Harrington v. Comm'r of Internal Revenue, Docket No. 3061-64.

• Citation: 48 T.C. 939
• Decision Date: 29 September 1967
• Docket Number: Docket No. 3061-64.
• Parties: H. M. HARRINGTON, JR., AND MARGUERITE HARRINGTON, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

48 T.C. 939

H. M. HARRINGTON, JR., AND MARGUERITE HARRINGTON, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 3061-64.

Tax Court of the United States.

Filed September 29, 1967.

H. M. Harrington, Jr., pro se, and J. W. Tyner for the petitioners.

Sidney B. Williams, for the respondent.

1. Following an initial audit, petitioners received a communication from the district director of internal revenue stating that their returns for 1959 and 1960 would be accepted as filed. Held, this routine letter did not constitute a closing agreement under sec. 7121, I.R.C. 1954.

2. Held, further: A reexamination of petitioners' returns and records for the years 1959 and 1960 did not violate sec. 7605(b), I.R.C. 1954. Petitioners acquiesced in the examination, and, in any event, respondent literally satisfied the provisions of the statute permitting such a reaudit when the taxpayer was notified in writing that a second inspection was necessary.

3. Held, further: Petitioners had no economic interest in oil which they extracted from wells deviated beyond the limits of their leases and bottomed beneath neighboring oil properties; the production from these slanted wells was of oil which had been in place beneath the adjacent properties. Petitioners had no investment in the mineral in place and they bore no ‘legal relationship’ to the income which was derived from the wrongful extraction of it. They are not entitled to depletion allowance deductions claimed and disallowed by respondent. Estate of H. W. Donnell, 48 T.C. 552 (1967), followed.

HOYT, Judge:

The respondent determined the following income tax deficiencies against the petitioners:

+--------------------+
                ¦Year  ¦Deficiency   ¦
                +------+-------------¦
                ¦      ¦             ¦
                +------+-------------¦
                ¦1959  ¦$11,778.23   ¦
                +------+-------------¦
                ¦1960  ¦7,401.92     ¦
                +------+-------------¦
                ¦1961  ¦12,500.37    ¦
                +--------------------+
                

After concessions by the parties the only issues remaining for our determination are:

(1) Whether the petitioners are entitled to certain depletion deductions claimed with respect to oil produced from illegally deviated oil wells bottomed outside of lease property in which they held interests in the East Texas and Hawkins fields.

(2) Whether respondent's determinations for 1959 and 1960 are invalid because they resulted from a reaudit and reexamination which followed an earlier examination resulting in notification to petitioners that the returns for those years were being accepted as filed.

(3) Whether petitioners are entitled to an increased net operating loss carryback deduction from 1962 to 1959 which in turn depends upon whether they are entitled to a depletion deduction for that year on some of the same leases deviated beyond the lease limits and bottomed in neighboring oil properties.

FINDINGS OF FACT

Some of the facts have been stipulated by the parties and such facts are adopted as our findings and by this reference are incorporated herein together with the stipulated exhibits.

Petitioners are H. M. Harrington, Jr., and Marguerite Harrington, husband and wife, and at the time of filing their petition herein their legal residence was Longview, Tex. They filed joint income tax returns for the years 1959, 1960, 1961, and 1962 with the district director of internal revenue at Dallas, Tex. Petitioner H. M. Harrington, Jr., is a practicing lawyer, but, during the tax years involved, the petitioners owned investments in certain oil and gas properties and their income for the years involved was derived primarily from these sources.

The petitioners' 1959 and 1960 income tax returns were audited by the Internal Revenue Service and approved without change. By letter dated November 7, 1961, the district director at Dallas notified petitioners that the examination for those years had disclosed that no change was ‘necessary to the tax reported’ and that the returns ‘will be accepted as filed.’

Following the so-called slant-hole investigation of 1962 by the State of Texas Railroad Commission, the respondent reaudited the petitioners 1959 and 1960 income tax returns, audited the 1961 return, and, inter alia, disallowed all oil and gas depletion allowance deductions on leases claimed by the respondent to contain one or more wells deviated and bottomed outside of petitioners' property. Accordingly, respondent determined deficiencies in income taxes for the years 1959, 1960, and 1961 in the respective amounts of $11,778.23, $7,401.92, and $12,50.37. These determinations were made on a reasonable basis and were not arbitrary. The deficiencies which remain unconceded by petitioners result from the disallowance by the respondent of depletion allowances for these years in the respective amounts of $17,410.81, $15,121.17, and $17,771.17.¹

Also in issue is the matter of a new operating loss carryback from 1962 to 1959. Respondent concedes that petitioners are entitled to such a deduction in the amount of $18,171.55. Petitioners contend that they are entitled to a carryback deduction of $22,003.32. This difference of $3,831.77 represents depletion claimed by petitioners in their 1962 return and disallowed by respondent, the disallowance again being based upon respondent's claim that certain of petitioners' wells were either deviated or nonproductive. Each of the leases in issue for the year 1962 is also in issue for the years 1959, 1960, and 1961. However, a greater number of leases and wells are in issue for these prior years, as the number of producing leases owned or operated by petitioners decreased considerably in 1962 for several reasons (including sanctions imposed by the Railroad Commission of Texas).

In the State of Texas, when an operator desires to drill or deepen an oil or gas well, he is required to file a document known as a form 1 with the Railroad Commission of Texas. This document states the name of the company or operator as well as a description of the lease and the location of the surface of the well with respect to the boundaries of the lease. A lease plat or map is required to be attached to the form 1 showing the surface location of the well, as well as the boundaries of the lease. The Railroad Commission after passing upon the application will either issue a permit to drill the well or will deny the application. After the completion of the drilling of the well, the operator is required to file a completion report setting forth the depth of the well, surface pipe, production pipe, production capacity, and other pertinent data with respect to the well. In certain cases the drilling permits specify and require that a survey report also be filed following the completion of drilling.

During the years involved the petitioners owned a working interest in the H. M. Harrington-Tom B. Blackstone lease, previously known as the J. K. Maxwell-Tom B. Blackstone lease. There were two wells on the Tom Blackstone lease—well 1-B and 2.

During the years involved the petitioners owned a working interest in the lease known as the T. F. Patton-Betty Coleman lease. There were 11 wells on the Betty Coleman lease.

During the years involved petitioners owned a working interest in a lease known as the W. J. Durham lease, which lease contained one well known as the No. 1 Durham well. In November 1961, the Durham lease was consolidated with the Van Sickle lease and the Ervin lease. The Van Sickle lease and the Ervin lease each had one well. After the consolidation, the Durham well became the Ralph Massad-Consolidated Royalties, Inc., well 1, the Ervin well became No. 2, and the Van Sickle well became No. 3.

During the years involved petitioners owned a working interest in the G. A. Erwin lease, also known as the Jack Peterson-J. T. Florence lease and the Ralph Massad lease. According to the form 1, both the surface and the bottom of the well were to be located on the Ralph Massad lease. By permission of the Railroad Commission, however, the surface of the well was located on an open corner of Danville and Knowles Street as shown by the lease plat. The Railroad Commission granted permission to locate the bottom of the well on the Ralph Massad lease.

During the period involved petitioners owned a working interest in the lease known as the L & G Oil Co.-W. L. Fuller lease. There were three wells on this lease, well 1 (previously well 3, 2, and 4-A. During the latter part of 1962 the Railroad Commission caused wells t(3), 2, and 4-A on the W. L. Fuller leases to be severed, thus prohibiting any further sales of oil from the three wells on this lease. On September 19, 1962, L & G Oil Co., the operator of the Fuller lease, applied to redrill well 1(3) on the W. L. Fuller lease. Well 1(3) was redrilled pursuant to the form 1 dated September 19, 1962, and is now producing oil. Since the severance of wells 2 and 4-A on the Fuller lease, no application has been made to the State Railroad Commission for a new allowable with respect to those two wells.

During the years involved petitioners also owned a working interest in the lease known as the W-L Operators-R.F. Green lease. There were two wells on that lease known as wells 1 and 2.

During the years involved the petitioners owned a working interest in the lease known as the H. M. Harrington, Jr.-Ann E. Miller lease. This well was one of the wells involved in Harrington v. Railroad Commission of Texas, 375 S.W.2D 892 (1964). It was redrilled as a result of that decision and is now producing on the Railroad Commission allowable schedules.

During the period involved the petitioners owned a working interest in the lease known as the Douglas Godfrey-Oscar Mitchell lease. There was one well known as well 1-B on the Oscar Mitchell lease.

During the years involved petitioners owned a working interest in the lease known as the H. M. Harrington, Jr.-W. F. Neal lease, also known as the Roy G. Carter-W. F. Neal lease. There was one well on the W. F. Neal lease known as well 1-A. This well was one...