Zuhone v. C.I.R.

• Decision Date: 28 August 1989
• Docket Number: No. 88-2248,88-2248
• Citation: 883 F.2d 1317
• Parties: -5451, 89-2 USTC P 9512 William H. ZUHONE, Jr. and Audra M. Zuhone, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1317

883 F.2d 1317

64 A.F.T.R.2d 89-5451, 89-2 USTC P 9512

William H. ZUHONE, Jr. and Audra M. Zuhone, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 88-2248.

United States Court of Appeals, Seventh Circuit.

Argued Feb. 10, 1989.

Decided Aug. 28, 1989.

H. Kent Heller, Naperville, Ill., for petitioners-appellants.

Gary R. Allen, William S. Rose, Jr., Asst. Atty. Gen., Dept. of Justice, Tax Div., Appellate Section, William F. Nelson, I.R.S., Charles Bricken, David I. Pincus, Dept. of Justice, Tax Div., Washington, D.C., for respondent-appellee.

Before CUMMINGS, CUDAHY and FLAUM, Circuit Judges.

CUMMINGS, Circuit Judge.

Petitioners William H. Zuhone, Jr. and his wife Audra have appealed from a decision of the Tax Court holding that there was a deficiency in income tax amounting to $467,746.91 for 1975 (App. A15). The Tax Court held that certain overriding royalty interests in oil and gas wells must be included in petitioners' 1975 and 1976 taxable income ¹ and also accepted the evaluation of those interests supplied by the Commissioner's expert. The propriety of these two rulings is now before us. ² We affirm.

I. Propriety of Income Tax Treatment of Taxpayer's Royalty Interests

When taxpayer ³ filed his petition in the Tax Court, he resided in Mattoon, Illinois. He was an independent oil producer and the president and sole stockholder (except for directors' qualifying shares) of W. Wilmar Oil, Inc. (Wilmar Oil) and Wilmar Petroleum Company (Wilmar Petroleum). Those corporations were in the business of promoting and selling drilling ventures.

In 1972, taxpayer bought for Wilmar Oil an overriding royalty interest ⁴ in 5,000 acres of land in two Texas counties including the operating mineral leases on that land. Both Wilmar Oil and Wilmar Petroleum promoted and sold drilling ventures consisting of fractional working interests in the oil leases on that property. The two corporations agreed to furnish all labor and supplies and to perform the work required to complete a well and place it in production. Each investor in the Wilmar offerings received a working interest in a well ready to start production. In return the investors paid Wilmar a fractional share of (1) the drilling costs, (2) the cost of readying a producing well for commercial production, and (3) the cost of operating a producing well.

The owner of the land subject to the leases retained a royalty interest of 1/8 of production and Wilmar Oil, the owner of the mineral rights lease, retained an overriding royalty of 1/8 of the remaining 7/8 of the mineral production. The remaining 7/8 of 7/8 of the mineral interest was divided into 64 equal parts, 40 of which were offered to the public by Wilmar Oil. The remaining 24 of the 64 parts were to be granted to taxpayer, Wilmar Oil salesmen, or retained by Wilmar Oil. The 40 fractional working interests were to be sold at a price that would yield a profit over Wilmar Oil's lease acquisition and drilling costs even if a dry hole resulted. Taxpayer received overriding royalty interests in various properties by assignment from Wilmar Oil as part of his compensation from the Wilmar companies. In September 1985, the Commissioner sent taxpayer a notice of deficiency for the overriding royalty interests conveyed to taxpayer in the amount of $483,738.95 for 1975 and $3,128.78 for 1976, the only years involved in this appeal.

Taxpayer does not contest the general rule that compensation for services is gross income to the service provider. When that compensation is in the form of unrestricted property, the fair market value of the property at the time it is transferred is ordinarily includible in the taxpayer's income. It is the Commissioner's position that Mr. Zuhone received overriding royalty interests as part of his compensation for rendering services to Wilmar Oil and Wilmar Petroleum companies.

To avoid taxation upon his receipt of these overriding royalty interests, taxpayer depends entirely upon the "pool of capital" doctrine first acknowledged by the government in a 1941 memorandum opinion of the then Chief Counsel of the Bureau of Internal Revenue. This lengthy opinion covers the tax implications of many hypothetical oil and gas leasing situations, but taxpayer seemingly relies only on the following excerpt: ⁵

By such arrangements [as involved here], a lessee commonly lessens his own investment and the risks and burdens attending the development by agreements to share the investment obligation and the proceeds of production. The lessee or assignee, like the lessor or assignor who retained a share interest in production having a value equivalent to that of the lessor's prior interest but passed on to the lessee the investment obligations and risks that attend development for a share in production, has parted with no capital interest but has merely in turn given another a right to share in production in consideration of an investment made by such other person. If the driller or equipment dealer is making an investment by which he acquires an economic interest in oil and gas in place, expenditures made by him represent capital expenditures returnable tax-free through the depletion allowance rather than by way of expense deduction, and the oil payment rights acquired do not represent payment in property for services rendered or supplies furnished. Similarly, one who, in return for an oil payment right, furnishes money which the lessee is pledged to use in developing the property would be regarded as making an investment representing an addition to the reservoir of capital investments in oil and gas in place * * *.

GCM 22730, reported in 1941-1 C.B. 214, 221-222. ⁶ The "pool of capital" principle allows a taxpayer who contributes development property or services to the "pool of capital" in establishing an oil or gas well to retain or receive an interest therein without having to pay income tax at the time of receipt. Instead, the proceeds of the interest, subject to depletion, are taxable on receipt. Taxpayer contends that his involvement in development of the wells at issue was such a contribution to capital rather than services performed for the receipt of overriding royalty interests in the wells.

Although the pool of capital doctrine has engendered several articles, it has received little treatment by the courts or Commissioner. Prior to its recognition by the Bureau of Internal Revenue, a pool of capital concept was merely alluded to by various courts predominantly under the reasoning that an economic interest in a mineral interest during the exploration and development stage may be too speculative to value at the time of its receipt. In Burnet v. Harmel, 287 U.S. 103, 53 S.Ct. 74, 77 L.Ed. 199, the Court determined that cash bonuses and production royalties received for leases of land for oil and gas exploration constituted ordinary income subject to depletion allowances. The Court referred to the economic interest as an interest that could only be recovered out of production rather than from sale of the property. Also, in Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489, the Court held that the transfer of bonuses and future royalty payments in exchange for oil and gas leases was not a sale, but a subleasing transaction entitling the taxpayer to depletion deductions. In so holding the Court reasoned that the critical issue in determining taxation is whether the taxpayer "has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of the oil, to which he must look for a return of his capital." Palmer, 287 U.S. at 557, 53 S.Ct. at 226. See also Transcalifornia Oil Co. v. Commissioner, 37 B.T.A. 119 (1938), and Laster v. Commissioner, 43 B.T.A. 159 (1940), affirmed in part and reversed in part, 128 F.2d 4 (5th Cir.1942), where the Tax Court held that the sale of shares in future recovery of minerals was not a taxable event since the funds received were to be used for drilling. In a series of similar cases, the Fifth Circuit has declined to tax the recipient of an economic interest in future oil payments at the time of receipt due to the uncertainty and contingency of its value. Commissioner v. Edwards Drilling Co., 95 F.2d 719 (5th Cir.1938); Dearing v. Commissioner, 102 F.2d 91 (5th Cir.1939); Lee v. Commissioner, 126 F.2d 825 (5th Cir.1942).

Following the issuance of GCM 22730, the Fifth Circuit had an opportunity to readdress the pool of capital doctrine in United States v. Frazell, 335 F.2d 487 (5th Cir.1964), where the taxpayer, a geologist, received a future mineral interest in properties he recommended to be acquired and developed by two investors. Immediately prior to the vesting of the geologist's interests, the properties were transferred to a corporation with the taxpayer receiving a percentage of the stock. The court held that the taxpayer received income when his interests vested in an amount equal to the value of the stock.

Later that year the Fifth Circuit decided James A. Lewis Engineering, Inc. v. Commissioner, 339 F.2d 706, 709 (1964), where the petitioner made the same argument as taxpayer here. Chief Judge Tuttle observed that the court "would have great difficulty accepting a construction of the Code [in GCM 22730] that would fly in the face of the general provisions of the tax laws to the effect that compensation for services must be returned as a part of gross income." However, the court found it unnecessary to pass upon the validity of GCM 22730 since it determined that the services performed by taxpayer were not development activities related to the acquisition and exploration of the mineral interest but were production activities that could not be capitalized. 339 F.2d at 709-710. The taxpayer there had conceded that the pool of capital doctrine applied only if the services performed were development rather than production...