Goodfellow v. Commissioner
| Citation | 83 T.C.M. 1733 |
| Decision Date | 28 May 2002 |
| Docket Number | Docket No. 8469-00. |
| Parties | James S. & Denise D. Goodfellow, Daniel R. & Claudia Goodfellow, James B. & Nancy B. Goodfellow v. Commissioner |
| Court | U.S. Tax Court |
This case is before the Court for decision without trial. See Rule 122. Petitioners petitioned the Court to redetermine deficiencies in their 1995 and 1996 Federal income taxes. Respondent determined the following deficiencies, all of which stem from respondent's disallowance of depletion deductions claimed by an S corporation named Goodfellow Bros. Inc. (GBI):
1995 1996
James S. and Denise D
Goodfellow ................. $69,594 $28,546
Daniel R. and Claudia
Goodfellow ................. 57,887 23,729
James B. and Nancy B
Goodfellow ................. -0- 2,858
We decide herein whether GBI had the requisite economic interest in certain unusable materials to deduct depletion under section 611. We hold it did not. Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the subject years. Rule references are to the Tax Court Rules of Practice and Procedure.
All facts were stipulated. We incorporate herein by this reference the parties' stipulation of facts and the accompanying exhibits. Petitioners resided in Wenatchee, Washington, when their petition was filed.
James S. Goodfellow, Daniel R. Goodfellow, and James B. Goodfellow (collectively, shareholders) own all of GBI's stock. Their respective ownership interests are 53.5 percent, 44.5 percent, and 2 percent. GBI's primary business activity is excavating and grading land. GBI works primarily as a general contractor but works sometimes, including on all occasions relevant herein, as a subcontractor.
In 1995 and 1996, GBI performed services for subdivisions of the State of Hawaii and others (collectively, landowners) under which it excavated and graded the landowners' land for future construction. GBI performed these services directly for general contractors, who, in turn, had contracted with the landowners. GBI's contracts with the general contractors generally required it to excavate materials from specified job sites (sites) and to grade the sites in accordance with certain specifications. GBI's grading services included using "fill". GBI was required by the contracts to use as fill any "usable" materials which were present on the site. When not enough usable materials were present on the site, the contracts required GBI to supply additional fill at its own expense.
Materials were considered usable if they met certain specifications. An engineer employed by the landowners examined the materials after their excavation and ascertained whether the materials met the specifications. Materials which the engineer rejected as not meeting the specifications were characterized as "unusable" and had to be removed from the site at GBI's expense. When GBI agreed to perform the relevant services at a site, it did not know (either actually or by estimate) the amount of materials at the site which would be considered usable or unusable.
Materials on the site which the engineer characterized as unusable became the property of GBI at or after the time of that characterization. GBI removed the unusable materials from the sites at its own expense and crushed and sold the removed materials to third parties as crushed rock. GBI crushed the unusable materials using equipment that it owned and maintained at a rock quarry (quarry) that was located on land owned by GBI. GBI used that equipment primarily to crush rock obtained from the quarry. For Federal income tax purposes, GBI depreciated the equipment in the subject years as well as in prior years.
GBI calculated and claimed percentage depletion deductions of $330,082 and $140,660 for 1995 and 1996, respectively, which passed through and were reported by the shareholders on their individual Federal income tax returns. GBI's deductions reflected its sale of both the unusable materials and the materials obtained from the quarry. Respondent disallowed GBI's deductions to the extent that they were attributable to the unusable materials. Respondent determined with respect to the unusable materials that GBI lacked an economic interest in a mineral in place.
OPINIONRespondent determined that petitioners are not entitled to the depletion deductions which GBI claimed as to the unusable materials. Petitioners argue that GBI is entitled to those deductions because it had an economic interest in the unusable materials.1 Petitioners rely on the 7-factor test set forth in Parsons v. Smith [59-1 USTC ¶ 9366], 359 U.S. 215 (1959). Respondent argues that petitioners lacked an economic interest in the unusable materials. Respondent asserts that the Parsons test supports his argument.
We agree with respondent that GBI is not (and thus petitioners are not) entitled to deduct depletion with respect to the unusable materials. Petitioners, as shareholders of GBI, an S corporation, are permitted to take into account their pro rata shares of GBI's "items of income * * *, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and * * * nonseparately computed income or loss." Sec. 1366(a)(1). GBI claimed the depletion deductions as to its excavation activities, and petitioners, in turn, claimed the depletion deductions through the passthrough provision of section 1366(a)(1). A deduction for depletion is a matter of legislative grace, Parsons v. Smith, supra at 219, and petitioners bear the burden of proving that they are entitled to such a deduction.2 Rule 142(a)(1); INDOPCO, Inc. v. Commissioner [92-1 USTC ¶ 50,113], 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering [4 USTC ¶ 1292], 292 U.S. 435, 440 (1934). The fact that the parties submitted this case to the Court fully stipulated does not change or otherwise lessen petitioners' burden in this case. Rule 122(b); Kitch v. Commissioner [Dec. 50,401], 104 T.C. 1, 8 (1995), affd. [97-1 USTC ¶ 50,124] 103 F.3d 104 (10th Cir. 1996).
Section 611(a) provides that a taxpayer may deduct a reasonable allowance for depletion as to "mines, oil and gas wells, other natural deposits, and timber", such allowance being ascertained under regulations prescribed by the Secretary. As relevant herein, the applicable regulations, the relevant portion of which we set forth in the appendix to this opinion, clarify that a depletion deduction may be claimed only by the taxpayer with an economic interest in the depleted mineral deposit. Sec. 1.611-1(b)(1), Income Tax Regs.; see also Parsons v. Smith, supra at 226; Kirby Petroleum Co. v. Commissioner [46-1 USTC ¶ 9149], 326 U.S. 599, 603 (1946); Helvering v. Bankline Oil Co. [38-1 USTC ¶ 9154], 303 U.S. 362, 368 (1938). The regulations explain that an economic interest is present when the taxpayer has: (1) Acquired by investment an interest in mineral deposits embedded within the earth (i.e., minerals in place) and (2) secured, by any form of legal relationship, income derived from the extraction of the minerals to which the taxpayer must look for a return of capital. Sec. 1.611-1(b)(1), (d)(4), Income Tax Regs.; see also Commissioner v. Southwest Exploration Co. [56-1 USTC ¶ 9304], 350 U.S. 308, 313-314 (1956); Palmer v. Bender [3 USTC ¶ 1026], 287 U.S. 551 (1933). Depletion deductions serve to compensate a taxpayer for minerals consumed in the production of income resulting from extraction, Anderson v. Helvering [40-1 USTC ¶ 9479], 310 U.S. 404, 408 (1940), so that when the minerals are exhausted, the taxpayer's investment in the mineral deposit remains unimpaired, Paragon Jewel Coal Co. v. Commissioner [65-1 USTC ¶ 9379], 380 U.S. 624 (1965). Commissioner v. Southwest Exploration Co., supra; Mo. River Sand Co. v. Commissioner [Dec. 41,404], 83 T.C. 193, 198 (1984), affd. [85-2 USTC ¶ 9732] 774 F.2d 334 (8th Cir. 1985). Whether the taxpayer has the requisite economic interest in a depletable asset is a factual determination. Ramey v. Commissioner [68-2 USTC ¶ 9480], 398 F.2d 478, 479 (6th Cir. 1968), affg. [Dec. 28,302] 47 T.C. 363 (1967).
The regulations recognize two methods for computing an allowance for depletion as to mineral deposits. Sec. 1.611-1(a), Income Tax Regs. The first method, cost depletion under section 612, focuses on the property's adjusted basis. Id. The second method, percentage depletion under section 613, focuses on the property's gross income. Id. Percentage depletion, the method at issue here, "is not computed with reference to the [taxpayer] operator's investment" and does not limit the taxpayer's deduction to the amount of any investment. United States v. Swank [81-1 USTC ¶ 9426], 451 U.S. 571, 576 (1981). Percentage depletion deductions continue as long as minerals are extracted from the property, and even where a taxpayer has invested no money in the deposit. Id. at 576-577. Nor must the taxpayer claiming percentage depletion as to a mineral deposit have legal title over the deposit. Kirby Petroleum Co. v. Commissioner, supra; Lynch v. Alworth-Stephens Co. [1 USTC ¶ 117], 267 U.S. 364 (1925). The linchpin of a percentage depletion deduction is that the taxpayer has an economic interest in the mineral deposit for which the deduction is claimed. Commissioner v. Southwest Exploration Co., supra; Kirby Petroleum Co. v. Commissioner, supra at 603.
Here, we find that GBI never had the requisite economic interest in the minerals (unusable materials) in place. GBI neither purchased by investment, nor contracted for, any interest in those materials as they sat embedded in the ground. GBI received the materials only after they were rejected by the landowners' engineer following the materials' excavation from the ground. GBI's receipt of the unusable...
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