Rife v. CIR

• Decision Date: 15 February 1966
• Docket Number: No. 22015.,22015.
• Citation: 356 F.2d 883
• Parties: M. O. RIFE and Maidee W. Rife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

356 F.2d 883 (1966)

M. O. RIFE and Maidee W. Rife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 22015.

United States Court of Appeals Fifth Circuit.

February 15, 1966.

Whitfield J. Collins, Robert A. Watson, Ft. Worth, Tex., for petitioners.

Frederick E. Youngman, Atty., Dept. of Justice, Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, John B. Jones, Jr., Acting Asst. Atty. Gen., Melva M. Graney, Anthony Zell Roisman, Attys., Dept. of Justice, Sheldon S. Cohen, Chief Counsel, Hu S. Vandervort, Atty., I. R. S., Washington, D. C., for respondent.

Before RIVES, BROWN and MOORE,^* Circuit Judges.

MOORE, Circuit Judge:

This is a petition to review a decision of the Tax Court, 41 T.C. 732 (1964), affirming the assessment of income tax deficiencies for the years 1954, 1955 and 1956 against petitioners M. O. Rife and Maidee W. Rife, husband and wife (hereinafter referred to collectively as petitioner), which resulted in large part from the disallowance of deductions claimed for drilling expenses in 1955, 1956 and 1957 and their deferral to succeeding calendar years.¹

During the years involved, petitioner owned and operated Rife Production Company (hereinafter referred to as Production), a sole proprietorship, which was engaged in the exploration and development of oil and gas production. He was also a partner, owning a five-sixths interest, in the partnership known as Rife Drilling Company (hereinafter referred to as Drilling), which was engaged in the contract drilling of oil and gas wells. From 1954 through 1957, petitioner, in his individual capacity, doing business as Production, participated in oil well development activities jointly with various co-owners. The wells were all drilled by Drilling and the drilling expenses were shared by petitioner and the co-owners according to their respective ownership interests.

All of the expenses incurred as a result of the drilling operations were paid currently by Drilling which, thereafter, billed the full amount of the expenses, plus its customary drilling profit, to Production and then charged the entire amount of such billings to petitioner's drawing account with the partnership. Production, in turn, billed each of the co-owners for his proportionate share of the drilling expenses. When Production received payment from the co-owners, petitioner transferred the amount received to Drilling, which then credited his drawing account for the amount it received. The amount remaining charged to petitioner's drawing account after the co-owners' payment was accounted for represented his individual share of the drilling expenses incurred.

Petitioner, individually and d/b/a Production, kept his books and records, and prepared his federal income tax returns, on the cash receipts and disbursements basis, using the calendar year as his accounting period. On the other hand, Drilling, the partnership, kept its books and records, and prepared its federal income tax returns on the accrual basis, using a fiscal year ending March 31. At the end of each partnership fiscal year, the balance in petitioner's drawing account was consolidated with his share of current partnership earnings and the resulting balance was closed out to his capital account on the partnership books. In computing his taxable income for the years 1955, 1956 and 1957, petitioner claimed a deduction for his share of the drilling expenses which were incurred, paid by Drilling, and charged to his drawing account with the partnership during those years. The Commissioner, however, disallowed the portion of the deductions taken by petitioner in the calendar years 1955, 1956 and 1957 which was charged to his drawing account during the period of April 1st to December 31st and allowed such amounts as deductions in each succeeding year.² The disallowance was explained on the ground that, as petitioner was a cash basis taxpayer, he could deduct only expenses when paid and, according to the Commissioner, the drilling expenses were not paid by petitioner until his drawing account was actually closed out to his capital account on the partnership books. Since the partnership books were not closed until March 31st of each year, the Commissioner concluded that the expenses in question should be deemed paid only on March 31, 1956, 1957 and 1958.

Petitioner challenged the disallowance of the expense deductions in proceedings before the Tax Court instituted in 1960, on the ground that he paid the expenses at the time they were charged to his drawing account by Drilling and, thus, was entitled to deduct them in the calendar year during which his account was charged. The Tax Court upheld the Commissioner's determination that the expenses could be deducted only at the end of the partnership tax year. Its theory was that the charges to petitioner's drawing account constituted advances of his share of current partnership earnings which, according to Sections 706 and 731 of the Internal Revenue Code of 1954, as interpreted in Treasury Regulations Section 1.731-1(a) (1) (ii), cannot be accounted for by a partner until the last day of the partnership tax year, i. e., March 31st.

In a supplemental petition filed before the Tax Court in 1962, petitioner objected to the deficiencies assessed for the years 1954 and 1955 on the ground that they were made as a result of a second examination of his books of account for the years 1954 and 1955 conducted in violation of Section 7605(b) of the Internal Revenue Code of 1954, which provides that "only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary or his delegate, after investigation, notifies the taxpayer in writing that an additional inspection is necessary." The facts with respect to this issue are undisputed. Petitioner's books and records for 1954 and 1955 were examined first in 1957, and deficiencies were proposed for each year (no adjustments were made with respect to the year of deductibility of the drilling expenses) which were paid promptly by petitioner. On April 17, 1957, petitioner filed an application for a tentative carryback adjustment with the District Director of Internal Revenue at Dallas, Texas, listing the loss year as 1956 and the prior taxable years affected as "1954-55". On July 12, 1957, petitioner received a "Notice of Allowance of Tentative Carryback Adjustment" which stated that "this allowance is a tentative adjustment pending an audit of the returns concerned." In December 1958, an IRS agent notified petitioner that he had been assigned to examine petitioner's books and records for the taxable years 1956 and 1957, and advised him that the examination of 1956 was in connection with the claimed net operating loss carryback. On July 3, 1959, upon completion of his examination, the agent sent a ten-day letter to petitioner in which he proposed adjustments for the taxable years 1956 and 1957, and as a result of the 1956 adjustments, one of which was an increase in his partnership income for 1956 of $68,219.55, proposed an adjustment in the net operating loss carryback claimed for 1954.

Some time between December, 1958 and June, 1959, the agent conducted a reexamination of petitioner's books of account for 1954 and 1955, and it was stipulated that petitioner received no written notice of the re-examination other than the "Notice of Allowance of Tentative Carryback Adjustment" issued July 12, 1957.³ At an informal conference held on July 30, 1959 (it was provided for in the ten-day letter dated July 1, 1959), the agent raised for the first time the issue of the taxable year in which petitioner's drilling expenses were allowable. It was not discussed at that time but, on September 9, 1959, a thirty-day letter was sent to petitioner proposing adjustments for the year 1955, including those relevant to the drilling expenses, which were based on information obtained as a result of the agent's re-examination of petitioner's books of account for 1955. Petitioner filed a formal protest to the thirty-day letter on October 8, 1959, in which he stated that the year 1955 had been reopened as to the item of drilling expenses by an agent "who conducted a second examination of taxpayer's records without complying with the required Internal Revenue procedures."

On the basis of the above facts, the Tax Court concluded that petitioner had actual notice of and consented to the second examination of his books of account for 1954 and 1955, and, therefore, was not entitled to any relief due to the failure of the Commissioner to comply with the requirements of Section 7605 (b), Internal Revenue Code of 1954. We agree and find that the record amply supports the Tax Court's findings of notice and consent.

Petitioner was notified in 1957 that his tax returns for 1954 and 1955 would be audited to ascertain the validity of the claimed operating loss carryback,^3a and in 1958 that his books of account relevant to a determination of his 1956 income would be examined. Moreover, in the ten-day letter dated July 1, 1959, he was told that he had understated his partnership income for 1956 by a substantial amount. Since the partnership kept its books on an accrual basis and for a fiscal year ending March 31st, it must have been apparent to petitioner that the agent's re-determination of his partnership income for 1956 involved an inspection of petitioner's and Drilling's books of account for the period April 1st to December 31, 1955, which of course showed the charges to petitioner's drawing account for the drilling expenses incurred and paid by Drilling during that period. Petitioner admitted before the Tax Court that he did not object to the re-examination of his 1954 and 1955 books of account necessitated by his application for a carryback adjustment. His only objection to the re-examination was made in October, 1959, after he discovered that certain...