Gibson Products Co. v. United States

• Decision Date: 17 November 1978
• Docket Number: Civ. A. No. CA-7-76-77.
• Citation: 460 F. Supp. 1109
• Parties: GIBSON PRODUCTS CO. — Kell Blvd., Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Northern District of Texas

460 F. Supp. 1109

GIBSON PRODUCTS CO. — Kell Blvd., Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. No. CA-7-76-77.

United States District Court, N. D. Texas, Wichita Falls Division.

November 17, 1978.

COPYRIGHT MATERIAL OMITTED

Robert I. White, Houston, Tex., Paul W. Eggers, Dallas, Tex., for plaintiff.

M. Carr Ferguson, Dept. of Justice, Washington, D. C., Howard A. Weinberger, Lawrence L. Jones, Dept. of Justice, Dallas, Tex., for defendant.

MEMORANDUM OPINION AND ORDER

ROBERT M. HILL, District Judge.

Came on for trial before the court the above-styled cause. Having considered the pleadings, testimony, stipulations and argument of counsel, the court is of the opinion that judgment should be rendered for the plaintiff in part and for the defendant in part.

Facts

The facts which give rise to this lawsuit are summarized in the following manner. Plaintiff, a Texas corporation having its principal place of business in Wichita Falls, Texas, became a limited partner in 1972 of the McNeill Street Drilling Venture ("McNeill Street"), a Texas limited partnership. The limited partnership was formed in December of 1972 for the purpose of acquiring oil and gas leasehold interests and engaging in the drilling of oil and gas wells on various leases. Robert K. Pace ("Pace") and Harold D. Rogers ("Rogers") were the general partners. The total number of limited partners was thirteen, including plaintiff. Plaintiff's cash contribution to the partnership was $25,000.

In the same year, McNeill Street entered into a joint venture with Midwest Drilling Venture ("Midwest") to acquire certain oil and gas leases (the combined joint venture hereinafter referred to as "McNeill Street/Midwest"). Under their joint venture arrangement McNeill Street was to participate to the extent of 59 percent, and Midwest was to participate to the extent of 41 percent. Thereafter, on December 29, 1972, McNeill Street/Midwest entered into an agreement to purchase five oil and gas leases from Galaxy Oil Company ("Galaxy"). As part of the purchase arrangement, the parties also agreed to a "no-out" turnkey drilling contract, whereby Galaxy agreed to drill a test well on each of the prospects. The drilling of each of the wells was to commence on or before January 31, 1973, subject to an oral understanding of the parties to grant reasonable extensions of time. The consideration for the leases was $63,500, of which $25,400 was paid in cash, and $38,100 was represented by the purchasers' note. The allocable share of McNeill Street in these amounts was cash: $14,986 (59% of $25,400), and note liability: $22,479 (59% of $38,100). The consideration for the drilling obligations was $1,036,500, of which $414,600 was paid in cash, and $621,900 was represented by the purchasers' note. The allocable share of McNeill Street in these amounts was cash: $244,614 (59% of $414,600), and note liability: $366,921 (59% of $621,900).

The promissory note, which covered the liability of $660,000 ($621,900 + $38,100), was dated December 29, 1972, and was payable with interest on January 1, 1977. The note was nonrecourse, Galaxy's sole recourse for nonpayment being determined by the terms of the mortgage and security agreement entered into by the parties to the transaction, and the properties pledged thereunder. More specifically, the security for the debt was the oil and gas leases, any operating equipment on the leases owned by the mortgagor, and eighty percent of all hydrocarbons produced by any completed well on the leases. Under the terms of the loan agreement, Galaxy was also given an option, after drilling had been completed to the casing point and if the partnerships elected to complete any of the oil and gas wells so drilled, to enter into a joint venture arrangement with the partnerships for completion of the particular well and for ownership, development, and operation of the well.¹

The fair market value of the leases in 1972 was $63,500. No value was proven for 1972 with respect to the operating equipment or the possible production from the drilled wells. The price for the drilling obligations, $1,036,500, was fair and reasonable. It has not been proven, on a reasonable basis, that the value added to the leases by such drilling would be commensurate with that price, nor that any value would be added by the drilling, apart from any production which resulted therefrom.

As a result of the foregoing transactions, McNeill Street, an accrual-basis taxpayer, deducted in its 1972 return $611,535 as its proportionate share of the intangible drilling costs, which it elected to expense rather than to capitalize. See I.R.C. § 263(c). Total loss of McNeill Street for that year was alleged to be $661,760. Plaintiff, in turn, deducted $49,317.34 as its share of the partnership's loss which resulted from the intangible drilling costs. Plaintiff's purported basis in its partnership interest was $56,403.23, the $25,000 cash investment plus $31,403.23 as its share of the nonrecourse liability. Upon examination of the McNeill Street partnership return for 1972, the Internal Revenue Service ("Service") disallowed as a deduction the $611,535 of intangible drilling costs and, therefore, disallowed the plaintiff's deduction of $49,317.34 attributable to McNeill Street's operations. As a result of this disallowance, the government assessed and collected from plaintiff additional taxes for 1972 of $25,414.48, part of which was attributable to the disallowance of partnership losses of $49,317.34.² The government also assessed against plaintiff interest of $6,173.27 for 1972.³ Within two years after plaintiff paid the $25,414.48 of additional taxes, plaintiff filed a claim for refund. Upon examination of the claim for refund, the service issued its notice of disallowance, and, within two years of receipt of the notice of disallowance, plaintiff filed this suit for refund.

The government in this case has made a number of concessions with respect to plaintiff's claim. First, the government has conceded that the plaintiff was entitled to deduct its proportionate share of the loss attributable to the cash portion of the payments made to Galaxy for the drilling obligations.⁴ The government contends, however, that any such deduction would be limited to the plaintiff's basis in its partnership interest, and the amount of such basis is an unresolved issue. The government has also retracted its attack on the allocation of the total purchase price between the leasehold costs and the drilling costs.

The disputed issues which this court is called upon to decide evolve from the nonrecourse liability which McNeill Street/Midwest incurred in purchasing the leasehold properties and the drilling obligations from Galaxy. Briefly stated, the government argues that: (1) the liability to Galaxy was contingent and, therefore, under the applicable "all-events" test, the deduction for such liability was improperly accrued in 1972 by McNeill Street; and (2) plaintiff's basis in its partnership interest could not be increased by its proportionate share of the nonrecourse liability under the doctrine of Crane v. Commissioner of Internal Revenue, 331 U.S. 1, 67 S.Ct. 1047, 91 L.Ed. 1301 (1947).⁵

I. The Accruability of McNeill Street's/Midwest's Liability to Galaxy Under the All-Events Test

The general principles which are applicable in resolving this issue are well-established. The test for determining whether a liability may be accrued in a particular year is the so-called "all-events" test. This test provides that an item may be deducted in the year in which all events necessary to determine both the fact and the amount of liability have occurred, United States v. Anderson, 269 U.S. 422, 46 S.Ct. 131, 70 L.Ed. 347 (1926); Subscription Television, Inc. v. Commissioner of Internal Revenue, 532 F.2d 1021 (5th Cir. 1976); Lawyers' Title Guaranty Fund v. United States, 508 F.2d 1 (5th Cir. 1975); W. S. Badcock Corp. v. Commissioner of Internal Revenue, 491 F.2d 1226 (5th Cir. 1974); see also Treas. Reg. § 1.446-1(c) 1(ii) and § 1.461-1(a)(2) (1956). As a general rule the existence of a contingency in the taxable year with respect to a liability or its enforcement prevents accrual. Accrual of a deduction item is permitted only in the taxable year when the obligation to pay it is unconditionally fixed, Trinity Construction Corp. v. United States, 424 F.2d 302, 305 (5th Cir. 1970); see also Gillis v. United States, 402 F.2d 501 (5th Cir. 1968).

Applying these basic principles, the government argues that McNeill Street's liability to Galaxy, as represented by the nonrecourse promissory note, was contingent upon the production of oil and gas from the wells drilled by Galaxy, the principal security for such liability. In support of this proposition, the government cites a case which involved an analogous situation, Sunburst Oil & Refining Co. v. Commissioner, 23 B.T.A. 829 (1931).⁶ In Sunburst Oil, the court found that the taxpayer's liability for expenses of drilling and operation was contingent since payment was to be made solely from the taxpayer's share of production from the wells drilled. The court held that liability could only be accrued "if and when sufficient oil was produced from the wells to pay for it." Id. at 836. Although the lease purchase and turnkey drilling agreement in the present case differs from the agreement in Sunburst Oil in that payment of the drilling price itself was not expressly made conditional upon production, the court does not believe that this distinction is controlling. In deciding whether the liability was contingent an examination must be made of all the related documents which were executed by the parties to the transaction, including the purchase agreement, the promissory note, and the security agreement, see Subscription Television, Inc. v. Commissioner, 532 F.2d at 1027. Under these agreements, Galaxy's sole recourse for nonpayment was against the...