Elkins v. Comm'r of Internal Revenue , Docket No. 19384–82.

Decision Date28 September 1983
Docket NumberDocket No. 19384–82.
PartiesPAUL ELKINS AND JUDITH ELKINS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Prior to Oct. 29, 1976, a limited partnership named Iaeger Partners (Iaeger) was formed and became obligated to pay coal royalties. Petitioner became a limited partner in Iaeger sometime between Oct. 29 and yearend. Iaeger accrued the royalties in its tax return for 1976, giving rise to a loss, part of which was passed through to petitioner. The partnership produced no coal in 1976.

On Oct. 29, 1976, proposed amendments to sec. 1.612–3(b)(3), Income Tax Regs., were announced which generally prohibited the accrual of mineral royalties in advance of production. The announcement of the proposed regulation stated, however, that the new regulation would not apply to royalties under a mineral lease which was “binding” prior to Oct. 29, 1976, on the party who in fact pays or accrues such royalties.” When the new regulation was made final in Dec. 1977, the effective date provisions of the Treasury Decision stated that, in the case of royalties paid or accrued by a partnership, the party who was required to be bound in order for the old regulation to continue to apply was “the partner, not the partnership.” Because petitioner did not acquire his interest in Iaeger until after the cutoff date, respondent moved for summary judgment that petitioner was not entitled to deduct a share of the loss generated by the accrual of the advanced royalties. That motion was denied. Respondent now moves the Court to reconsider its denial of his motion for summary judgment.

Held: Respondent's motion for reconsideration is denied. The record does not establish that respondent's belated interpretation of the term party to mean the partner rather than the partnership was not an abuse of discretion under sec. 7805(b), I.R.C. 1954. Sidney Gelfand, for the petitioners.

Theodore J. Kletnick and Kendall C. Jones, for the respondent.

OPINION

FEATHERSTON, Judge

This case is before the Court on respondent's motion for reconsideration of an order, dated May 13, 1983, denying his motion for partial summary judgment pursuant to Rule 121.1 The motion for partial summary judgment raised an issue as to whether the Commissioner properly applied the amended section 1.612–3(b)(3), Income Tax Regs., in disallowing a partnership loss deduction claimed by petitioner for 1976. Most of the partnership's loss was attributable to a deduction for advanced royalties which the partnership accrued as a result of a sublease of certain West Virginia coal properties prior to October 29, 1976, the prescribed effective date of a revision of the regulation.

Respondent's motion for reconsideration will be denied. We shall, however, give a more extensive statement of our reasons for denying his original motion than was contained in our order of May 13, 1983.

The record on which the partial summary judgment motion was based shows that Iaeger Partners (Iaeger) is a limited partnership formed for the purpose of engaging in coal mining. The partnership was apparently formed on October 27, 1976; in any event, it is uncontested that the formation occurred before October 29, 1976. Prior to October 29, 1976, Iaeger entered into a sublease agreement with respect to certain coal properties in West Virginia. 2

Under the sublease agreement, Iaeger was obligated to pay a royalty of $5 for each ton of coal mined (the production royalty). Iaeger was also obligated to pay a royalty in the fixed amount of $4,530,000 (the fixed royalty or the advanced royalty). The payment of the fixed royalty was structured as follows: (1) A nonnegotiable, non-interest-bearing note in the amount of $280,000, due on or before December 15, 1976; and (2) a nonrecourse promissory note in the amount of $4,250,000, bearing interest at the rate of 1– 1/2 percent per quarter due December 31, 1991. The $280,000 note was evidently paid on schedule out of the investments by the individuals, including petitioner, who became limited partners. Payments of the fixed royalty were subject to recoupment by Iaeger out of payments made under the production royalty agreement. The term of the sublease was “that period of time necessary for the Partnership to mine and remove the coal from the Property.”

Iaeger adopted the accrual method of accounting; it chose the calendar year as its taxable year. No coal was mined by Iaeger during 1976.

About a month after Iaeger was formed, a “Private Placement Memorandum” was issued. The memorandum was dated November 28, 1976. In addition to a description of the partnership agreement and the coal mining project to be undertaken, it contained a summary of the opinion to be rendered later by the partnership's counsel with regard to the “Federal Income Tax Aspects of the Offering.”3

The memorandum stated that:

Counsel, relying upon various factual representations described in the Tax Opinion, is of the opinion that the Partnership should be permitted to treat the Advanced Royalty under the sublease as a deduction, for Federal income tax purposes, in 1976.

Potential investors were warned, however, that—

the characterization of such payment and the timing of the deductions therefor, for Federal income tax purposes, involve complex questions of fact and law with respect to which no rulings will be sought from the Service, and for which there is no specific legislative, judicial or administrative authority. Consequently, there can be no assurance that the Service will not contest the deductibility of the Advanced Royalty, or the taxable year for the deduction therefor, for reasons which include, but are not limited to, the contention that the Partnership is engaged in a joint venture with * * * [the sublessor], the deduction of the Advanced Royalty materially distorts the Partnership's income, the Advanced Royalty constitutes a leasehold bonus or other capital cost, or a portion of the Advanced Royalty constitutes organizational or syndication costs of the Partnership that must be capitalized. If the Service does contest the deduction in full of the Advanced Royalty in 1976, there can be no assurance that the Service will not be successful in such contest.

The memorandum also noted proposed amendments to section 1.612–3(b)(3), Income Tax Regs., which, on becoming final, would forbid deductions of advanced royalties such as the one Iaeger planned to claim for 1976.4 Potential investors were advised that:

The effective date of the proposed amendment is to be October 29, 1976 “unless the advanced royalties are required to be paid pursuant to a mineral lease which (i) was binding prior to that date upon the party who in fact pays or accrues such royalties . . .” The parties entered into the various agreements on October 27, 1976 which were memoralized [sic] in written documents as of such date. Counsel is of the opinion that the agreements of October 27, 1976 (including the sublease) were binding upon the Partnership and, therefore, the proposed Regulation will not apply to the payment by the Partnership of its Advanced Royalty. There can be no assurance that the Internal Revenue Service will not challenge this position nor that such challenge will not be successful.

It was emphasized that: “There can be no assurance that the Internal Revenue will not contend that the proposed Regulation is applicable to the payment of the Advanced Royalty by the Partnership.”

In its Partnership Return of Income for 1976, Iaeger deducted as accrued liabilities the entire amount of the advanced royalties it was obligated to pay under the two promissory notes described above, a total of $4,530,000. A deduction of $10,000 for professional fees was also claimed. No income was reported in the return; thus, the partnership reported a loss in the amount of $4,540,000.

Petitioner Paul Elkins acquired an interest as a limited partner in Iaeger in 1976, on or after November 29 of that year. Under the terms of the acquisition, he became entitled to .855 percent of the partnership profits and losses. Accordingly, petitioners claimed a deduction in the amount of $38,817 as their distributive share of Iaeger's loss for 1976 in their own joint Federal income tax return for that year. Respondent denied this deduction in its entirety on the ground, among others,5 that a 1977 amendment to section 1.612–3(b)(3), Income Tax Regs., operated retroactively to invalidate the deduction of the advanced royalties. Several other adjustments were made to petitioners' return, but respondent's motion for partial summary judgment involved only the Iaeger deduction, and that only to the extent that it was attributable to the deduction claimed by the partnership for the accrual of advanced royalties in the amount of $4,530,000.

Rule 121(b) provides that a decision may be rendered on a motion for summary judgment if it is shown “that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law.” The rule further provides that “partial summary adjudication may be made which does not dispose of all the issues in the case.” The factual materials presented and the inferences to be drawn therefrom “must be viewed in the light most favorable to the party opposing the motion.” Jacklin v. Commissioner, 79 T.C. 340, 344 (1982).

Accordingly, for the purposes of respondent's motion, the Court assumed, but did not decide, that Iaeger Partners was a valid partnership; that it was in the business of subleasing and mining coal; and that, prior to October 29, 1976, Iaeger entered into a bona fide sublease obligating Iaeger to pay an advance royalty of $4,530,000 by means of a valid $4,250,000 nonrecourse note and a $280,000 promissory note. The Court further assumed, without deciding, that prior to October 29, 1976, Richard Siegal was the only general partner and John Spooner was the only limited partner. Finally,...

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