Maddrix v. C.I.R., 85-3173

• Decision Date: 22 January 1986
• Docket Number: No. 85-3173,85-3173
• Citation: 780 F.2d 946
• Parties: -690, 86-1 USTC P 9189 James MADDRIX and Alice Maddrix, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 946

780 F.2d 946

57 A.F.T.R.2d 86-690, 86-1 USTC P 9189

James MADDRIX and Alice Maddrix, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 85-3173.

United States Court of Appeals, Eleventh Circuit.

Jan. 22, 1986.

Elliot I. Miller, Pawling, N.Y., for petitioners-appellants.

Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Chief, Tax Div., David E. Carmack, Francis M. Allegra, Attys., U.S. Dept. of Justice, Washington, D.C., for respondent-appellee.

Appeal from a Decision of the United States Tax Court.

Before RONEY and ANDERSON, Circuit Judges, and MORGAN, Senior Circuit Judge.

ANDERSON, Circuit Judge:

James Maddrix and Alice Maddrix ("Taxpayer") ¹ appeal from a decision of the Tax Court disallowing, inter alia, certain advanced minimum royalty deductions and determining a $74,069.51 deficiency in their 1977 joint federal income tax return. This case presents a question of first impression concerning the proper application of 26 C.F.R. Sec. 1.612-3(b)(3) (1985), which governs the deductibility of advanced minimum royalties paid or accrued in connection with mineral deposits. We affirm.

I. BACKGROUND

Taxpayer is the owner of an undivided working interest in a mineral investment program known as Investors Mining Program 77-2 ("Investors Mining"), ² which was formed in September 1977 for the purpose of developing and mining coal reserves. In September 1977, Investors Mining entered into a coal sublease with Olentangy Resources, Inc. ("Olentangy"), which provided Investors Mining with the right to mine coal reserves on 236 acres of land in Logan County, West Virginia. The sublease was for a term of ten years or until the coal reserves were exhausted.

Under the terms of the sublease agreement ("Agreement"), Investors Mining agreed to pay Olentangy an "annual minimum royalty" of $300,000 to be paid on December 1 of each year. The Agreement also provided that upon commencement of the sublease, Investors Mining would pay Olentangy $2,540,000 of the "annual minimum royalty," with $590,000 to be paid in cash ("initial annual minimum royalty") and $1,950,000 to be paid by nonrecourse promissory notes bearing six percent annual interest and payable in quarterly installments from March 31, 1978 through June 30, 1985 ("subsequent annual minimum royalty payments"). ³

The Agreement also obligated Investors Mining to pay a tonnage royalty of $3 per ton of coal mined and removed from the property. Under the terms of the Agreement, Investors Mining could recoup the "initial annual minimum royalty" against the tonnage royalty at the rate of $3 per ton for 846,667 tons extracted. In addition, the "subsequent annual minimum royalty payments" could be recouped at the rate of $3 per ton at the time coal was extracted subsequent to the delivery of these payments. Finally, Olentangy's sole recourse for Investors Mining's default of any of its obligations under the sublease was to terminate the sublease and proceed against Investors Mining's interest in the sublease. ⁴

Upon execution of the sublease in 1977, the Taxpayer contributed $31,230 cash and executed a $103,239 nonrecourse note as his pro rata share of the "annual minimum royalty." As specified in the Agreement, the note provided for the payment of interest on the unpaid balance at the rate of 6% per annum and provided for quarterly installment payments. Any unpaid principal or interest would be fully due and payable on June 30, 1985, or the prior termination of the borrower's fractional undivided interest. Under the terms of the note, if the Taxpayer were to default on any payment on the note for a period of twenty-four months and this default was not remedied within three months after the receipt of written notice, or in the event of any other event of default under the sublease, Olentangy could declare the entire unpaid principal and any accrued and unpaid interest immediately due. The note, however, specifically provided that the Taxpayer would not be personally liable for any amounts payable under the note, and that the note was secured solely by Taxpayer's interest in the sublease.

Simultaneously, with the execution of the sublease, Investors Mining entered into a mining services contract ("Contract") with Big Sandy Creek Mining Co., Inc. ("Big Sandy Creek"), an affiliate of Olentangy. ⁵ The Contract would remain in force, unless otherwise terminated by the parties, for an initial period of eight years, and after the expiration of that period, Big Sandy Creek had the option to renew for three additional periods of five years each or until all the coal had been mined from the property.

Under the provisions of the Contract, Big Sandy Creek agreed to mine no less than 100,000 tons of coal during each contract year. The Contract also contained a liquidated damages clause:

It is understood that in the event that [Big Sandy Creek] shall default in the performance of minimum delivery obligations herto, damages would be difficult to determine. Accordingly, [Big Sandy Creek] agrees that [in the event of] its failure to deliver the minimum tonnage set forth above in any year, it shall promptly pay to [Investors Mining] liquidated damages in an amount equal to $3.00 per ton multiplied by the difference between the minimum deliveries required for such year and the actual delivery made in such year (the "Deficiency"), which sum shall be applied toward the principal and interest payments due by the Co-owners of [Investors Mining] on the Notes issued by [them] pursuant to the lease with Olentangy Resources, Inc. (the "Notes").

In order to secure the payment of the Deficiency, [Big Sandy Creek] agrees to loan to each Co-owner funds sufficient to make all required principal and interest payments under such Co-owners' Notes. In lieu of advancing cash, [Big Sandy Creek] may issue its own promissory notes to [Olentangy] under the lease provided that [Olentangy] accepts the same on a dollar-for-dollar basis as being equivalent to a cash payment under the Notes.

Record on Appeal, Doc. 9, Exh. E at 7. The Contract was subsequently modified to give Big Sandy Creek the option, in its sole discretion, to pay these liquidated damages either in cash or in notes payable to Olentangy. Olentangy also agreed to accept from the co-owners of Investors Mining, without recourse, any notes received by them from Big Sandy Creek and to apply these notes as credits against their obligations to pay their nonrecourse notes to Olentangy. ⁶

The Taxpayer elected to be taxed on the accrual method of accounting with respect to his proportionate share of the income, gain, loss, deductions and credits arising from his investment in Investors Mining. During 1977, no coal was mined on behalf of Investors Mining, and Taxpayer filed a joint federal income tax return for 1977, claiming a business loss of $142,387 arising from his participation in Investors Mining. This loss was comprised of "advance mining royalties" expenses of $134,471 ⁷ and miscellaneous fees and interest of $7,916. The Commissioner of Internal Revenue disallowed the deductions in their entirety.

Taxpayer filed a petition in the United States Tax Court seeking a redetermination of the deficiency asserted by the Commissioner, and the Commissioner moved for partial summary judgment on the issue of the deductibility of the advanced minimum annual royalty. The Tax Court entered judgment for the Commissioner, holding that Taxpayer had not met the requirements of 26 C.F.R. Sec. 1.612-3(b)(3) because Taxpayer's "execution of a nonrecourse note, payments on which were contingent on coal sales proceeds, does not establish an enforceable requirement that substantially uniform minimum royalties be paid annually in any event, regardless of annual production." Maddrix v. Commissioner, 83 T.C. 613, 623 (1984) (emphasis in original). The Tax Court also rejected Taxpayer's contention that a liquidated damages clause in the mining services contract eliminated the contingent nature of the note, reasoning that this clause did not create an enforceable requirement for substantially uniform payments of minimum royalties. Id. at 623-26. The Tax Court denied Taxpayer's motion for reconsideration, and this appeal ensued. ⁸

II. DISCUSSION

On appeal, Taxpayer contends that Treasury Regulation 1.612-3(b)(3)'s requirement of annual payment of substantially uniform royalties has been satisfied in the instant case because the liquidated damages clause in the mining services contract requires Olentangy to credit to Taxpayer's advanced minimum annual royalty obligation the amount of Big Sandy Creek's promissory notes, regardless of whether the notes from Big Sandy Creek to Olentangy are ever actually paid. We disagree.

Under Treas.Reg. 1.612-3(b)(3), advanced minimum royalties are generally deductible only in the year the mineral product to which they relate is sold. 26 C.F.R. Sec. 1.612-3(b)(3) (1985). This regulation, however, does allow a current deduction for advanced royalties when they are paid or accrued "as a result of a minimum royalty provision." Id. In order to fall within this exception, the minimum royalty provision must "require[] that a substantially uniform amount of royalties be paid at least annually either over the life of the lease or for a period of at least twenty years, in the absence of mineral production requiring payments of aggregate royalties in greater amounts." Id.

An examination of the relevant documents in this case establishes that there is no requirement for the annual and uniform payment of advanced minimum royalties. ⁹ The sublease and the nonrecourse notes executed by Taxpayer pursuant to its terms do not contain such a requirement. Since the notes issued by the Taxpayer were nonrecourse and secured only by the mineral interest itself, Olentangy could only look to the Taxpayer's interest in the minerals themselves for payment of Taxpayer's obligation. In Wing v....