Yates v. Comm'r of Internal Revenue
| Decision Date | 07 June 1989 |
| Docket Number | Docket No. 14832-87. |
| Citation | 92 T.C. No. 79,92 T.C. 1215 |
| Parties | RICHARD M. AND BRENDA R. YATES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
In a Federal oil and gas lottery, petitioners were awarded three oil and gas leases on properties in Wyoming and North Dakota. The properties were not within any known geologic structure of producing oil or gas fields. Petitioners transferred their interests in the leases in consideration of cash payments, retaining various percentages of future oil or gas production. Petitioners' retained interests in the leases would terminate at ‘such time as the then estimated recoverable reserves * * * are 10 percent or less.‘
Held, petitioners have not proven that the expected economic lives of their retained interests were less than the expected economic lives of the underlying mineral leases. United States v. Morgan, 321 F.2d 781 (5th Cir. 1963), followed. Sec. 1.636-3(a)(1), Income Tax Regs. HELD, FURTHER, respondent's determination that petitioners' retained interests were overriding royalties taxable as ordinary income subject to depletion is sustained. Kendall O. Schlenker, Barbara A. Schneider, and A. J. Losee, for the petitioners.
Martin Van Brauman and Val J. Albright, for the respondent.
Respondent determined deficiencies of $131,475 and $52,497 in petitioners' Federal income tax for 1981 and 1982, respectively. The sole issue for decision is whether cash payments received by petitioners in 1981 and 1982 for the transfer of interests in oil and gas leases should be treated as ordinary income subject to depletion or as long-term capital gains.
Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code, as amended and in effect for the years in issue.
Some of the facts have been stipulated. The facts set forth in the stipulations are incorporated in our findings by this reference. Richard M. and Brenda R. Yates resided in Santa Fe, New Mexico, at the time they filed their petition.
Although petitioner Richard M. Yates is an architect, members of his family are in the oil and gas business and own Yates Drilling Company and Yates Petroleum Corporation. During the 1970s, petitioners participated in a Federal noncompetitive lottery of oil and gas leases conducted by the Bureau of Land Management (BLM) of the United States Department of the Interior.
Pursuant to a verbal agreement, petitioners were represented by Jack McCaw (McCaw), an experienced landman and manager of the land department at Yates Petroleum Corporation, in entering into the transactions in issue. When acting on behalf of Yates Petroleum Corporation, McCaw filed for all available leases in ‘oil country.‘ When acting on behalf of petitioners, however, McCaw filed only for those leases that he deemed the ‘best‘ available and filed only on leases that had been held for 10 years or longer by a major oil company.
Under the Federal lottery system, petitioners were awarded three oil and gas leases, as follows:
+-----------------------------------------------------------+
¦BLM ¦Lease ¦Tract covered ¦Location of property ¦
+-----------+-------+--------------+------------------------¦
¦lease No. ¦date ¦by lease ¦covered by lease ¦
+-----------+-------+--------------+------------------------¦
¦M31845 (ND)¦8/01/75¦554.39 acres ¦Golden Valley County, ¦
+-----------+-------+--------------+------------------------¦
¦ ¦ ¦ ¦North Dakota ¦
+-----------+-------+--------------+------------------------¦
¦W59609 ¦8/01/77¦2,060.98 acres¦Campbell County, Wyoming¦
+-----------+-------+--------------+------------------------¦
¦W59617 ¦8/01/77¦1,120.00 acres¦Converse County, Wyoming¦
+-----------------------------------------------------------+
The lands leased under the Federal lottery system were not within any known geologic structure of a producing oil or gas field. 30 U.S.C. sec. 226(c) (1982). Petitioners' cost for these leases consisted of a $10.00 filing fee and $1.00 per acre annual delay rental.
Oil and gas activity in the Northern Rockies during 1981 and 1982 was at unprecedented high levels. Areas of particularly high activity included the Powder River Basin. Both Campbell County, Wyoming, and Converse County, Wyoming, are located in the Powder River Basin.
After winning these leases in the lottery, petitioners received oral and written inquiries from potential purchasers. When petitioners received offers to acquire any of their leases, they would forward the offers to McCaw for his review and recommendations. Before beginning negotiations to transfer the leases, McCaw would review numerous factors, including: the total lease acreage, the lease termination date, the lease rental payments, the number of Federal lottery filings previously submitted for the lease, dry hole maps, the ownership of adjoining acreage, well completion cards listing the depth and production of wells in the area, and daily petroleum information bulletins listing the location of every drilling well in the Rocky Mountains. Based on these factors, McCaw determined a price that he thought was reasonable and transferred the lease for that price.
During 1981 and 1982, petitioners assigned 100 percent of the Converse County and Golden Valley leases and 50 percent of the Campbell County lease, subject to retained interests in production proceeds, as described below. Petitioners received cash payments for the lease assignments, as follows:
+----------------------------------------------+
¦BLM ¦Date of ¦ ¦Cash ¦
+-------------+--------+--------------+--------¦
¦lease No. ¦transfer¦Transferee ¦payment ¦
+-------------+--------+--------------+--------¦
¦W59617 ¦4/16/81 ¦Davis Oil ¦$112,000¦
+-------------+--------+--------------+--------¦
¦Converse Co. ¦ ¦Co.(Davis) ¦ ¦
+-------------+--------+--------------+--------¦
¦W59609 ¦9/24/81 ¦Lear Petroleum¦309,147 ¦
+-------------+--------+--------------+--------¦
¦Campbell Co. ¦ ¦Exploration ¦ ¦
+-------------+--------+--------------+--------¦
¦ ¦ ¦(Lear) ¦ ¦
+-------------+--------+--------------+--------¦
¦M31845 (ND) ¦3/08/82 ¦Anadarko ¦250,000 ¦
+-------------+--------+--------------+--------¦
¦Golden Valley¦ ¦Production Co.¦ ¦
+-------------+--------+--------------+--------¦
¦ ¦ ¦(Andarko) ¦ ¦
+----------------------------------------------+
McCaw recommended that petitioners retain a limited interest in the lease properties in order to participate in any future revenues that might come out of oil or gas production. In order to qualify the transactions for capital gains treatment on the cash payments received at the time of the assignments, McCaw intended that the retained interests would terminate when 90 percent of the oil or gas had been produced.
On McCaw's recommendation, petitioners retained interests in the proceeds received from the sale of the oil and gas that might be produced from the properties subject to the leases, as follows: Converse County, 5 percent; Campbell County, 7.5 percent; and Golden Valley, 6.25 percent.
The language contained in the assignments of the three leases was identical in all material respects. To reflect petitioners' retained interest, the assignment of the Converse County, Wyoming, lease contained the following language:
Assignor hereby excepts and reserves an overriding royalty of 5% of the proceeds received from the sale of all (8/8ths) of the oil and gas which may be produced, saved and marketed from said lands under the terms of the lease or any extensions or renewals thereof, UNTIL SUCH TIME AS THE THEN ESTIMATED RECOVERABLE RESERVES IN ANY PRODUCIBLE FORMATION IN ANY WELL DRILLED ON SAID LANDS ARE 10% OR LESS, WHEREUPON SAID OVERRIDING ROYALTY SHALL AUTOMATICALLY TERMINATE ONLY WITH RESPECT TO SAID FORMATION, but said overriding royalty shall continue as a burden on all other formations underlying said lands. Upon termination of this overriding royalty with respect to any formation, Assignor shall execute and deliver unto Assignee a recordable reassignment of the overriding royalty with respect to the formation in which the then estimated recoverable reserves are 10% or less. ‘Recoverable Reserves‘ is defined as the unproduced but recoverable oil and/or gas in place in a formation which has been proven by production.
The determination of Recoverable Reserves shall initially be made by a ‘Qualified Engineer‘ (defined as a petroleum engineer, licensed or certified by the State of New Mexico, provided a person having a direct or indirect interest in the lease shall not be deemed a Qualified Engineer), selected by Assignee. If Assignor does not accept such determination, then, and within 60 days after receipt of such determination, Assignor shall cause a Qualified Engineer of Assignor's selection to determine Recoverable Reserves and furnish such determination to Assignee. If Assignee does not accept such determination, then, and within 20 days after receipt of such determination, the two Qualified Engineers shall select a third Qualified Engineer, provided if such two Qualified Engineers are unable to agree upon a third Qualified Engineer, Assignor or Assignee may request the District Court to select a third Qualified Engineer. Within 30 days after the selection of such third Qualified Engineer, the three Qualified Engineers shall determine the Recoverable Reserves and the written determination of a majority of such three Qualified Engineers shall be conclusive and binding upon Assignor and Assignee. [emphasis supplied.]
Under the terms of the transfer of the Campbell County lease to Lear, Lear was also obligated to drill...
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Yates v. C.I.R.
...be paid out prior to the extraction of 100 percent of the recoverable reserves, and whether petitioners so expected. Yates v. Commissioner, 92 T.C. 1215, 1226 (1989). The tax court then analyzed the evidence and concluded that at the time of the assignments the likelihood of commercial prod......