Gail v. U.S.

• Citation: 58 F.3d 580
• Decision Date: 27 June 1995
• Docket Number: No. 93-4234,93-4234
• Parties: -5351, 64 USLW 2029, 95-2 USTC P 50,458 Ila I. GAIL, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 580

58 F.3d 580

76 A.F.T.R.2d 95-5351, 64 USLW 2029,

95-2 USTC P 50,458

Ila I. GAIL, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 93-4234.

United States Court of Appeals, Tenth Circuit.

June 27, 1995.

J. Franklin Allred of Salt Lake City, UT, for plaintiff-appellant.

Patricia M. Bowman, Dept. of Justice, Tax Div., Washington, DC (Loretta C. Argrett, Asst. Atty. Gen., and David English Carmack, Dept. of Justice, Tax Div., Washington, DC, with her on the brief), for defendant-appellee.

Before KELLY, BARRETT, and HENRY, Circuit Judges.

HENRY, Circuit Judge.

Taxpayer Ila Gail appeals the district court's summary judgment order characterizing the proceeds of a judgment in a fraud and conversion action as income. We have jurisdiction pursuant to 28 U.S.C. Sec. 1291. For the reasons set forth below, we reverse in part and remand to the district court.

BACKGROUND

Mrs. Gail is an elderly woman who owned an undivided one-half interest in ninety-six acres of real property in Trumball County, Ohio. When Mrs. Gail moved to Utah, the owner of the other one-half interest forged her name on a power of attorney form and executed an oil and gas lease to a development company. The developer found that the land was rich in natural gas and extracted the gas. However, the owner of the other one-half interest did not tell Mrs. Gail about the development activities or pay her any of the proceeds.

When she did become aware of the drilling activity, Mrs. Gail filed an action against the co-owner and the developer in Ohio state court. She alleged that the oil and gas lease was "invalid" and that it therefore did not convey her interest in the property. She further alleged that she had not received any royalties from the lease and that the defendants had converted the gas and royalties for their own use. Mrs. Gail sought to recover damages for "royalties not paid to plaintiff to date pursuant to the oil and gas lease, and for plaintiff's share of all other value which defendant ... has derived from the oil and gas lease." Applts.App. at 78A. Finally, Mrs. Gail's complaint included a general prayer for compensatory damages for "trespass, fraud, oil and gas well royalties, and rental income under the lease." Id.

During closing argument, Mrs. Gail's attorney asked the jury to compensate Mrs. Gail for unpaid royalties and for the loss of choice as to whether to develop the land in the future. "They didn't give her the right to decide whether [the gas] should remain; didn't give her the right to decide what should be done with it, whether the property should be sold with those reserved [sic] on it. They just took her gas and oil." Id. at 104. At the close of the trial in the Ohio action, the trial court submitted fraud and conversion claims to the jury. Mrs. Gail prevailed, ultimately recovering $250,000 in compensatory When Mrs. Gail failed to declare the judgment as income, the government alleged a deficiency. Mrs. Gail paid the alleged deficiency and filed an action in United States District Court for the District of Utah seeking a refund pursuant to 28 U.S.C. Sec. 1346. Although the government and Mrs. Gail agreed that the punitive damages should be characterized as income, they disagreed as to whether the compensatory damages should be characterized as income or a capital gain. In its summary judgment order, the district court noted that proceeds from a conversion judgment for gas in place are characterized as a capital gain while the proceeds from the production of gas are characterized as income. See, e.g., Anderson v. Helvering, 310 U.S. 404, 407, 60 S.Ct. 952, 954, 84 L.Ed. 1277 (1940) ("The production of oil and gas ... is treated as an income-producing operation, not as a conversion of capital investment as upon a sale."). The district court next observed that while the jury instructions in the Ohio action did not state whether the conversion was of gas in place or gas removed, Mrs. Gail's attorney had used language in closing argument suggesting that Mrs. Gail was asking to be compensated for the value of the gas produced from her land. Specifically, the district court noted that her attorney had asked for "royalties." Based upon the complaint and the closing argument, the district court held that the judgment compensated Mrs. Gail for unpaid royalties for gas removed from the property rather than for the diminution in the value of her property, and therefore characterized the judgment as income.

damages and $65,000 in punitive damages. ¹

DISCUSSION

The only issue on appeal is whether the proceeds from the judgment should be characterized as income or a capital gain. This is a close question that few courts have examined in the oil and gas context. We review the district court's grant of summary judgment de novo. Boone v. Carlsbad Bancorporation, Inc., 972 F.2d 1545, 1550 (10th Cir.1992).

Our general rule for characterizing the proceeds of a judgment for tax purposes focuses upon what the judgment replaces. Gilbertz v. United States, 808 F.2d 1374, 1378 (10th Cir.1987). In making this inquiry, we ask: "In lieu of what were the damages awarded" and characterize the judgment accordingly. Id. (quoting Raytheon Prod. Corp. v. C.I.R., 144 F.2d 110, 113 (1st Cir.), cert. denied, 323 U.S. 779, 65 S.Ct. 192, 89 L.Ed. 622 (1944)).

The most relevant Supreme Court case is C.I.R. v. Gillette Motor Transport, Inc., 364 U.S. 130, 80 S.Ct. 1497, 4 L.Ed.2d 1617 (1960). In Gillette, the government took control of a taxpayer's trucking business during World War II to advance the war effort. When the Federal Claims Commission awarded the taxpayer damages for the period in which the government controlled the company, the taxpayer characterized the damage award as a capital gain. The Gillette Court disagreed, holding that the damage award was more like rent than it was the sale of a capital asset. Id. at 135, 80 S.Ct. at 1501. The Court reasoned that "[h]ad the Government taken a fee in those facilities, or damaged them physically beyond the ordinary wear and tear incident to normal use, the resulting compensation would no doubt have been treated as gain from the involuntary conversion of assets." Id. (citing Henshaw v. C.I.R., 23 T.C. 176 (1954)) (emphasis added).

Henshaw is the leading oil and gas tax characterization case. In Henshaw, the taxpayers recovered a judgment when another party drilled on adjacent land connected to the same oil pool and destroyed the taxpayers' ability to recover oil from their property. The trial court that had presided over the conversion action had instructed the jury to determine the diminution of value to the taxpayers' property and the jury had found that the property had been damaged. Relying upon the rule that proceeds from oil and The government relies mainly upon Henshaw for the proposition that the pleadings and language of the Ohio action control the characterization of a judgment for tax purposes. We cannot agree that the potentially confusing language of the Ohio proceeding is dispositive in characterizing the entire judgment as income, for two reasons. First, while it may have been proper at the time of Henshaw to rely upon "magic words" in a complaint, notice pleading under the rules of civil procedure and the tax code now emphasize function instead of form, and economic reality rather than labels. See, e.g., Alexander v. City of Chicago, 994 F.2d 333, 340 (7th Cir.1993) (holding that there is no need to plead magic words in notice pleadings); Kirchman v. C.I.R., 862 F.2d 1486, 1491 (11th Cir.1989) ("[T]he general notion that courts should look at the substance of a transaction rather than just its form" has become accepted.); Carr Staley, Inc. v. United States, 496 F.2d 1366, 1375 (5th Cir.1974) ("Taxation should be based on the economic realities of the particular commercial transaction involved."), cert. denied, 420 U.S. 963, 95 S.Ct. 1355, 43 L.Ed.2d 441 (1975). ²

gas in place are considered capital assets rather than income, the tax court held that the judgment should be considered a capital gain because the other party's action destroyed the value of oil reserves still in the ground. Henshaw, 23 T.C. at 181-82.

Second, the term "royalties" in the context of the conversion action is confusing and inconsistent with the district court's holding in this case. The government argues that Mrs. Gail used the term "royalties" in her complaint and that her attorney used the term three times in his closing statement in the Ohio action, suggesting that Mrs. Gail's suit sought royalties--which are clearly income--rather than compensation for the diminution of value for her property.

However, the government's reliance on the "royalties" language to characterize the entire judgment is difficult to reconcile with the usual use of that term and the size of the judgment. One commentator notes that royalties on oil and gas leases generally range from 3/16 to 3/8 depending upon the jurisdiction, the bargaining power of the parties, and the amount of bonus payments. Richard W. Hemingway, Law of Oil and Gas Sec. 2.5, at 58 n. 89 (3d ed. 1991). In this case, the jury awarded Mrs. Gail more than the fractional value of production she would have received as a royalty. It is therefore clear that the jury did not only award Mrs. Gail royalties. In addition, Gilbertz suggests that the issue in this case is not whether Mrs. Gail's attorney used certain magic words in the Ohio action; the issue is whether Mrs. Gail's judgment actually represents gas production or the diminution to the value of her real property. ³

Mrs. Gail makes two arguments in support of the proposition that she is entitled Mrs. Gail's second argument is that the entire judgment represents the diminution to the value of her real property and that she is therefore entitled to characterize the judgment as a capital gain. Again, she invokes Henshaw, maintaining that both cases involve involuntary...