Estate of Johnston by Payne v. U.S., 84-1757

• Court: U.S. Court of Appeals — Fifth Circuit
• Writing for the Court: Before CLARK, Chief Judge, POLITZ, and JONES; POLITZ
• Citation: Estate of Johnston by Payne v. U.S., 779 F.2d 1123 (5th Cir. 1986)
• Decision Date: 08 January 1986
• Docket Number: No. 84-1757,84-1757
• Parties: -1502, 86-1 USTC P 13,655 The ESTATE OF Nellie S. JOHNSTON, Deceased, by Robert B. PAYNE, Independent Executor, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

Page 1123

779 F.2d 1123

57 A.F.T.R.2d 86-1502, 86-1 USTC P 13,655

The ESTATE OF Nellie S. JOHNSTON, Deceased, by Robert B PAYNE, Independent Executor, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 84-1757.

United States Court of Appeals Fifth Circuit.

Jan. 8, 1986.

James A. Rolfe, U.S. Atty., U.S. Dept. of Justice, Tax Div., Dallas, Tex., Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Chief, Appellate Sect., Robert A. Bernstein, Francis M. Allegra, Tax Div., U.S. Dept. of Justice, Washington, D.C., for defendant-appellant.

Robert B. Payne, Robert Q. Stanton, Dallas, Tex., for plaintiff-appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before CLARK, Chief Judge, POLITZ, and JONES, Circuit Judges.

POLITZ, Circuit Judge:

This case presents the res nova question whether proceeds from interests in oil and gas properties, received by a decedent's estate between the date of death and the alternate valuation date authorized by 26 U.S.C. Sec. 2032(a), are includible in the gross estate, in whole or in part, for the purpose of determining the federal estate tax. ¹ The district court held that no portion of such proceeds was includible in the gross estate. 586 F.Supp. 500 (N.D.Tex.1984). The government appeals. We reverse and remand.

BACKGROUND

The facts are not in dispute and need only be summarized since this appeal presents solely a question of law.

Nellie S. Johnston died testate on January 27, 1974. Her will named Robert B. Payne as executor. Payne exercised the option authorized by 26 U.S.C. Sec. 2032(a) ² and chose to value Johnston's estate as of six months after her death rather than on the date of her death. Johnston died owning various working and royalty interests in numerous oil and gas properties, most of which were located in Texas. In the six months after her death her interests generated net income of $156,011 on which the estate paid income tax after deducting the statutory allowance for depletion. 26 U.S.C. Sec. 611. Following an audit by the Internal Revenue Service, this entire income was included in Johnston's gross estate ³ under 26 U.S.C. Sec. 2032(a)(1), and a net deficiency of $278,941.59 in estate taxes was assessed. ⁴

The IRS made its determination pursuant to 26 CFR Sec. 20.2032-1(d) ⁵ and Rev.Rul. 71-317, 1971-72 Cum.Bull. 328, issued thereunder, in which the IRS opined that "the value of the royalty interest [in mineral-producing properties] in the gross estate at the alternate valuation date is the sum total of the in-place fair market value of the reserves ... in existence [six months] after the date of death plus the value of the included property disposed of during the interim period." The IRS also declared that "[t]he value of the included property is determined by applying an appropriate discount factor to the net proceeds (net income) from mineral production during the interim period." Rev.Rul. 71-317, 1971-72 Cum.Bull, 328, reprinted in 38 Oil & Gas Rptr. 711.

After paying the deficiency, the executor filed a claim for refund, which was denied. This action followed. After all other claims were settled, both parties moved for summary judgment since no genuine issue of fact existed and the matter presented only a question of law. The district court granted the motion of the estate.

ANALYSIS

At the threshold we note that the district court correctly concluded that federal law was applicable to this dispute. 586 F.Supp. at 503. State law is relevant to the determination of the existence of legal and equitable interests, but federal law governs "when and how [these interests] shall be taxed." Burnet v. Harmel, 287 U.S. 103, 110, 53 S.Ct. 74, 77, 77 L.Ed. 199, 205 (1932); Carr Staley, Inc. v. United States, 496 F.2d 1366, reh'g denied, 502 F.2d 1167 (5th Cir.1974), cert. denied, 420 U.S. 963, 95 S.Ct. 1355, 43 L.Ed.2d 441 (1975); see also Gilchrist's Estate v. C.I.R., 630 F.2d 340 (5th Cir.1980).

The Internal Revenue Code of 1954 imposes an excise tax on the transfer of an estate at death. The statutory scheme and regulations provide that the contents of a decedent's gross estate are fixed as of the moment of death. 26 CFR Sec. 20.2032-1(a); ⁶ 26 U.S.C. Secs. 2031-33; see generally Bittker, Federal Taxation of Income, Estates and Gifts (1984) p 132.7.2. The variable allowed relates only to the valuation of the estate; it does not affect the inventory of assets which becomes inviolate at the death of the owner. Under the statute and regulations, assets sold continue as included property "even though they change in form." The issue before us is whether the proceeds received after Nellie Johnston's death are to be considered as in her estate at the time of her death, subsequently appearing in a changed form, or whether these proceeds are income of the estate wholly severed from taxable estate assets.

Under the government's rationale, the oil and gas payments are nothing more than a change in the form of estate assets from in-place oil and gas reserves to money. Since the in-place reserves were in the estate at Johnston's death, the payments, representing a conversion of those reserves to money, are likewise in the estate. 26 CFR Sec. 20.2032-1(d).

The argument advanced by the estate, accepted by the district court, is based on its reading of the Supreme Court's decision in Maass v. Higgins, 312 U.S. 443, 61 S.Ct. 631, 85 L.Ed. 940 (1941). In Maass and its companion cases, the Court reviewed an IRS regulation issued under a predecessor to Sec. 2032. ⁷ That regulation directed that when an estate was valued on the alternate valuation date, all rents, royalties, interest, and dividends received by the estate after the decedent's death, and not accrued prior to date of death, were to be fully included in the taxable estate. The petitioners in the Maass litigation challenged the inclusion in the gross estate of such rental and dividend income received between the date of the decedents' deaths and the alternate valuation dates. The Court agreed with the petitioners' arguments.

In upholding the contention of the taxpayers-petitioners in Maass, the Court referred to the "common understanding [that] rents, interest, and dividends are income." Id. at 447, 61 S.Ct. at 633. The Court expressly rejected as "unreal and artificial" the theory behind the IRS regulation that for purposes of estate tax valuation the asset consisted of two elements, "one the right of ownership the other the right to receive the income." Id. Instead, the Court held that the value of an asset is to be determined by viewing all of its components, including the income stream, "as an entirety." Id. at 448, 61 S.Ct. at 633.

The government argues that Maass and its progeny are inapposite, maintaining that the contents of the estate are fixed as of the moment of the decedent's demise. This point is not in dispute. From this linchpin the government contends that, unlike the proceeds in Maass, the proceeds at bar are nothing more or less than a change in the form of the asset in Johnston's estate at the time of her death, from in-place oil and gas reserves to cash. Analogies to cases involving dividend income from stock or bond investments or rentals from leased property are not applicable because those proceeds would not be in the estate on the date of decedent's death. Finally, the government urges that the existence of the oil and gas depletion allowance in the income tax code, 26 U.S.C. Secs. 611-17, is recognition by the Congress that revenues derived from the production of oil and gas reserves are commonly understood to be different from dividends or rental income.

We perceive Maass as directing a review of each case on its own facts, with an eye toward determining the common understanding whether the proceeds in question truly represent income produced by the estate or, rather, are the translation of the corpus of the estate into another form. The former would not be included in the estate tax inventory, the latter would. One might suggest that the result in Maass derives as much from intuition as logic. All investment income, from whatever source, represents to some extent a portion of the investment principal. As a matter of "common understanding," however, rents, dividends, and the like represent an income stream separate from the principal. The value of the principal is determined by viewing it as an "entirety," factoring in the income stream. Maass, 312 U.S. at 448, 61 S.Ct. at 633; 26 CFR Sec. 20.2032-1(d)(1). This common understanding results in large measure from the apparent perception that the principal generating the dividends and rentals is not diminished by the use which produces the income. This perception of non-wasting principal is slightly fogged. ⁸ The tax system recognizes wasting by providing for depreciation. The critical difference, however, is that a fully depreciated building or piece of personal property generally survives its tax-depreciation lifespan and continues to provide use or an income stream, whereas a fully depleted mine or well produces nothing but storage space. Responding to the latter, Congress directly and through the IRS established what some view as the painfully complex system of depletion allowances. 26 U.S.C. Secs. 611-17; 26 CFR Secs. 1.611 through 0-1.617-4; Commissioner v. Southwest Exploration Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347 (1956); Anderson v. Helvering, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277 (1940); Murphy Oil Co. v. Burnet, 287 U.S. 299, 53 S.Ct. 161, 77 L.Ed. 318 (1932); see also Commissioner v. Engle, 464 U.S. 206, 78 L.Ed.2d 420 (1984).

Applying the foregoing, we must determine which party's position is unreal and artificial and which comports with our common understanding. Maass. To do so we recast the arguments.

The government argues that when Nellie Johnston died she owned interests in X amount of in-place oil and gas reserves. That amount,...