Weinert's Estate v. CIR

• Decision Date: 31 August 1961
• Docket Number: No. 17992.,17992.
• Citation: 294 F.2d 750
• Parties: ESTATE of H. H. WEINERT, Deceased, Jane W. Blumberg, Executrix, and Hilda B. Weinert, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

294 F.2d 750 (1961) ESTATE of H. H. WEINERT, Deceased, Jane W. Blumberg, Executrix, and Hilda B. Weinert, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 17992.

United States Court of Appeals Fifth Circuit.

August 31, 1961.

Stanley Schoenbaum, Leon O. Lewis, San Antonio, Tex., for petitioners.

Lee A. Jackson, Atty., Dept. of Justice, Hart H. Spiegel, Chief Counsel, I.R.S., C. R. Marshall, Sp. Atty., I.R.S., C. Guy Tadlock, Atty., Dept. of Justice, Washington, D. C., Charles K. Rice, Asst. Atty. Gen., Meyer Rothwacks, Melva M. Graney, Kenneth E. Levin, Attys., Dept. of Justice, Washington, D. C., for respondent.

Before CAMERON, BROWN, and WISDOM, Circuit Judges.

WISDOM, Circuit Judge.

This case presents an oil and gas income tax problem concerning an oilmaninvestor sharing arrangement cast in the outward form of a loan, but one that is in substance a carried interest transaction¹ or a carved out production payment² for development. The taxpayer's original brief describes the arrangement as a carried interest transaction. The Commissioner, relying on Lake,³ describes the arrangement as an oil payment that is nothing more than an assignment of future income. In reply briefs the taxpayer appears willing to accept the change in nomenclature, if the Commissioner will accept all of Lake; the Lake opinion excludes from taxable assignments of income carved out payments pledged for development. The case turns on economic interest, not correct nomenclature.

The taxpayer, the carried party, sold to the investor, the carrying party, for $100,000 cash, (1) a one-half interest in certain unitized oil and gas leases and a processing plant to be built and (2) a $50,000 production payment payable out of the retained half. There is no tax issue as to this sale. In addition, the carrying party agreed to make "loans and advances", up to $150,000, to pay the taxpayer's proportionate share of development costs (drilling, operating, and cycling plant costs) repayable solely out of net profits from the carried party's retained half interest in the leases and the plant. The taxpayer had no personal liability for these loans and advances. Simultaneously with the execution of these agreements, the carried party assigned to a trustee his retained half interest in the leases and the plant, under a trust agreement requiring the trustee to pay all of the income to the carrying party until he recouped his development costs. The tax issue relates to this transaction. The question for decision is whether the carried party is taxable on the revenues paid to reimburse the carrying party for the advance of development costs.

A majority of the Tax Court, 31 T.C. 928, considered that the form of the transaction was controlling; that limiting the carrying party's recovery to the taxpayer's one-half interest in the leases and recycling plant could not "convert what was clearly a loan * * * into a conveyance of the equitable interest in the oil and gas in place, or into an unfettered assignment of the right to future income for a consideration". Since this was the rationale of its decision, the Tax Court did not reach the question of whether the carrying party acquired the economic interest in the minerals in place. Abercrombie is conspicuous by its absence from the opinion. The Tax Court distinguished its decisions in Manahan,⁴ Prater,⁵ and Wood.⁶ Three judges concurred only in the result. They rejected the majority's reasoning that such transactions were loans, but held for the Commissioner on the ground that the carried party's right of recovery extended to the net profits from the cycling plant as well as from the mineral production; that, therefore, under Anderson v. Helvering,⁷ the carrying party did not possess the economic interest in the minerals in place that would shift to him the tax burden.

Before this Court the Commissioner relies: (1) on Abercrombie and Prater to show that the carrying party's advances were a loan; (2) on Lake to show that the carried party received ordinary taxable income at the time when the assigned interest produced the income used in repayment of the loan; (3) on Anderson and LaGloria⁸ to show that the carrying party had no economic interest in the minerals in place. The taxpayer contends that: (1) the transaction was not a loan, distinguishing Abercrombie and Prater, and analogizing the case to Manahan; (2) the substance of the transaction was the exchange of a carved out mineral interest for cash sums pledged to the development of the property; and, under Lake, such sums come within an exception to the general rule relating to assignments of future income since they are used to develop the property; (3) Anderson and LaGloria are distinguishable, and the interest the carrying party received in exchange for advancing development costs was an economic interest.

The case is close, but we conclude that the taxpayer's reasoning comes closer than the Commissioner's to carrying out perhaps the most basic principle in taxation: economic realities determine tax consequences. In no area of the law is the application of this principle more necessary than in taxation of oil and gas. This conclusion is in harmony with the administrative position on the allocation of income and deductions in sharing arrangements, a position that since the publication of GCM 22730, 1941-1 Cum. Bull. 214, has been relatively stable.⁹ Whether the subject transaction is in the nature of a carried interest or a carveout for development, its effect is to shift the economic interest in the mineral deposit thereby causing a shift in the division of the taxable income. It is unrealistic to consider it a loan.

We reverse and remand.

I.

The case was submitted on a stipulation of agreed facts and documents. A review of these shows that the carrying party's so-called "loans and advances" were pledged to the development of the minerals and were a vital consideration for the taxpayer's sale of half the mineral interest and the $50,000 production payment.

The petitioners are the Executrix of the Estate of H. H. Weinert, deceased, and Hilda B. Weinert, widow of the deceased. Mr. and Mrs. Weinert filed joint income tax returns for 1949 and 1950, the taxable years in question. They kept their books and filed their tax returns on the cash basis of accounting.

H. H. Weinert and others (collectively referred to as Weinert or the carried party) owned certain oil and gas leases covering lands in the North Pettus Field in Goliad and Karns counties, Texas. The leases were subject to an operating and unitization agreement pooling the rights in the oil and gas leases in the area as if the unitized substances and land were included within a single lease. Participation in the unit was determined on the basis of acre feet of effective sand put in the unit. The participating parties joined in an agreement with the members of another unit and agreed to construct a cycling plant to process the unitized substances, each of the participants to share in the extracted products in accordance with his interest in the plant. Each participant was personally liable for his pro rata part of all costs and expenses incurred in the development and operation of unit area and in construction annd operation of the processing plant.

April 15, 1947, Weinert entered into an agreement to sell to The Lehman Corporation and Maracaibo Oil Exploration Corporation (collectively referred to as Lehman or the carrying party) an undivided one-half interest in the leases and a $50,000 production payment payable out of the proceeds from Weinert's retained one-half interest and also from his interest in the proceeds of the cycling plant to be built. The agreement stated that the conveyance to Lehman would be subject to the unitization agreements covering the leasehold. The sales agreement provided that "the consideration to Sellers for said interest in said oil and gas leases to be assigned and conveyed to Buyers" is not only $100,000 in cash but also:

"(b) Simultaneously with the execution and delivery of said assignment and the payment of the purchase price therefor as hereinabove set out, the parties hereto shall enter into a Loan Agreement as per copy attached hereto and marked Exhibit `B\', and the said Sellers shall also execute and deliver the Assignment of Runs and Production Payment from their remaining ½ interest in the leases and acreage to be assigned to Buyers, all as set out in said Assignment of Runs and Production Payment, a copy of which is attached hereto and marked Exhibit `C\'."

October 30, 1947, in accordance with the April sales agreement, Weinert executed an assignment to Lehman of an undivided one-half interest in the leases, subject to the unitization agreement. This assignment did not mention the $50,000 production payment. Simultaneously with the execution of this conveyance, Weinert and Lehman executed the other required instruments, the Loan Agreement and the Assignment of Runs and Production Payment. The Loan Agreement provided that Lehman would "loan and advance" to Weinert up to $150,000 to pay Weinert's pro rata share of the drilling costs and the costs of the processing plant and other equipment. The loans and advances were to bear two per cent interest. Weinert signed no notes, obligations, or other evidences of indebtedness. The loans and advances were to be made "as and when Weinert was required to pay his share of the costs". The principal and interest were to be "repaid only out of the net profits" arising from Weinert's retained interest in the leases and in the proposed plant. As we read the agreement, Weinert incurred no personal liability to repay Lehman for the advances. Referring to Weinert's assignment of his interest to a trustee, the Loan Agreement provided that upon receipt of any revenues from the interest in trust the trustee should "first use such funds * * * to reimburse Weinert for any operating costs". The trustee...