Wood v. United States

• Decision Date: 11 May 1967
• Docket Number: No. 22693.,22693.
• Parties: Nathaniel C. WOOD and Gertrude L. Wood, Appellants, v. UNITED STATES of America, Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

377 F.2d 300 (1967)

Nathaniel C. WOOD and Gertrude L. Wood, Appellants, v. UNITED STATES of America, Appellee.

No. 22693.

United States Court of Appeals Fifth Circuit.

May 11, 1967.

Clarence P. Brazill, Jr., Nelson, McCleskey & Harriger, Lubbock, Tex., for appellants.

Mitchell Rogovin, Asst. Atty. Gen., John B. Jones, Jr., Act. Asst. Atty. Gen., Dept. of Justice, Lee A. Jackson, Meyer Rothwacks, Melva M. Graney, Crombie J. D. Garrett, Attys., Dept. of Justice, Washington, D. C., Melvin M. Diggs, U. S. Atty., Dallas, Tex., Richard M. Roberts, Acting Asst. Atty. Gen., Washington, D. C., for appellee.

Before RIVES, BELL and THORNBERRY, Circuit Judges.

THORNBERRY, Circuit Judge:

This appeal presents a question of proper tax treatment of compensation received under a contract permitting removal of sand and gravel from appellant taxpayer's land. Taxpayer argues that the contract was in essence a sale of the minerals in place and that payment received should be taxed as long-term capital gains. The government argues that the contract constituted a mineral lease and that the payments received are taxable as ordinary income subject to a five per cent depletion allowance. The district court held for the government. We affirm.

Mr. and Mrs. Wood own 14,088 acres of land in Crosby County, Texas. Since the date of purchase in 1950, Mr. Wood has used the land for ranching.¹ Shortly after purchasing the land Mr. Wood entered into a five-year contract with Chancey-Dickey Materials Company for the purpose of exploiting deposits of sand and gravel known to exist on the ranch. As the date for expiration of this contractual agreement neared, Noble W. Prentice and his associates,² being in the sand and gravel business, approached Mr. Wood in an effort to reach some agreement whereby Prentice could exploit the sand and gravel deposits.

Negotiations between Wood and Prentice resulted in a contractual agreement, entitled SAND, GRAVEL AND ROCK LEASE, whereby Wood did "grant, lease, and let" to Prentice the exclusive right to mine sand, gravel and rock on his ranch for an indefinite period.³ Pursuant to the agreement, Prentice moved upon the taxpayer's land and commenced operations. In 1958, 1959, and 1960 Wood received as consideration under the agreement the respective sums of $85,078.32, $140,426.72, and $114,006.72 which, less annual allowances for depletion of five per cent, were reported in his income tax returns as gravel royalties and taxed as such by the Commissioner.⁴

In March, 1962, Wood filed amended returns for the years 1958, 1959 and 1960, asserting overpayment of income tax and claiming refunds.⁵ Taxpayer's action was based on the theory that the royalty receipts under the lease agreement were actually income from the sale of a capital asset. Taxpayer's claim for refund was disallowed by the Commissioner and this action was subsequently filed. On November 13, 1964, the district court heard the case, sitting without a jury, and on April 23, 1965, the court entered judgment dismissing taxpayer's suit on the merits.

The central question upon which appellant's tax liability must turn is whether he has, by his contractual relation, retained an interest in the minerals which must be classified as an "economic interest." Palmer v. Bender, 1933, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489. The Supreme Court has stated that an economic interest exists where a taxpayer has: "(1) `acquired, by investment, any interest in * * * the minerals in place,' and (2) secured by legal relationship `income derived from the extraction of * * * the mineral, to which he must look for a return of his capital.'" Commissioner of Internal Revenue v. Southwest Explor. Co., 1956, 350 U.S. 308, 314, 76 S.Ct. 395, 398, 100 L.Ed. 347, 353.⁶

It should be noted that the controlling concept of "economic interest" was enunciated and refined by the Supreme Court in cases involving oil and gas leases. A study of hard mineral cases indicates that its application by other courts has been far from consistent outside of the field of oil and gas, although there would appear to be no apparent justification for a difference in approach depending upon the nature of the mineral involved.⁷ In spite of this lack of uniformity of approach, an exhaustive examination of the cases in light of the policies of the relevant portions of the internal revenue laws, leads us to the firm opinion that the proceeds here under consideration were properly taxed as ordinary income.

I.

The "economic interest" test as developed by the Supreme Court clearly supports the classification of the funds involved here as ordinary income. In Burnet v. Harmel, 1932, 287 U.S. 103, 53 S.Ct. 74, 77 L.Ed. 199, the Supreme Court dealt with the precise issue now before this Court, although the contractual agreement there involved dealt with the extraction of oil and gas. The assertion of the taxpayer was the same — that the lease agreement was actually a sale of the minerals in place and that he was therefore entitled to capital gains treatment. This contention was rejected by the Court, which used the case as an opportunity to investigate the policies behind the then relatively new capital gains provisions of the Internal Revenue law. The Court recognized that the purpose behind capital gains treatment is to avoid the hardship of taxing as income in one year the entire gain due to appreciation of value of a capital asset over a considerable period of time.⁸ It was noted, however, that "taxation of the receipts of the lessor as income does not ordinarily produce the kind of hardship aimed at by the capital gains provision of the taxing act."⁹ The Court continued by pointing out that the capital gains provision "speaks of a `sale,' and these leases would not generally be described as a `sale' of the mineral content of the soil, using the term either in its technical sense or as it is commonly understood."¹⁰

It can thus be stated that Harmel stands for the proposition that an agreement in the nature of a mineral "lease" is not entitled to tax treatment as a sale of capital assets. Yet, Harmel did not set forth any criteria to facilitate a determination of whether a given agreement contains those characteristics which render that decision controlling. The needed standard was supplied by the economic interest test of Palmer v. Bender, 1933, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489. The issue in Palmer, dissimilar to that in Harmel, was whether a lessee under an oil and gas lease who subsequently conveyed certain of his lease interests to a third party was entitled to depletion on that consideration paid him by the third party. The Court held that he was entitled to depletion since he had retained by his stipulation for royalties with the third party "an economic interest in the oil, and gas in place." The provisions of the agreement, the Court held, retained in the original lessee "an economic interest in the oil, in place, identical with that of a lessor." This interest was "depleted by production" and this reliance upon production for gain under the agreement was clearly the critical factor in the Court's reasoning.¹¹

Subsequent Supreme Court cases have shown that the test for determination of whether proceeds are taxable as capital gains or ordinary income is the same as that for determining whether proceeds are subject to depletion.¹² The standard, first enunciated in Palmer v. Bender, has been clarified but not altered in any significant manner to this date.¹³

A detailed discussion of the subtleties and intricacies of the economic interest test is not necessary to its application in the present case. Clearly, where a "typical" mineral lease is entered into by a landowner, there is a retention of an economic interest in the minerals. In any case, therefore, an inquiry into the presence of such an interest need go no further unless it can be shown that some characteristics of the agreement make it atypical.

The agreement here involved is on its face a typical mineral lease.¹⁴ Yet, the taxpayer bases his claim upon the presence of an allegedly uncommon provision which stipulates royalty payments of a fixed amount per cubic yard of mineral removed, rather than of a certain percentage of market value, sales price, or some similar quantity. Contrary to taxpayer's position, royalty payment measurement, as in the lease under consideration, is anything but uncommon in hard mineral cases. In fact, such a provision appears to be typical.¹⁵ Granted, a royalty determined by quantity removed is foreign to the field of oil and gas leases, the area in which the economic interest test originated. As stated earlier, however, that test is not limited to the oil and gas area and its application to other areas is not to be controlled by the peculiarities of oil and gas leases. Under the economic interest test, the critical consideration is whether payment is dependent upon extraction, not the method by which that payment is calculated.¹⁶ Thus, the difference in the typical measurement of payment under oil and gas and hard mineral leases should not affect the application of the economic interest test.

Taxpayer next argues that, even if the royalty payments are based upon production, the presence of minimum guaranteed royalty provisions in the agreement, requires a finding that his income was not based solely upon production as required by the economic interest.¹⁷ This contention is without merit as the courts have stated many times that a minimum royalty, such as that present in this case, is merely an advancement for future payments in the form of a guarantee and does not render payment dependent upon a factor other than extraction or production.¹⁸

Taxpayer advances several other arguments in support of his contention that the agreement totally divested him of all economic interest in the minerals under his land. As stated earlier, however, nothing in the agreement persuades us that it varies...