton. The contract's $1 per ton royalty resulted from the.parties' negotiations and reflected petitioner's willingness to accept a lower royalty in exchange for payments over a shorter period of time, 10 years rather than the usual 20 or 30 years for coal leases. Petitioner relied on the estimate of recoverable coal in negotiating the tonnage royalty.

Petitioner was represented by C. Kilmer Combs (Combs), an attorney, and Caleb B. Cooley (Cooley), a certified public accountant, during the negotiation of the contract. They advised petitioner to dispose of the coal in such a manner that she would receive the proceeds therefrom in a relatively short period of time. Petitioner instructed Combs and Cooley to negotiate and draft the contract so that she could obtain the most favorable tax consequences thereunder. She hoped to receive capital gain treatment on the entire proceeds.

To the date of the trial, Wellmore had not mined any coal from the property. Wellmore has not defaulted on its obligations under the contract, and its right to mine the coal has not expired, terminated, or been abandoned. Wellmore has paid petitioner the annual minimum royalty under the contract in the amount of $430,000 each year since 1978. Cooley has prepared petitioner's Federal income tax return each year since the date of the contract and has consistently treated the annual minimum...