Thomas v. Comm'r of Internal Revenue

• Decision Date: 04 June 1985
• Docket Number: Docket No. 29942-81.
• Citation: 84 T.C. 1244,84 T.C. No. 68
• Parties: JAMES P. THOMAS AND MARY LOU THOMAS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

84 T.C. 1244

84 T.C. No. 68

JAMES P. THOMAS AND MARY LOU THOMAS, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 29942-81.

United States Tax Court

Filed June 4, 1985.

Petitioner, as a participant in the Wise County Mining Program, claimed a deduction for ‘mining development costs,‘ ‘operating management fees,‘ and ‘professional fees.‘ HELD, petitioner has failed to carry his burden of proving that the Wise County Mining Program was organized and operated with the primary and predominant objective of realizing an economic profit. Therefore, petitioner is not entitled to deduct under sec. 616(a), I.R.C. 1954, his allocable share of ‘mining development costs.‘ HELD FURTHER, petitioner is not entitled to deduct his allocable share of ‘operating management fees.‘ HELD FURTHER, petitioner is not entitled to deduct his allocable share of ‘professional fees.‘ ELLIOT I. MILLER and RICHARD S. KESTENBAUM, for the petitioners.

JOSEPH A. MASELLI, PATRICIA A. DONAHUE, and MICHAEL GOLDBAS, for the respondent.

STERRETT, CHIEF JUDGE:

By notice of deficiency dated September 25, 1981, respondent determined a deficiency of $37,411 in petitioners' 1978 Federal income tax. ¹ The ultimate issue for decision is the amount, if any, that petitioners are entitled to deduct in 1978 for ‘mining development costs,‘ ‘operating management fees,‘ and ‘professional fees.‘

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference.

At the time they filed their petition herein, petitioners, who are husband and wife, resided at 2309 Jefferson Street, Bluefield, West Virginia. Petitioners filed their Federal income tax return for the year in question with the Office of Internal Revenue in Memphis, Tennessee.

The determined deficiency in this case arises out of petitioner James P. Thomas's participation in the Wise County Mining Program (hereinafter sometimes referred to as the Program), which was organized and operated for the avowed purpose of exploiting certain coal rights. When used hereinafter, ‘petitioner‘ will refer to James P. Thomas.

The Wise County Mining Program was organized primarily through the efforts of Samuel L. Winer, who actively engages in the structuring of various types of tax-sheltered investments, promising as high as 6-to-1 writeoffs. Winer first became involved in coal mining ventures in 1976, when he joined Knox County Partners, Ltd., as a general partner. ² In 1977 Winer formed Investors Coal Corporation (Investors Coal), and through that corporation, he organized and managed several coal mining ventures, including Investors Mining Programs 77-1 through 77-5 ³ and Investors Mining 78-1. Winer served as president of Investors Coal, and he and his wife were the sole shareholders and officers of the corporation.

In late October 1978, Winer was contacted by his attorney in Miami, Florida, Ronald Fieldstone, of Levine & Fieldstone, about developing the coal program that eventually became known as the Wise County Mining Program. Fieldstone had represented Winer in connection with a different coal mining venture organized earlier in the year. Fieldstone invited Winer to his office to meet with Bill Humphreys, a miner from Norton, Virginia. At that meeting Winer told Humphreys that he might be interested in negotiating a coal venture if Humphreys would perform services with respect to the property on a turnkey basis. After Winer met Humphreys he telephoned a reference at the Bank of Pound, Virginia, who informed him that Bill Humphreys and his brother, Jim Humphreys, had ‘a big mountain‘ and did extensive mining.

At the end of October or the beginning of November 1978, Winer traveled to Norton, Virginia to meet with Bill Humphreys and his brother, Jim Humphreys, at the offices of Humphreys Enterprises, Inc. (Humphreys Enterprises), a production and management company primarily involved in strip mining. Jim Humphreys had joined his brother's business on a full-time basis in 1977 in order to handle administrative matters for Humphreys Enterprises. Prior to that time Jim Humphreys' background was in the field of education.

After touring the offices of Humphreys Enterprises, Winer and the Humphreys turned to a discussion of what sort of mineral leases the Humphreys had to offer. The Humphreys informed Winer that they had recently acquired the deep mining rights to the Clintwood seam on what was known as the Amburgey Hollow property in Wise County, Virginia and had formed Shelton Coal Corporation (Shelton Coal) to develop the property. Shelton Coal was one-third owned by each Bill Humphreys, Jim Humphreys, and one Douglas Shelton. These gentlemen were the officers and directors of the corporation, as well. Winer asked how much capital would be needed for a turnkey development of the mine and was informed that development of the mine, over approximately a 10-year period, would cost between $2,500,000 and $3,000,000. According to the Humphreys, approximately $700,000 would be required as initial funding. An understanding was reached that, if a transaction between the parties in fact was consummated, the investors would put up approximately $700,000 in cash and execute nonrecourse promissory notes secured by the investors' interests in the mineral lease as ‘payment‘ for the deferred portion of mining development costs.

At this point, it was contemplated that Shelton Coal would be engaged to perform the actual mining operations and would be the obligee under the nonrecourse notes. The parties, at Winer's suggestion, agreed generally that, in the event Shelton Coal failed to mine sufficient coal to enable the investors to amortize their nonrecourse notes, the corporation would pay to the investors a sum that would be adequate to compensate for the shortfall in mining and also adequate to enable the investors to satisfy their notes. At some later date, Winer and the Humphreys agreed that Shelton Coal would not pay cash to the investors in satisfaction of any default in the minimum mining commitment; rather, such a default would be evidenced by ‘offsets‘ or journal entries reducing the investors' notes.

Before leaving Norton, Virginia, Winer accompanied Bill Humphreys on a visit to various mine sites operated or supervised by Humphreys Enterprises. In addition, he flew over the Amburgey Hollow property in a helicopter. Winer did not see any mines operated or supervised by Douglas Shelton, but he was given a copy of Shelton's resume. Winer left Norton, Virginia with the understanding that he would send a mining engineer to inspect the Clintwood seam on the Amburgey Hollow property.

The Amburgey Hollow property, which consisted of approximately 169 acres, was acquired in fee in 1971 by Greater Wise, Inc., a leaseholding company owned and controlled by the Humphreys. The property was acquired in conjunction with an overall acquisition of 126 tracts of property and the buildings thereon for $400,000 in cash. The acquisition consisted of about 7,000 to 9,000 acres of property. In 1972 Greater Wise, Inc. leased all the property, with the exception of 1,000 acres, to Paramont Mining Corporation (Paramont). Pursuant to the lease, Paramont obtained both the surface and deep mining rights to the coal located on the leased property. On November 14, 1978 an agreement was entered between Humphreys Enterprises and Paramont, whereby Paramont authorized Humphreys Enterprises to deep mine the Clintwood seam of coal. In exchange, Paramont received mineral rights to another piece of property known as the Hagan Estate. Pursuant to the November 14, 1978 agreement, Humphreys Enterprises agreed to sell all coal mined from the Clintwood seam to Paramont for $23.50 per clean ton of coal, subject to upward or downward price adjustments. In the event that Paramont was unable to purchase the coal produced, then Humphreys Enterprises could sell the coal to third parties and pay Paramont 10 percent of the sales price. Paramont retained the surface mining rights to the Clintwood seam and in fact was mining the seam at the time Winer visited Humphreys Enterprises in late 1978 and continued doing so for a number of years thereafter.

The Amburgey Hollow tract is divided into two distinct areas separated by a narrow corridor or passageway. The southern portion of the property is much smaller than the northern portion. It was contemplated that mine development would commence on the smaller southern portion of the tract and then proceed through the passageway to the larger northern portion of the property.

Shortly after his trip to Norton, Virginia, Winer engaged Eric Roberts, a mining engineer, to prepare an engineering report on the Amburgey Hollow property. Roberts had evaluated coal property for Winer earlier in the year in connection with another transaction. The report was to consist of a reserve evaluation and a discussion of the quality of the coal, operating and development costs, and marketing. Roberts visited Humphreys Enterprises and inspected the proposed mine site on November 8, 1978. Jim Humphreys transported Roberts to a highwall where there had been previous surface mining operations and where it was proposed that mining would begin. Roberts measured the seam at 90 inches in height at five locations along the highwall. ⁴ He observed an average of about a 5-inch shale parting in the seam. Roberts walked approximately one-half mile around the outcrop and made other inspections of the coal seam where it was outcropping. Roberts then flew around the mountain in a helicopter and observed that the seam was continuous through the mountain. From the helicopter Roberts could not observe the thickness of any parting in the seam.

After Roberts completed this inspection, he was transported back to the Humphreys' offices where he examined maps, surveys and other data relating to the Amburgey Hollow...