Gilbertz v. U.S.

• Decision Date: 07 January 1987
• Docket Number: No. 84-1323,84-1323
• Citation: 808 F.2d 1374
• Parties: -424, 55 USLW 2408, 87-1 USTC P 9116 Lawrence E. GILBERTZ and Verna Ann Gilbertz, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 1374

808 F.2d 1374

59 A.F.T.R.2d 87-424, 55 USLW 2408, 87-1

USTC P 9116

Lawrence E. GILBERTZ and Verna Ann Gilbertz, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.

No. 84-1323.

United States Court of Appeals Tenth Circuit.

Jan. 7, 1987.

Rehearing Denied Feb. 23, 1987.

James A. Clark (Claude M. Maer, Jr. with him on the brief), of Baker & Hostetler, Denver, Colo., for plaintiffs-appellees.

Steven Frahm of the Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, William S. Estabrook, and Mary L. Fahey, Attys., Dept. of Justice, Washington, D.C., and Richard Allen Stacy, U.S. Atty., Cheyenne, Wyo., with him on the briefs), for defendant-appellant.

Before HOLLOWAY, Chief Judge, MOORE, Circuit Judge, and THEIS, District Judge. ^*

JOHN P. MOORE, Circuit Judge.

The government appeals from a judgment of the United States District Court for the District of Wyoming awarding Lawrence E. and Verna Ann Gilbertz (Taxpayers) a tax refund of $37,557 and $9,314.66 assessed interest for the 1977 tax year. Gilbertz v. United States, 574 F.Supp. 177 (D.Wyo.1983). The issue before us is whether the district court properly characterized payments of approximately $111,800 received by Taxpayers in 1977 as the recovery of capital gains from the sale of a capital asset. Upon our review of the record and the briefs submitted by the parties, we reverse in part, affirm in part, and remand for a determination of apportionment consistent with this opinion.

I. Background

Taxpayers, husband and wife, raise cattle on their 6,480-acre ranch in Campbell County, Wyoming. Although they hold title to all the surface rights in their land, Taxpayers own only a fractional interest in the mineral rights. The federal government has reserved most of the mineral rights pursuant to the Stock Raising Homestead Act of 1916, 43 U.S.C. Sec. 299 (the Act).

In 1973, the government issued federal oil and gas leases to individuals and companies to explore and develop the minerals underlying the Gilbertz Ranch. Subsequently, in 1976 and 1977, Mr. Gilbertz negotiated more than fifty contracts with oil and gas lessees and pipeline companies to receive payments in connection with their anticipated drilling activities on the ranch. These contracts were in essentially two forms: releases from damage claims and the sale of easements. Although most of the contracts were executed with Davis Oil Company and several pipeline companies, the Gilbertzes also received payments from surveying and engineering firms, public services, and other companies. The bulk of the payments at issue in this litigation related to well sites, tank batteries, roads, and pipelines used to develop the mineral rights beneath the Gilbertz Ranch. ¹ However, Diamond Shamrock Corporation (Diamond Shamrock) made one payment to Taxpayers for an access road across their ranch to develop the mineral rights on the adjoining property.

Taxpayers then filed their 1977 tax return and characterized all payments received pursuant to these contractual agreements as recovery of capital. Taxpayers applied the payments against their basis in the entire ranch and treated the excess as capital gains. The Commissioner of Internal Revenue disagreed, determined all of the payments to be ordinary income, and assessed a deficiency. The Gilbertzes paid the deficiency and sued for a refund in the United States District Court for the District of Wyoming.

The parties made the following stipulations. First, oil and gas activity was projected to last fifteen to fifty years; when production ceased, the structures and equipment of the oil and gas companies would be removed. Second, the oil and gas companies and pipeline companies had agreed to a rehabilitation plan to reshape and reseed the affected areas when production stopped. Third, the exploration and drilling activity on sections of the ranch had increased the traffic, noise, and dust on the entire ranch. Finally, Taxpayers had reduced the carrying capacity of their ranch by 20% in response to the oil and gas activity.

In the one-day trial to the court, Mr. Gilbertz testified that his intent in agreeing to the releases from damages was to protect himself from the unreasonable use of his property, to negotiate a figure for excessive damages caused by negligent operations, and to avoid costly and continual court battles. Taxpayers presented pictures of the areas affected by the oil and gas operations and testified to the permanent destruction of the natural grasses on the acreage utilized by the lessees and pipelines. Mr. Gilbertz also testified to the disruption in the management of the ranch in 1977 and the continuing problems caused by the presence of the oil and gas operations. Mr. Gilbertz stated that after the minerals were exhausted and the equipment had been removed, "restoration" of the affected acreage would be virtually impossible based on his prior experiences with attempts at reclaiming abandoned uranium exploration holes. A reclamation expert testified that "reclamation" of the affected land would cost $1.2 million. Mr. Gilbertz testified that he intended to purchase additional land as it became available to return the ranch to its pre-1977 holding capacity.

In the trial court, the government argued that the payments at issue were in the nature of rent and, therefore, should be characterized as ordinary income. To support this theory, the government cross-examined Mr. Gilbertz, who testified that prior to 1977 the ranch had shown a loss only one year; but after the oil and gas development, it began operating at an annual net loss. The government sought to prove the payments received were intended to compensate Taxpayers for the loss of farm income due in part to the falling price of livestock. The government presented evidence that the ranch, which was appraised at between $500,000 and $600,000, had suffered less than a $10,000 decrease in value due to the oil and gas activity on the property. Finally, the government presented evidence on the palatability of the grasses used in reclamation to rebut the Taxpayers' arguments that the acreage used for oil and gas operations had suffered permanent damage.

After presentation of the evidence, the trial court trisected the contract payments at issue and made the following conclusions. First, the payment contracts with mineral lessees, "Release and Damage Payments," provide a release from liability for surface damages relating to the development of the mineral rights and are not in the nature of rent. Thus, these payments cannot be characterized as ordinary income. Second, the payments from pipeline companies for rights-of-way and damage to the land are subject to capital gains treatment, the court holding the transfers to be easements, interests in real property or a capital asset. Third, because the court also found the transfer of the right-of-way to Diamond Shamrock to be an easement, this payment would receive capital gains and not ordinary income treatment. In each instance, the trial court considered the terms of the written agreements, the intent of the parties, and applicable precedent. We follow this guide and address each area of payment seriatim.

II. Release and Damage Payments From the Oil and Gas Companies

A typical "Release and Damage Payment Receipt" executed by the Taxpayers and Davis Oil Company provided for the payment of $2,096 as the

full payment, settlement and satisfaction of all detriment, injuries and damages of whatsoever nature and character, growing out of, incident to, or in connection with ... [the Gilbertz No. 2 well] caused by the moving in, removing of derrick drilling tools, vehicles, and all other machinery and equipment necessary or incident to the drilling, testing, completion of said well for oil and gas, and for the same consideration, the undersigned does hereby release, acquit, and discharge the said DAVIS OIL COMPANY of and from any and all claims for detriment, injuries, and damages as set out above.

OTHER CONSIDERATIONS:

It is specifically understood that this payment covers all damages arising from the use of a well location and the road thereto, but does not include any damages to the personal property or other property of the undersigned landowners.

This particular contract called for a one-time payment of $1,000 for the tank battery location and annual payments of $1,096 for the tank battery, well site, and 896 rods of access road. ²

After reviewing the agreements and Mr. Gilbertz' testimony on his intent in signing the releases, the district court determined that the payments received by the Taxpayers were "compensation for the damage caused or sure to be caused to the land." Moreover, in response to the government's arguments, the court stated, "[T]here is simply no indication that the payments were intended to be rent." Therefore, the Taxpayers were entitled to treat the payments relating to these various contracts as recovery of capital. The district court erred, however, in failing to consider the limited damage claims these Taxpayers could have brought against the oil and gas companies under the Act and the actual damages suffered.

Surface damage payments are commonplace in landowner-mineral lessee relations. ³ The tax consequences which attach to these payments must be determined by examining their nature and what they were intended to compensate. Raytheon Production Corp. v. C.I.R., 144 F.2d 110 (1st Cir.), cert. denied, 323 U.S. 779, 65 S.Ct. 192, 89 L.Ed. 622 (1944). See also Rev.Rul. 73-161, 1973-1 C.B. 366; Henshaw v. C.I.R., 23 T.C. 176 (1954). ⁴ In Raytheon, the First Circuit summarized the analysis to be followed by asking, "In lieu of what were the damages awarded?" 144 F.2d at 113. See also C.I.R. v. Glenshaw Glass Co., 348 U.S. 426, 75 S.Ct. 473, 99 L.Ed. 483 (1955). In our case, we must ask what surface rights were the payments designed to compensate or...