Keller v. C.I.R., 82-2486

• Citation: 725 F.2d 1173
• Decision Date: 01 February 1984
• Docket Number: No. 82-2486,82-2486
• Parties: 84-1 USTC P 9194 Stephen A. KELLER and Ethel L. Keller, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (8th Circuit)

Page 1173

725 F.2d 1173

84-1 USTC P 9194

Stephen A. KELLER and Ethel L. Keller, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 82-2486.

United States Court of Appeals Eighth Circuit.

Submitted June 13, 1983.

Decided Feb. 1, 1984.

Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Carleton D. Powell, George L. Hastings, Jr., Tax Division, Dept. of Justice, Washington, D.C., for appellee.

Tom G. Parrott, Kornfeld, Satterfield, McMillin, Harmon, Phillips & Upp, Oklahoma City, Okl., for appellants.

Before JOHN R. GIBSON, FAGG, Circuit Judges, and WOODS, ^* District Judge.

JOHN R. GIBSON, Circuit Judge.

This case presents the issue of whether intangible drilling and development costs (IDC) prepaid by taxpayer Stephen A. Keller in 1973 are deductible in that year rather than in later years when the goods and services are rendered. The issue essentially concerns timing; the deductibility of the IDC is not in dispute. In resolving this issue the tax court, sitting as a whole, weighed three considerations: (1) whether the expenditure was a payment or a deposit, (2) whether the prepayment was made for a business purpose or for tax avoidance, and (3) whether the prepayment resulted in a material distortion of income. The tax court concluded that Keller improperly deducted certain prepaid IDC in 1973. We affirm.

Taxpayer ¹ in 1973 invested $50,000 in a limited drilling partnership through Amarex, Inc., and its wholly-owned subsidiary, Amarex Funds, Inc. Both corporations were general partners of the Amarex Drilling Program, Ltd.--72/73 (the Program Partnership), a limited partnership in which taxpayer and investors became limited partners. Funds invested in the Program Partnership were reinvested in four drilling partnerships. The share purchased by taxpayer was allocated to Amarex Drilling Partnership No. 72/73-D (the Drilling Partnership).

The issue of tax liability in this case centers around the activities of the Drilling Partnership during late 1973. Keller purchased his subscription on July 31, 1973. The Drilling Partnership was formed on August 14, 1973, and commenced operation shortly thereafter. Ninety-eight investors, as limited partners of the Program Partnership, invested a total of $1,372,000 in the Drilling Partnership. The Drilling Partnership began drilling in August, 1973, and completed 62 wells that year. Thereafter it completed 94 wells in 1974 and 25 wells after December 31, 1974. Of 182 wells altogether, located in fourteen states, 27 were oil wells, 40 were gas wells, one was an oil and gas well, and 114 were dry wells.

Both the Program Partnership and the Drilling Partnership reported their incomes on a calendar year basis, using the cash receipts and disbursement method of accounting. On its 1973 partnership tax return, the Drilling Partnership reported an ordinary loss of $1,373,257. The Program Partnership reported a $1,372,000 ordinary loss on its 1973 partnership tax return as its distributive share of the Drilling Partnership's loss. Keller, in turn, deducted a $50,000 ordinary loss on his 1973 income tax return as his distributive share of the Program Partnership's loss.

Pursuant to 26 U.S.C. Sec. 263(c) (Supp. V 1981) and Treas.Reg. Sec. 1.612-4(a), the Drilling Partnership had elected to "expense," or currently deduct, its intangible drilling and development costs (IDC) on its 1973 partnership tax return. The Commissioner of Internal Revenue, however, disallowed the Drilling Partnership's deductions as to IDC prepaid in 1973 for drilling services not to be rendered until after 1973. Accordingly, the Commissioner determined Keller's distributive share of the partnership's loss to be $21,595 instead of $50,000, and notified Keller of a $14,202 tax deficiency.

The prepaid IDC in question took several forms. In December of 1973, the Drilling Partnership transferred $487,869.33 to various drilling contractors and service companies pursuant to 330 contracts concerning 87 proposed oil and gas wells. These contracts were of three types: (1) footage and daywork drilling contracts, (2) turnkey drilling contracts, and (3) third party well servicing contracts. The Drilling Partnership also transferred $142,691.38 to Amarex Funds as prepaid "well charges" under the drilling agreement. The Commissioner disallowed 1973 deductions for all of these prepayments of IDC.

The tax court upheld the Commissioner's determinations of nondeductibility in 1973, except for those prepayments made pursuant to turnkey drilling contracts. It applied a variation of a three-part test that the Commissioner had previously proposed in the context of prepaid livestock feed. As postulated by the Commissioner, the test required that [f]irst, the expenditure must be a payment ... rather than a mere deposit; second, the prepayment must be made for a business purpose and not merely for tax avoidance; and third, the deduction of such costs in the taxable year of prepayment must not result in a material distortion of income.

Rev.Rul. 75-152, 1975-1 C.B. 144; Rev.Rul. 79-229, 1979-2 C.B. 210. In Van Raden v. Commissioner, 71 T.C. 1083, 1096 (1979), aff'd, 650 F.2d 1046 (9th Cir.1981), the tax court adopted the test but declined to consider the second part of the test as an independent requirement; a legitimate business purpose could satisfy the distortion of income requirement. The tax court in the present case applied the same "two-part variation" of the proposed three-part test to the deductions of prepaid IDC taken by the Drilling Partnership and Keller. ²

The tax court found that prepayments made under the footage and daywork contracts and the third party well servicing contracts were refundable deposits, not payments. It further found no convincing business purpose for such prepayments. (TC at 47) The tax court determined that the prepayment of "well charges" to Amarex Funds, regardless of whether they constituted payments or deposits, could not be deducted in 1973 because to do so would materially distort the partnership's income; no business purpose existed for prepaying the "well charges." (TC at 59-60) It found that IDC prepaid under turnkey contracts, however, were deductible in 1973. Such prepayments could not be refunded, hence they were payments, not deposits. (TC at 62) The tax court further found that turnkey contracts locked in prices, thus serving a valid business purpose, and therefore did not materially distort income because the partnership "effectively got its bargained for benefit in the year of payment." (TC at 65)

I.

Taxpayer appeals the tax court's finding that prepaid IDC (1) under the footage and daywork contracts, (2) under the third party well servicing contracts, and (3) as "well charges" were not deductible in 1973. ³ Specifically, taxpayer contends that the three-part test relied upon by the tax court does not properly apply to the timing of a deduction for prepaid IDC. None of the courts of appeals has passed upon this issue.

The Commissioner initiated the three-part test in the context of a cash-method taxpayer's deduction of prepaid livestock feed. Rev.Rul. 75-152, 1975-1 C.B. 144; Rev.Rul. 79-229, 1979-2 C.B. 210. Observing that these Revenue Rulings merely represented the Commissioner's legal position and did not carry the force of law, the tax court nonetheless adopted a variation of the three-part test for prepaid livestock feed in Van Raden, supra. The court modified the proposed three-part test by considering the second factor, business purpose, only to the extent that it bore upon the third factor, material distortion of income. It found that a substantial business purpose could satisfy the distortion of income test, 71 T.C. at 1106, and concluded that the taxpayers satisfied all three requirements. See also Haynes v. Commissioner, 38 T.C.M. (CCH) 950 (1979) (current deductibility determined on material distortion factor); Smith v. Commissioner, 35 T.C.M. (CCH) 1246 (1976) (current deductibility determined on refundability factor); Owens v. Commissioner, 64 T.C. 1 (1975) (same).

The courts of appeals have considered the three-part test in prepaid livestock feed cases but have expressly withheld judgment as to its undivided applicability. In Clement v. United States, 217 Ct.Cl. 495, 580 F.2d 422 (Ct.Cl.1978), cert. denied, 440 U.S. 907, 99 S.Ct. 1214, 59 L.Ed.2d 455 (1979), the Court of Claims denied a current deduction for prepaid livestock feed solely on the basis of the resulting material distortion of income, i.e., the third factor of the three-part test. The court did not need to consider the first factor of the test because the government conceded that the prepayment was a payment, not a deposit. 580 F.2d at 424 n. 1. Discerning an adequate business purpose for the prepayment from the totality of the evidence, the court further declined to decide whether the second factor of the test, a business purpose, was a requirement for deductibility. Id. at 427-29.

Likewise, the Fifth Circuit in Frysinger v. Commissioner, 645 F.2d 523 (5th Cir.1981), did not need to decide the validity of the entire three-part test because the sole issue raised was whether the Commissioner erred in determining that the deduction for prepaid livestock feed resulted in a material distortion of income. Id. at 525 n. 2. The Ninth Circuit in Commissioner v. Van Raden, 650 F.2d 1046 (9th Cir.1981), avoided passing upon the validity of the three-part test altogether, even though the tax court had adopted it. ⁴

In the present case, the Commissioner argues that the three-part test is not confined to the prepaid feed context. The tax court agreed that the modified version of the three-part test that it adopted in Van Raden was applicable to prepaid IDC. (TC at 34) Taxpayer, however, vehemently contends that while the statutory provisions underlying the three-part test may apply to prepaid livestock feed, they do not apply to prepaid IDC, hence neither does the three-part test....