United States v. Foster

• Decision Date: 14 November 1963
• Docket Number: No. 20370.,20370.
• Citation: 324 F.2d 702
• Parties: UNITED STATES of America, Appellant, v. Murphy J. FOSTER and Olive R. Foster, Appellees.
• Court: U.S. Court of Appeals — Fifth Circuit

324 F.2d 702 (1963)

UNITED STATES of America, Appellant, v. Murphy J. FOSTER and Olive R. Foster, Appellees.

No. 20370.

United States Court of Appeals Fifth Circuit.

November 14, 1963.

Louis F. Oberdorfer, Asst. Atty. Gen., Dept. of Justice, Lee A. Jackson, Melva M. Graney, Michael Mulroney, Attys., Dept. of Justice, Washington, D. C., Louis C. LaCour, U. S. Atty., New Orleans, La., for appellant.

Walter J. Suthon, III, New Orleans, La., Thomas A. Harrell, Shreveport, La., for appellees, Monroe & Lemann, New Orleans, Blanchard, Goldstein, Walker & O'Quin, Shreveport, La., of counsel.

Before RIVES and JONES, Circuit Judges, and DAWKINS, District Judge.

BENJAMIN C. DAWKINS, Jr., District Judge.

This appeal tests the correctness of a judgment by the trial court wherein appellees prevailed in a tax refund suit. The question for decision is whether, in a case involving facts as here presented, proceeds from the sale of an oil payment^* are to be treated as ordinary income or capital gain. Both the oil payment and a royalty interest were reserved by the taxpayer (See fn. 1) when he executed a mineral lease, but only the oil payment subsequently was sold.

Murphy J. and Olive R. Foster brought this action for refund of income taxes and interest for the year 1955 amounting to $1,517.38.¹ Taxpayer owned an undivided 1/10th interest in Dixie Plantation, containing about 800 acres, in St. Mary Parish, Louisiana. July 1, 1955, he and his co-owners executed an oil, gas and mineral lease upon all but 11.11 acres of the land to Chester Hunter, for a six-months primary term and so long thereafter as oil or gas was produced.

Taxpayer and his co-lessors received a bonus of $5,000, but they retained what was termed a 10/24ths "royalty" interest until $220,000 was paid, and thereafter a 5/24ths royalty.² On the same day this lease was executed, the lessors sold to other parties what they described as a "royalty," but which was limited to a payment of $110,000 out of 5/24ths of production.³ The transfer was made subject to the Hunter lease. The assignors received $100,882.35 for the oil payment, of which taxpayer's share was $10,088.23.

In his 1955 income tax return taxpayer treated this transaction as the sale of a capital asset held for more than six months. After an audit, the Internal Revenue Service disallowed capital gain treatment and determined that the proceeds were ordinary income subject to depletion allowance.

The District Court, however, in granting plaintiffs' motion for summary judgment (the parties having stipulated the facts), held that there had been a sale of a capital asset.⁴ It reasoned that the true nature of the interest conveyed must be examined in order to determine whether it was property subject to capital gain treatment under the provisions of the Internal Revenue Code.⁵ In a footnote, the Court explained Louisiana's concept as to mineral servitudes. It noted that, although ownership of minerals in place is not recognized in Louisiana, for income tax purposes Louisiana mineral servitudes, leases, royalties, oil payments, and other mineral interests are property rights which may be treated as capital assets if they meet the test of Section 1221 of the 1954 Internal Revenue Code, as interpreted by the Courts.⁶

Applying the accepted rule that the substance of the transaction must be determined from its total effect, the Court found that two separate and distinct property interests had been retained by taxpayer: 1) his share of a 5/24th royalty interest and 2) his share of a $110,000 oil payment from another 5/24th of production. These interests ran concurrently, so the Court held, as did the oil payment interests in Witherspoon v. United States,⁷ in which it was held that where two retained oil payments run concurrently, proceeds from the sale of one are subject to capital gain treatment.

The District Court thus reasoned that two separate interests were retained, that they were concurrent interests, each independent of the other, and therefore the oil payment assignment here made was not that of a carved out interest. Therefore, it held, the proceeds of this sale were subject to capital gain treatment.⁸

A further basis for the Court's decision was that the ultimate pay-out of an oil payment on nonproducing land, such as here, could not be calculated with the degree of accuracy required by the Supreme Court to classify it as an assignment of future income.⁹ Other considerations mentioned by the Court in this connection were that the lessee was not obligated to drill a well on the land, and the lease would terminate if no well was drilled within four months from the date of the lease agreement. It also would terminate if a second well was not begun within three months after completion or abandonment of the first well. An affidavit given by the lessee indicated that, although he considered "there was a reasonably good possibility the premises would be productive of oil or gas," the formation was known to be faulted and therefore production could not be predicted with certainty. Later developments substantiated in some measure the correctness of his estimate in that the second well drilled was a dry hole. But we must note significantly at this point, and as later discussed in more detail, there were producing wells on adjoining property and the 11.11 acres of Dixie Plantation excluded from the lease already were included in a producing unit established by the Louisiana Commissioner of Conservation.

For the reasons we now present, it is our conclusion, despite the persuasiveness of the District Court's opinion, that it erred in holding the proceeds from taxpayer's assignment of the oil payment to be entitled to capital gain treatment.

In a case decided after Witherspoon — Estate of O. W. Killam, 33 T.C. 345 (1959) — the Tax Court held that proceeds from the sale of a "carved out" oil payment¹⁰ amount to a transfer of anticipated future income, and therefore are taxable as ordinary income. However, in Killam the Court apparently deemed it necessary expressly to distinguish Witherspoon by pointing out that there the interests ran concurrently, whereas in Killam they ran successively.¹¹

The significance as to whether an oil payment runs concurrently with another interest lies in the test sometimes used in determining whether an oil payment is a capital asset or not. This concept is to the effect that, if the oil payment is carved out of another, larger and longer mineral interest, and the price received for the sale is not pledged to development, then it is treated as ordinary income.¹²

The landmark case of Commissioner v. P. G. Lake, Inc., supra, fn. 9, laid down certain broad principles which govern in determining whether proceeds from the sale of an oil payment are subject to capital gain treatment. There the Supreme Court found that the Internal Revenue Code's capital gain provisions are designed to relieve the taxpayer from an excessive tax resulting from conversion of property which has appreciated in value over a period of time.¹³ This treatment is an exception to the general rule of taxing all net income as ordinary income, and, as an exception, it should be narrowly construed.¹⁴ Consideration received upon transfer of mineral interests will be carefully scrutinized to determine whether it was accepted for an increase in value of an income-producing property or merely in place of the right to receive future income.¹⁵

No rule was established by Lake requiring all carved out interests to be taxed as ordinary income simply upon a finding that they were carved out and that the price received was not pledged for development. The substance and effect of the whole transaction must be examined; form alone will not control. Nevertheless, the Commissioner, some courts, and legal writers continue to espouse definitions and rules as to ordinary income or capital gain couched in terms of whether an interest is carved out or not.¹⁶ An oil payment is said to be carved out if the owner of any royalty, lease, or other mineral interest, including a larger oil payment, assigns an oil payment but retains an interest in the property from which the oil payment is assigned.¹⁷ We believe a close analysis of Killam and Floyd, supra, fn. 17, will clarify application of this concept in determining whether there has been a sale of a capital asset or assignment of future income.

In Killam, the taxpayer sold his interest in a mineral lease and reserved a $150,000 oil payment, plus 4% interest on the unpaid balance, from 75% of 7/8 ths of the oil produced; and thereafter a $200,000 oil payment, plus 4% interest on the unpaid balance from 80% of 7/8 ths of the oil produced. Subsequently, he sold the $150,000 oil payment. It was held that this was a carving out of an interest extending over less than the life of the entire depletable lease property from which the interest was carved. The two reserved oil payments were treated as one property interest from which the taxpayer carved out and sold one of the oil payments. Quoting from Lake, the Tax Court held that "the substance of what was received was the present value of income which the recipient would otherwise obtain in the future."

Subsequent to decision by the lower court of the present case, this Court affirmed the Tax Court decision in Floyd, supra, fn. 17.¹⁸ The District Court, in a footnote, found a distinction between this case and Floyd because in that case there was an agreement by the assignor of the oil payment to repurchase portions thereof contingent upon production. This, the Court indicated, amounted to less than the complete divestiture required by the Commissioner to avoid ordinary income tax treatment. However, an examination of the assignment in Floyd reveals that the taxpayer sold the oil payment for $75,000 and agreed to repurchase a $7,500 portion for each well less than 21 drilled on the property by a certain date (there being 15...