Sowell v. CIR

• Decision Date: 25 April 1962
• Docket Number: No. 19090.,19090.
• Citation: 302 F.2d 177
• Parties: Thomas W. SOWELL and Lillian K. Sowell, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

302 F.2d 177 (1962)

Thomas W. SOWELL and Lillian K. Sowell, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 19090.

United States Court of Appeals Fifth Circuit.

April 25, 1962.

Leland E. Fiske, Dallas, Tex., for petitioners.

Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, John B. Jones, Jr., Acting Asst. Atty. Gen., Melva M. Graney, Earl J. Silbert, Attys., Dept. of Justice, R. P. Hertzog, Acting Chief Counsel, John M. Morawski, Atty., I. R. S., Washington, D. C., for respondent.

Before BROWN, WISDOM, and BELL, Circuit Judges.

WISDOM, Circuit Judge.

This is a man-bites-dog case. Here, taxpayers — not disinterestedly, of course — contend that they received income. The Commissioner denies that they did.

Thomas W. Sowell and his wife petition for review of an adverse decision by the Tax Court.¹ The prime question before us is whether the taxpayers constructively received the income from an oil lease in 1955, 1956, and 1957. We hold that they did, and reverse the decision below.

The taxpayers and J. B. Sowell were the sole stockholders of the Riverside Production Company, which owned a seven-eighths working interest in an oil and gas lease in Texas known as the Luse Lease. In 1942 they liquidated the corporation and conveyed legal title to the lease to H. C. Moseley under an oral agreement giving Moseley a 1/5th interest in the lease. The taxpayers retained a 2/5ths interest and J. B. Sowell a 2/5ths interest. Moseley was to operate the lease and remit to the other owners their share of the net income. This he did faithfully for twelve years. In 1954, however, Moseley had financial problems which he attempted to solve by treating the lease as if he were its sole owner. He borrowed $131,800 from the Citizens National Bank of Tyler, Texas in 1954 and an additional $36,000 from the First National Bank of Dallas the following year. He secured both debts by a pledge of the Luse Lease and an assignment of the production income from it. It is undisputed that although Moseley acted without the knowledge or authority of the taxpayers or J. B. Sowell, they are estopped, under Texas law, to deny the validity of his pledge and assignment to the banks because of their having put legal title to the Luse Lease in him.² During 1955, 1956, and 1957 the taxpayers' share of the income from the lease was paid to the banks and applied on Moseley's loans. Moseley repaid part of the 1955 income to the taxpayers and he executed a note for the remainder. During 1955 he became hopelessly insolvent, and the taxpayers have been unable to recover anything further from him.³

The petitioners, who use a cash-basis accounting system, reported the income from the lease during the taxable period as constructively received and deducted the depletion allowance on it. They then deducted as a bad debt the amounts received by the bank and not repaid by Moseley. The deductions overlap each other and exceed the amount of the income. If the petitioners are not taxable on the lease income, they are not entitled, as they concede, to either of the deductions.⁴ The Commissioner asserts that the money paid to the bank was not taxable income to the petitioners. He does not dispute either deduction, if the taxpayers constructively received the income.

The Commissioner argues that there was no constructive receipt, because the payments were not set apart or credited to the taxpayer, subject to his demand. 2 Mertens, Law of Federal Income Taxation, Sections 10.01-10.03. The taxpayers' relation to the income, so the argument runs, does not satisfy any of the tests of income receipt postulated by the Supreme Court; the taxpayers received no economic benefits from the diversion of the payments. They did not enjoy any of the privileges and benefits attributable to ownership.⁵ They had no control and dominion over the funds.⁶ They derived no economic value from them.⁷ The Commissioner relies especially on Alsop v. Commissioner, 2 Cir., 1961, 290 F.2d 726 and Rossi v. Commissioner, 41 B.T.A 734.

The facts on which these postulates are based have little, if any, similarity to the unusual facts in this case. But before discussing the principles we consider applicable here, we point out that Alsop and Rossi are distinguishable. Generally, receipt of income by an agent is equivalent to receipt by the principal and the income is actually or constructively received by the principal. In both Alsop and Rossi an agent of the taxpayer diverted it to his own use. In Alsop the court held that "this rule of constructive receipt can hardly apply where the agent of a cash basis taxpayer spirits away income of whose receipt the taxpayer never knew". In Rossi the Tax Court held that the agency had terminated before receipt of the money and therefore there could be no constructive receipt based on agency. In both these cases the owners suffered a loss from embezzlement without any economic benefit. That is not the case here.

In 1942 the petitioners acquired an interest in the Luse Lease. Their economic interest in the lease was not divested when title was placed in Moseley's name for convenience. Ownership of an economic interest does not depend on legal title. Palmer v. Bender, 1933, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489; Estate of Weinert v. Commissioner, 5 Cir., 1961, 294 F.2d 750. For twelve years before Moseley's misappropriation, the Luse Lease produced depletable income which the Sowells reported. They did not lose their economic interest when Moseley pledged it as security for his loan; Moseley could not and did not purport to transfer this interest when he assigned to the bank the proceeds representing the Sowells' royalties.

Unlike the unfaithful agents in Alsop and Rossi, Moseley did not just intercept current revenue as the funds came to his hands. The significant fact in this case is that Moseley accomplished his misappropriation by burdening the property with a valid mortgage. This was, of course, a detriment to the owners, but the tax controversy is not over that detriment; it is over the producing income under the lease. Every payment of that income to the bank reduced the burden, increased the owners' equity, and hastened the day when the owners would have unfettered control over the property. Accepting the validity of the mortgage or pledge under Texas law, as we must, it is unrealistic to contend that payments made to reduce the debt were of no economic benefit to the owners of the burdened property.

The controlling principle is that income applied on a debt is constructively received. This principle is often applied in oil and gas tax cases. Thus, in Reynolds v. McMurray, 10 Cir., 1932, 60 F.2d 843 the leases in question were originally owned by Armstrong who mortgaged the property. Later he sold a fractional interest to McMurray. McMurray, however, was not personally liable for the mortgage, although the property remained subject to the mortgage. McMurray agreed to advance Armstrong's share of the development costs, to be recouped only from the income. The court held that McMurray constructively received as taxable income the income applied on the mortgage debt. "Profits", the court said, "which would constitute income if paid directly to a person are also income to him if paid pursuant to his agreement to a third person to discharge his obligation to such third person". The important point, as in this case, is that payments were applied in discharge of a mortgage on property owned by the taxpayer. We see no distinction in principle between the application of...