Nicolazzi v. Comm'r of Internal Revenue , Docket No. 12611-79.

• Decision Date: 21 July 1982
• Docket Number: Docket No. 12611-79.
• Citation: 79 T.C. 109
• Parties: ROBERT J. NICOLAZZI and JUDITH M. NICOLAZZI, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

79 T.C. 109

ROBERT J. NICOLAZZI and JUDITH M. NICOLAZZI, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 12611-79.

United States Tax Court

Filed July 21, 1982.

In 1976, petitioner and two other individuals jointly participated in a program whose objective was to acquire noncompetitive “lottery” leases on Federal lands for oil and gas exploration and development. Lottery leases are made available to the public as their terms expire under monthly lotteries administered by the Bureau of Land Management. Persons interested in a particular lease must submit an application and nonrefundable $10 filing fee before the filing deadline. Thereafter, a drawing is held to determine the winning applicant. An applicant may file only one application on each lease, but he may make as many filings as there are available leases.

For a basic fee of $40,300, the program's sponsor prepared and filed applications on 600 carefully selected lottery leases. The selection process involved the use of professional oil and gas landmen to value the leases and a sophisticated computer program to estimate the number of applicants on each one. The lease targets were then selected in such a way as to maximize the participants' chances of acquiring one or more valuable leases from a limited number of applications. One of the lottery lease applications was successful and the participants were issued a lease on a Wyoming parcel.

In 1977, they exercised a “put option” which they had purchased for $2,900 when they invested in the program, and forced the sponsor to purchase a one-third interest in their lease for the prearranged price of $27,800. In 1978, the parties sold the lease to a third party for $7,000 plus an overriding royalty.

Held: Petitioner's share of the $40,300 fee is a nondeductible cost of acquiring his interest in the Wyoming lease and must be capitalized under sec. 263, I.R.C. 1954. Thus, no portion of the fee is deductible as a payment for investment advice or clerical and administrative services under sec. 212(1) or (2), I.R.C. 1954. Held, further: No portion of the fee is deductible as a loss on a transaction entered into for profit under sec. 165, I.R.C. 1954. The relevant “transaction” is petitioner's investment in the program, not each separate lease application, and, because he acquired an interest in a valuable lease and was guaranteed of some return by the put option, he did not sustain a bona fide loss on his investment during the taxable year. Abraham N. M. Shashy, Jr., and Alan Levine, for the petitioners.

William F. Garrow, for the respondent.

DAWSON , Judge:

Respondent determined a deficiency in petitioners' 1976 Federal income tax in the amount of $3,735. The deficiency stems from the disallowance of a $10,075 fee paid by Robert Nicolazzi during 1976 to Melbourne Concept, Inc., a company engaged in the business of procuring noncompetitive Federal oil and gas leases on behalf of its clients. The following issues are presented for decision:

(1) Whether any portion of the $10,075 fee is deductible under section 212(1) or (2);¹

(2) Whether any portion of the fee is deductible as a loss on a transaction entered into for profit under section 165.

If all or a portion of the fee is currently deductible under one of the foregoing provisions, then we must decide whether and to what extent the deduction is limited by the at-risk rules of section 465.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated herein by reference.

Petitioners Robert J. Nicolazzi (hereinafter petitioner) and Judith M. Nicolazzi are husband and wife and resided in West Bloomfield, Mich., when they filed their petition in this case. They timely filed a joint Federal income tax return for the calendar year 1976 with the Internal Revenue Service Center in Cincinnati, Ohio. The petitioners are cash method taxpayers.

On June 23, 1976, petitioner entered into an advisory and service agreement (agreement) with Melbourne Concept, Inc. (Melbourne), a company which provides certain services to persons interested in leasing federally owned lands for oil and gas exploration. Petitioner was referred to Melbourne by Robert Johnston, an agent commissioned by Melbourne to solicit business. Joining petitioner in the agreement were two other individuals, Mary E. Cannon and Christine W. Willis (hereinafter the co-participants). Their interests under the agreement were set at 25 percent and 50 percent, respectively. Petitioner was assigned the remaining 25 percent. To understand the nature of the services provided by Melbourne under the terms of the agreement, a brief discussion of the various ways in which Federal oil and gas leases may be obtained is necessary.

Background Information Concerning Federal Oil and Gas Leases

Under the Mineral Leasing Act of 1920, the Government is required to make available to U.S. citizens the mineral leasehold rights with respect to Federal lands. The regulations under the act provide that oil and gas leases are to have 10-year terms and carry an annual rental, which was 50 cents an acre during the year in issue. The leases are renewable for an additional 2-year period if drilling has commenced when the lease expires, and may be renewed indefinitely if the property is producing oil and gas in paying quantities.

The oil and gas leases are divided into two basic categories: competitive and noncompetitive. Competitive leases are on parcels located within a “known geologic structure,” i.e., a geologic formation which is either currently producing oil and gas or thought to be a likely candidate for future production. When the existing lease on the property expires, it is advertised as available for lease by the Bureau of Land Management of the Department of Interior (BLM), and sealed bids are then submitted by prospective lessees, principally the major oil companies.

Noncompetitive leases relate to properties which are not located near a known geologic structure. There are basically two different methods by which a noncompetitive lease may be acquired. Leases which have expired or been relinquished or canceled are known as lottery or simultaneous-filing leases and are posted on the third Monday of each month in the BLM land Offices which have jurisdiction over the underlying properties. Each person who wishes to obtain a particular lottery lease must file a lease application form with the proper BLM Office, together with a $10 nonrefundable filing fee, no later than the fifth working day after the list of available leases is posted. An applicant is limited to only one application per lease, but there is no limit on the number of separate leases with respect to which he can file applications each month. If, as is usually the case, a BLM Office receives multiple applications with respect to a particular lease, a public drawing is held to determine the applicant to whom the lease will be awarded. Leases are issued to successful applicants upon the payment of the first-year rental within 15 days after being notified of the drawing results.

A different procedure applies to noncompetitive leases which have not previously been issued, or which were originally posted as lottery leases but were not sought after by any qualified applicants. Such leases are commonly known as open-parcel or over-the-counter leases. They are made available to qualified applicants on a first-come, first-served basis. The applicant must file an “Offer to Lease” with the proper BLM Office containing a description of the desired property and accompanied by a $10 filing fee and payment of the first-year rental. However, the lease is not issued until the BLM Office determines that (1) no other lease applications are pending on the parcel, and (2) there are no State or Federal restrictions, such as environmental restrictions, on the use of the parcel. If any restrictions are found to exist, the BLM Office may decide to issue the lease on a “subject to” basis—-for example, the lease could be restricted so as to preclude surface occupancy, thereby making it difficult or impossible to carry on oil and gas exploration activities.

During 1976, approximately 600 to 700 lottery leases were posted each month in the BLM Offices located in the various States where Melbourne operated. Each lease description provided only the serial number and location and size of the parcel. This information did not enable a prospective applicant to distinguish readily a particular lease from any other lease in terms of its proximity to producing oil and gas properties, its estimated value or desirability, or its appeal to other prospective applicants. Thus, a layman having no oil and gas or real estate experience and lacking familiarity with the mechanics of the lottery lease system would have been severely hampered in his attempts to acquire valuable lottery leases. Further complicating matters was the fact that the prospective applicant only had 5 working days to research the posted leases, determine which ones were worth filing on, and prepare and file the necessary lease applications.

Services Provided by Melbourne Under Advisory and Service Agreement

Under the terms of the advisory and service agreement, Melbourne agreed to select and file applications on “approximately 600” unspecified leases on behalf of petitioner and the co-participants for a fee of $40,300. Petitioner's share of this fee was $10,075. The filings were to take place over a period of 6 months ending on December 31, 1976, at a rate of approximately 100 per month. Melbourne notified each successful client as soon as the results of the public drawings were available. If the client decided to acquire the lease, Melbourne paid the required first-year rental to the proper BLM Office on his behalf and thereafter billed him for the amount plus the cost of the $10 filing fee which had been tendered with the...