Rhodes v. United States, 71-3215

• Decision Date: 14 August 1972
• Docket Number: No. 71-3215,71-3216.,71-3215
• Parties: William S. RHODES and Sara G. Rhodes, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee. Spears R. RHODES and Martha Jane Rhodes, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

464 F.2d 1307 (1972)

William S. RHODES and Sara G. Rhodes, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

Spears R. RHODES and Martha Jane Rhodes, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

Nos. 71-3215, 71-3216.

United States Court of Appeals, Fifth Circuit.

August 14, 1972.

Hobart A. McWhorter, Jr., Lee C. Bradley, Jr., Bradley, Arant, Rose & White, Birmingham, Ala., for plaintiffs-appellants.

Ira De Ment, U. S. Atty., Montgomery, Ala., Fred B. Ugast, Acting Asst. Atty. Gen., Meyer Rothwacks, Atty., Scott P. Crampton, Asst. Atty. Gen., Virginia H. Gallagher, Richard W. Perkins, Virginia M. Hopkinson, Attys., Tax Div., Dept. of Justice, Washington, D. C., for defendant-appellee.

Before WISDOM and INGRAHAM, Circuit Judges, and BOOTLE, District Judge.

BOOTLE, District Judge:

These consolidated appeals require us to determine the proper tax treatment of income received by taxpayers under a contract with their wholly owned corporation, Excelsior Brick Company, Inc., disposing of brick clay deposits on a tract of taxpayers' land. The issue presented is whether the contract was in essence a sale of minerals in place or a mineral lease. If a sale, as contended by taxpayers, the payments they received constituted proceeds from the sale of a capital asset and were taxable as capital gain. If the transaction was a lease agreement, as contended for by the Commissioner of Internal Revenue, the payments were taxable as ordinary income subject to an allowance for depletion.

Taxpayers filed suits in the district court seeking refund of income taxes assessed against them by the Commissioner following the Commissioner's disallowance of their claim for capital gains treatment of sums received by them in the years 1964 and 1965 from the disposal of their mineral interests. The actions were consolidated for trial along with the suit of Excelsior Brick Company seeking recovery of taxes assessed against it by the Commissioner.¹ The case was tried to a jury, which answered special interrogatories placing the value of the clay deposits at a figure less than that contended for by taxpayers but more than that insisted upon by the Commissioner and denoting the transfer of the clay deposits to Excelsior by taxpayers as a lease rather than a sale. The court entered judgment on the jury verdicts. Taxpayers subsequently filed a motion for judgment notwithstanding the verdict or in the alternative for a new trial. The motion was denied by the court. Excelsior did not appeal the jury's determination of the fair market value of the deposits, nor do the parties here challenge such determination.

We conclude that the payments taxpayers received for the transfer of the clay deposits were returns from the sale of capital assets and should have been taxed as capital gains. The trial court should have granted the motion for judgment notwithstanding the verdict. Accordingly, we reverse.

In July of 1959, taxpayers purchased about 23 acres of land from Mrs. Martha Henry Stay (hereinafter referred to as the "Stay" tract) for some $55,000.00 or roughly $2300.00 an acre. This tract was adjacent to the Excelsior Brick Plant. Exploration of the tract by taxpayers indicated extensive clay deposits underlying the tract for an average depth of 20 feet. Additionally, the taxpayers determined that substantial sand and gravel deposits lay under the clay deposits.

In 1962, taxpayers and Excelsior, with Spears Rhodes as president and William Rhodes as vice-president, entered into an agreement termed an "indenture" whereby taxpayers, as "grantors", purported to "grant, bargain, sell, assign, convey, transfer and set over unto" Excelsior, as grantee, "in fee simple", all of the "merchantable brick clay" deposits underlying a specifically designated and described one acre parcel of the Stay tract, the purchase price being $7500.00. In pertinent part the provisions of the indenture were as follows. The grantee was to mine and remove the clay in a progressive and orderly fashion so as not to impair the availability or value of surrounding land, or increase the cost of removing other clay and the sand and gravel deposits. A 15 year period was allocated to effect the removal. If all of the merchantable clay was not removed in 15 years grantors had the option of removing the clay and selling it for the account of the grantee, any excess of payment received for the clay above expense of extraction to be paid to grantee. If, however, the payment received for any clay so removed was less than the cost of removal, the difference was to be a debt of the grantee. Merchantable clay was defined in the instrument as clay which can be economically removed at a net profit as of the date of the execution of the instrument. It was provided though that if any clay which was merchantable on that date later becomes unmerchantable in fact, or in the opinion of the grantee, grantee, in lieu of removing same, or having same removed at its expense after 15 years by grantor, may reconvey same to grantors who may accept such reconveyance in lieu of exercising their option to remove it at grantee's expense. Further, grantee agreed to remove the clay in a proper and workmanlike manner according to the best practices pursued by skilled operators in the business of mining. Rights of ingress and egress were guaranteed grantee over other lands of grantors.

The indenture, in addition to transferring all the merchantable clay on the one acre parcel contained a contract for the sale of all merchantable clay contained on the entire tract. Stating that Excelsior desired "to acquire all such deposits (merchantable clay deposits) of brick clay as and when the same may be used in its business of making brick, and the grantee (Excelsior) may have the financial resources with which to pay for the same in full", the instrument provided that the "Grantors do hereby agree to sell unto the Grantee, and the Grantee does hereby agree to purchase from the Grantors, all of the merchantable brick clay deposits" which were located under the remainder of the Stay tract, at the rate of $7500.00 per acre, with the proviso that if portions of the tract contained no merchantable brick clay deposits, those portions were to be excluded from the portions to be sold. The parties to the indenture expressly contracted that merchantable brick clay deposits were located on not less than five additional acres of the Stay tract which five acres would yield not less than $37,500.00 in addition to the one acre which was conveyed by the instrument and grantee agreed to pay not less than said sum subject to the terms and conditions of the indenture. A procedure was set out by which grantee could require grantors to convey all of the merchantable brick clay located under the remaining part of the Stay tract in two acre parcels, under the same provisions contained in that part of the indenture conveying the one acre tract. If Excelsior did not call for the conveyance of at least two acres per year, beginning in 1963, taxpayers could require Excelsior to accept the conveyance of a two acre tract in each year at the specified price. If payment for the parcels so conveyed was not forthcoming, grantors could reserve a vendor's lien upon said parcels to secure any unpaid purchase money.² The only limitation on Excelsior's right to require further conveyances was that Excelsior pursue its business of removing brick clay from all portions of the larger tract in an orderly way and in general conformity with certain provisions of the indenture which, inter alia, required Excelsior to remove the clay in a workmanlike manner and "in such a manner as will not unnecessarily disturb the surface of related or contiguous areas, or unreasonably impair the availability or value of the land surrounding the same for the future uses and purposes of the Grantors, especially for the removal of sand and gravel."

Following the execution of this indenture by subsequent deeds containing provisions with respect to the land transferred thereby essentially the same as those which were contained in the original indenture, nine additional two acre tracts were transferred by taxpayers to Excelsior and payments made as follows:

                Amount
                          "Date of Acreage Paid to
                Deed Involved Taxpayers
                March 20, 1963          2       $15,000
                February 24, 1964       2        15,000
                September 24, 1964      2        15,000
                March 24, 1965          2        15,000
                December 6, 1965        2        15,000
                December 14, 1966       2        15,000
                March 29, 1968          2        15,000
                March 24, 1969          2        15,000
                March 23, 1970          2        15,000."
                

In transactions of this type, to determine whether the purported transfer was a sale of minerals in place or a mineral lease, it must be determined whether taxpayers, pursuant to the contract between the parties, retained an economic interest in the minerals and in determining whether an economic interest was retained "the critical consideration is whether payment is dependent upon extraction. . . ." Rutledge v. United States, 428 F.2d 347 (5 Cir.1970); Wood v. United States, 377 F.2d 300 (5 Cir.1967). If such an interest has been retained the transaction was a mineral lease and not a sale of minerals in place. Wood, supra. An economic interest exists where a taxpayer has "(1) `acquired, by investment, any interest in . . ., (the minerals) in place,' and (2) secured by legal relationship `income derived from the extraction of . . . (the mineral), to which he must look for a return of his capital.'" C.I.R. v. Southwest Explor. Co., 350 U.S. 308, 314, 76 S.Ct. 395, 398, 100 L.Ed. 347, 353 (1956). (Emphasis added).

A number of cases nationwide have dealt with this question, but as Judge Thornberry in Wood recognized, the law in this circuit is controlled by Crowell Land & Mineral Corp. v. C.I.R., 242 F.2d 864 (5 Cir.1957) (transaction found to be a sale of...