Ward v. C.I.R., 85-7038

CourtUnited States Courts of Appeals. United States Court of Appeals (9th Circuit)
Citation784 F.2d 1424
Docket NumberNo. 85-7038,85-7038
Parties-1012, 86-1 USTC P 9286 Jimmie J. and Bonnie M. WARD, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.
Decision Date18 March 1986

John Patrick Kelly, Santa Ana, Cal., for petitioners-appellants.

Francis M. Allegra, Dept. of Justice, Washington, D.C., for respondent-appellee.

Petition to Review a Decision of the United States Tax Court.

Before KENNEDY, SKOPIL, and ALARCON, Circuit Judges.

ALARCON, Circuit Judge:

Appellants Jimmie J. and Bonnie M. Ward (hereinafter the Wards) appeal a judgment from the tax court upholding the Internal Revenue Service's (IRS) determination that their minimum royalty payment of $22,500 for unmined coal in 1977 was not deductible under Treas.Reg. Sec. 1.612-3(b)(3), T.D. 7523, 1978-1 C.B. 192. We affirm.


On December 21, 1977, Jimmie J. Ward entered into a mining lease (hereinafter lease) with Wyoming and Western Coal Reserves, Inc. (hereinafter W & W), the lessor. The lease granted the Wards certain rights to enter and mine coal on a parcel of land in Wyoming. W & W warranted that the premises contained at least 72,000 tons of recoverable coal. The lease was for a term of eight years plus the balance of 1977, with the option to extend on a yearly basis as required to exhaust the coal.

The lease required that the Wards pay a royalty equal to the greater of (1) 15% of the "net pit price" plus 50cents per ton of 2,000 pounds of run-of-mine merchantable coal leased or (2) $3 per net ton of run-of-mine merchantable coal sold from the premises. In addition, the Wards were obligated to pay a royalty of $2.50 per net ton of the initial 36,000 tons sold or mined, removed and marketed.

The lease provided that the Wards would pay a "minimum annual royalty" of $22,500. It is this royalty payment which is at issue in this case. For the first year's royalty, one quarter was due at the inception of the lease and three quarters were due by December 31, 1977. Each of the remaining seven annual royalty payments were due on December 31 of the following years. These minimum royalty payments were recoupable at a rate of $2.50 per ton of coal sold or mined, removed and marketed.

The Wards and W & W added an "Addendum to Mining Lease" (hereinafter Addendum) On December 21, 1977, the Wards also entered into a sales contract with Coal and Mineral Leasing and Development Corporation (hereinafter C & M). Under this sales contract, C & M agreed to buy 18,000 tons of coal reserves at $3.50 per ton for a total purchase price of $63,000. According to the sales contract, the terms created a "carved out production payment." Payment was to be made only from coal sold or mined, removed and marketed. The total outstanding balance was due on December 31, 1987, however, C & M could extend the due date until December 31, 1997. At that time, the Wards could extend the due date further or cancel C & M's coal interest.

when the lease was signed. The Addendum provided that the "minimum annual royalty payments" due for the years 1979 and thereafter could be paid by cash or note. If payment was to be by note, the Addendum provided the required terms of the note. The note would be nonrecourse. Payment was to be made only from coal sold or mined, removed and marketed, in excess of the initial 18,000 tons, at a rate of $3 per ton. The total outstanding balance was due on December 31, 1997. If not paid then, W & W's only recourse would be to foreclose on the Wards' interest in the lease.

No coal was mined from the leased premises in 1977. The Wards paid $22,500 in cash to W & W that year as a minimum royalty payment. 1

The Wards filed a joint tax return for 1977. They indicated that their mining business was being conducted on a cash method of accounting. They reported a $22,546 loss on the business, $22,500 in royalties and $46 in auto expenses which they claimed as a deduction.

The Commissioner of the Internal Revenue Service notified the Wards of a deficiency in their income tax of $7,680. The Commissioner asserted that the $22,546 deduction was not allowable under any provisions of the Internal Revenue Code.

The tax court sustained the Commissioner's disallowance of the deduction from which the Wards now appeal.


The Wards contend that their minimum royalty payment of $22,500 to W & W for coal production for the year 1977 is tax deductible under Treas.Reg. Sec. 1.612-3(b)(3). Alternatively, they argue that section 1.612-3(b)(3) is invalid. We find both contentions meritless. 2


The Wards first contend that Treas.Reg. Sec. 1.612-3(b)(3) allows the $22,500 deduction they claimed as royalty payments on their 1977 tax returns. 3

The Wards made an advanced royalty "payment" of $22,500 in 1977. Under section Section 1.612-3(b)(3) also provides, however, that if the lease contains a "minimum royalty provision," advanced royalties can be deducted in the year in which they are paid or accrued, whether or not minerals are produced. Id. The section defines "minimum royalty provision" as a provision which "requires that a substantially uniform amount of royalties be paid at least annually either over the life of the lease or for a period of at least 20 years...." Id. (emphasis added).

                1.612-3(b)(3) advanced royalties paid or accrued can be deducted for the year in which the minerals are "sold."    26 C.F.R. Sec. 1.612-3(b)(3) (1985).  In the case of royalties paid in advance of production, "sold" is defined as "when the mineral is produced (i.e., when a mineral product first exists)."    Id.  No coal was produced in 1977 from the Wards' subleased property

Thus, whether the Wards could claim the 1977 royalty payment as a deduction depends in turn on whether their sublease agreement contained a minimum royalty provision requiring a payment of $22,500 paid at least annually over the life of the lease. As set forth above, the Addendum provides that if the Wards elect to pay by note, the note could be a nonrecourse note secured only by the Wards' interest in the coal.

In Maddrix v. Commissioner, 780 F.2d 946 (11th Cir.1986), the Eleventh Circuit adopted the reasoning in Wing v. Commissioner, 81 T.C. 17 (1983) and held that nonrecourse notes secured only by a taxpayer's mineral interest do not qualify under the exception within section 1.612-3(b)(3). 4 In Maddrix and Wing deductions for advanced royalties paid under an agreement substantially similar to that set in the Addendum were disallowed. The Wards' attempt to distinguish their royalty agreement from the one before the tax court in Wing is unpersuasive. 5

The agreement in Wing called for a payment of $60,000 in advanced royalties, $10,000 The Wards correctly note that in Wing a lump sum payment of the total amount due was to be paid in advance. Therefore, substantial payment by nonrecourse notes was compelled. Wing, 81 T.C. at 20. The Wards argue that, under their sublease, minimum royalty payments were to be paid annually. Unlike Wing, the Wards' Addendum did not provide for a lump sum payment to be applied against future years. The Wards also point out that the Addendum merely provided an option for payment by nonrecourse note. Payment by means of a nonrecourse note was not required.

                by cash and $50,000 by nonrecourse note secured by the taxpayer's mineral interests.    Wing, 81 T.C. at 20.  This payment was to be applied as minimum annual royalty payments of $6,000 over the ten year life of the lease.  The agreement in Maddrix called for annual minimum royalties of $300,000.  At the commencement of the sublease, $2,540,000 of the annual minimum royalty was to be paid, $590,000 in cash and $1,950,000 in nonrecourse notes secured only by the taxpayer's interest in the coal.    Maddrix, 780 F.2d at 947

The Wards' argument ignores the underlying rationale in Wing. By tendering a nonrecourse note, actual payment is so speculative that nothing in fact is required to be paid annually. Wing, 81 T.C. at 38-42. Maddrix termed such an arrangement "illusory." Maddrix, 780 F.2d at 951. An option to tender a nonrecourse note is completely inconsistent with the requirement of section 1.612-3(b)(3) that a minimum royalty payment be paid under the taxpayer's sublease. The Wards argue that the note option simply provides an alternative method of payment. It is clear that an option to pay by nonrecourse note secured only by the mineral interest in question would give the taxpayer an option to pay nothing.

Under section 1.612-3(b)(3) as applied in Maddrix and Wing, subleases for mineral extraction which are payable by nonrecourse notes are not deductible.

2. VALIDITY OF THE 1977 AMENDMENT TO TREAS.REG. Sec. 1.612-3(b)(3)

The Wards alternatively contend that the 1977 amendment of Treas.Reg. Sec. 1.612-3(b)(3), under which the IRS disallowed their deduction, was invalidly promulgated. They insist that earlier versions of section 1.612-3(b)(3) should be applied to their transaction. 6 The Wards assert that the

1977 amendment is invalid for five reasons. First, the amendment's inclusion of the word "sold" to mean "produced" is contrary to the meaning of the previous versions, is redundant, and in effect eliminates advanced royalties. Second, the IRS abused its discretion under I.R.C. Sec. 7805(b) by applying the 1977 amendment retroactively. Third, the final version of the amendment was not published in the Federal Register as required by the Administrative Procedure Act Sec. 4, 5 U.S.C. Sec. 553(d) (1976). Fourth, under the legislative reenactment doctrine, the administrative practice had acquired the force of law under the prior amendments and therefore only Congress could change section 1.612-3(b)(3). Fifth, neither the proposed or final version of the amendment was published...

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