Sneed v. Commissioner , 40 B.T.A. 1136 ( 1939 )

J. T. SNEED, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Sneed v. Commissioner

Docket No. 94400.

United States Board of Tax Appeals

40 B.T.A. 1136; 1939 BTA LEXIS 749;

December 15, 1939, Promulgated

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1. Where, in computing the taxpayer's net income for 1926, depletion deductions of 27 1/2 percent were properly allowed on bonuses paid the taxpayer for granting certain oil and gas leases, and in 1936 these same leases were terminated without any oil or gas having been produced therefrom, the Commissioner did not err in restoring to petitioner's income for 1936 the amounts of the depletion deductions legally taken in 1926 with respect to these certain leases. Grace M. Barnett,39 B.T.A. 864">39 B.T.A. 864, followed.

2. Where the leases in question covered parcels and tracts of land included in a cattle ranch of about 80,000 acres owned by petitioner and in 1926 petitioner leased other tracts and parcels of this ranch, on which wells were later drilled which produced oil and gas in large quantities, petitioner's ranch is not to be considered as "one property" within the meaning of the applicable statutes and regulations and the fact that these other leases have produced oil and gas does not affect the question of restoration to income of depletion deductions taken from bonuses received from leases which have never produced any oil or gas.

3. Where the evidence shows that, because of producing wells on petitioner's ranch and in the Panhandle field in general, the gas pressure under petitioner's entire ranch has been lowered, indicating a definite diminution of the gas under the entire area, including the leases here involved, such fact does not change the rule announced in Grace M. Barnett, supra. There having been no production from the particular leases in question, the Commissioner did not err in restoring to petitioner's income in 1936 the depletion deductions which were legally allowed as to these leases in 1926.

H. C. Pipkin, Esq., Chas. H. Keffer, Esq., and Harry C. Weeks, Esq., for the petitioner.

Paul E. Waring, Esq., and Elizabeth B. Fegan, Esq., for the respondent.

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BLACK

The Commissioner has determined a deficiency of $17,352.99 in income tax against petitioner for the year 1936. This deficiency results from certain adjustments made by the Commissioner in petitioner's income tax return for that year. The principal one of these adjustments was that designated in the deficiency notice as "(d), depletion 1926, restored to income, $38,720.62." In explaining this adjustment, the Commissioner stated in his deficiency notice:

(d) In the year 1926 you were allowed as a deduction depletion at the rate of 27 1/2 percent with respect to cash bonuses received in that year for the granting of oil and gas leases on various properties. During the year 1936 various leases covering a total of 5,995 acres, which had not been developed and had not produced either oil or gas lapsed and reverted to you. In accordance with the provisions of article 216(d) of Regulations 69 and article 23(m)-10(c) of Regulations 94 and General Counsel Memorandum 14448, Internal Revenue Cumulative Bulletin XIV-1, page 98, it is held that the amount of $38,720.62 allowed to you as depletion deduction in 1926 on the cash bonuses received on the 5,995 acres constitutes taxable income for the year 1936 when the leases reverted to you. * * *

The petitioner, by an appropriate assignment of error, contests this action of the Commissioner in restoring to petitioner's income in 1936 depletion deductions which had been granted to him in 1926. The petitioner does not contest the other adjustments which the Commissioner made in his income tax return for 1936 and these adjustments are, therefore, not in issue.

At the hearing, the Commissioner conceded that, of the $38,720.62 depletion restored to petitioner's income in 1936, he included $5,192.55 erroneously, because petitioner had either disposed of the land covered thereby, or the leases were surrendered in other years. This $5,192.55 is, therefore, no longer in controversy, and effect to this concession by the Commissioner will be given in a recomputation under Rule 50.

FINDINGS OF FACT.

The petitioner, J. T. Sneed, Jr., is an individual taxpayer, with his principal office and place of business at Amarillo, Texas. For the year 1936, he filed his income tax return with the collector of internal revenue at Dallas, Texas.

In 1926 the petitioner made ten-year commercial oil and gas leases to various individuals, firms, and corporations which, in the aggregate with similar leases theretofore made, covered his "Sneed Ranch", approximately eighty thousand acres of land lying in contiguous tracts in the southeastern portion of Moore County, Texas. He had owned a large portion of this land since prior to 1913, and all of it for many years prior to 1926. During the years 1925 and 1926 there were about fifty different leases made of various tracts included in this ranch.

The petitioner received in 1926 amounts aggregating $210,857.18 as cash bonuses for executing the leases which were made in that year. He reported his portion of these sums as a part of his gross taxable income for 1926, either on the basis of his separate property or as community income. He claimed in his 1926 tax return, and was ultimately allowed by decision of this Board (J. T. Sneed, Jr.,30 B.T.A. 1121">30 B.T.A. 1121, and 33 B.T.A. 478">33 B.T.A. 478), a deduction for depletion equal to 27 1/2 percent of each cash bonus so received.

At the time these leases were made in 1926, the whole of petitioner's ranch was regarded "as proven oil or gas territory." A gas well had been brought in near the center of the ranch in 1922, but was shut in because of lack of pipe line facilities. There were no oil or gas wells upon any of the tracts covered by the leases made in 1926 at the time these leases were made. After the execution of these leases, extensive developments were carried on at various locations on the Sneed ranch which resulted, prior to 1936, in the production of some 40 billion cubic feet of gas therefrom (considering only the gas taken and paid for by gas purchasers) and large quantities of oil. None of this production, however, was from wells drilled on the 26 leases which are involved in this proceeding. The leases involved in this proceeding ranged from 40 acres in size to as high as 480 acres.

During the same period (1926 to 1936) similar developments and operations took place on contiguous lands belonging to others and in the Texas Panhandle Oil and Gas Field, in which the Sneed ranch was located, with the result that very large quantities of gas were withdrawn from the reservoir which underlies the entire field, including petitioner's lands.

The "pressure" of gas in an underground stratum is the recognized measure of the quantity of gas present and the decline in that pressure measures the extent to which that gas has been withdrawn or has escaped, and such decline establishes the fact of withdrawal or escape, though the exact quantity in cubic feet of gas can not be accurately estimated.

The "virgin" or initial pressure of gas in the stratum under petitioner's lands was 430 to 435 pounds in 1926. In 1936 this pressure had declined so that it varied from 400 to 420 pounds in some portions, to 280 to 300 pounds in others, decreasing generally from west to east. This measured and proved a corresponding decline in the gas reserves under the ranch. The gas which was under the ranch in 1926, to the extent that the reserves or quantity underground had diminished by 1936, had been extracted through wells on the Sneed ranch drilled on other leases than those involved in this proceeding, and through other wells on contiguous lands owned by others than Sneed, and in the Panhandle Field, and had been disposed of commercially in part and in part wasted because not used.

On some 26 tracts of land on the Sneed ranch covered by leases so made in 1926, no wells had been drilled prior to expiration dates of the primary terms of those leases in 1936, and no oil or gas had been produced from these 26 leases. These leases were surrendered by their owners, in accordance with the terms of the leases in 1936. The bonuses which the petitioner received in 1926 upon these leases aggregated $120,920.25, and the depletion allowed petitioner in 1926 with respect thereto aggregated $33,528.07. In determining petitioner's 1936 tax liability, the respondent included in petitioner's gross income for that year an amount equal to the depletion so allowed in 1926, to wit, $33,528.07, upon the theory that since these leases had expired without production, these depletion allowances should be "restored" to income.

The reserves of gas which were under the leases described above in 1926, when these leases had been made, had, by 1936, been diminished to the extent of from 2.7 percent to 28.9 percent, an average of 11 percent, through the escape of these reserves to neighboring tracts and the production of this gas through wells on other portions of the Sneed ranch and elsewhere in the Panhandle Field. There still remained under the tracts covered by these surrendered leases, which tracts are scattered over various portions of the ranch, gas in commercial quantities which would be produced subsequent to 1936, through the wells then in existence on said ranch and elsewhere, or through wells which might thereafter be drilled on such tracts, under new leases granted by petitioner to other parties in 1936 and 1937.

After the aforesaid leases were surrendered in 1936, the petitioner executed new leases upon these tracts to concerns actively engaged in producing oil in that area, receiving cash bonuses therefor in each instance. Depletion was allowed the petitioner on said bonuses received in 1936. It is probable that wells will be drilled upon many of these tracts and it is definitely established that production of gas will be obtained in any well so drilled to completion.

The leases involved in this proceeding were introduced in evidence as petitioner's Exhibits 1 to 26. Their location, as well as the development in the area, is disclosed by petitioner's maps, Exhibits 28 and 29. These several exhibits are not set out in detail herein because there is no fact issue concerning them. They are incorporated herein by reference. The leases were executed on the usual form used for Texas oil and gas leases. Lease No. 72 is typical of all the other 25 leases involved, and it is believed the following portion of it will be pertinent to a discussion of the issues involved:

OIL AND GAS LEASE

AGREEMENT, Made and entered into the third day of May 1926 by and between J. T. Sneed, Jr. and wife Zella Sneed of Amarillo, Texas hereafter called lessor (whether one or more), and Amerada Petroleum Corporation hereafter called lessee:

WITNESSETH: That the said lessor, for and in consideration of Fifty-six Hundred and no/100 Dollars, cash in hand paid, the receipt of which is hereby acknowledged, and of the covenants and agreements hereinafter contained on the part of lessee to be paid, kept and performed, have granted, demised, leased and let, and by these presents do grant, lease and let unto the said lessee for the sole and only purpose of mining and operating for oil and gas and of laying pipe lines and of building tanks, power stations and structures thereon to produce, save and take care of said products, all that certain tract of land situated in the county of Moore, State of Texas, described as follows, towit:

The south-east quarter of Section No. 24, Block 6 T Grantee -

T&NO Ry. Company.

and containing 160 acres, more or less.

It is agreed that this lease shall remain in force for term of 10 years from this date, and as long thereafter as oil or gas, or either of them is produced from said land by the lessee.

OPINION.

BLACK: In our findings of fact, no emphasis is laid on the facts that petitioner was married in 1926, a portion of the lands leased was community property, his wife, Zella Sneed, died prior to 1936, and other related matters. The parties are in agreement that the Commissioner has given proper effect to these facts in his determination of the deficiency, if it is otherwise correct.

The petition, as we have already stated, contains only one assignment of error, to wit, that the Commissioner erred in restoring to petitioner's income in 1936, depletion which was deducted in 1926 from lease bonuses, where, upon the expiration of leases, there had been no oil or gas production thereon. The petitioner, in pressing this assignment of error, raises several points which we think merit separate consideration and we shall take these points up in their order.

Frist, petitioner makes the broad general contention that the sums which respondent has restored to petitioner's income for 1936 under the circumstances narrated in our findings of fact do not come within the definition of gross income contained in the Revenue Act of 1936 and that respondent's regulations upon which he relies do not purport to require their inclusion as income.

Petitioner presents forceful arguments in his brief in support of these contentions. However, substantially the same arguments and reasoning were used in behalf of the taxpayer in Grace M. Barnett,39 B.T.A. 864">39 B.T.A. 864, and we rejected them. Petitioner urges that our decision in that case was wrong and that we should reconsider the whole question and reverse our position. We are not convinced that our decision in that case was wrong and so we adhere to it. We do not consider that it is necessary to repeat in this opinion the reasons which we gave for reaching our conclusions in the Barnett case. Inasmuch as we adhere to the same conclusions on the general proposition involved as we expressed in the Barnett case, we refer to the reasons which we gave in that case without restating them.

Second, petitioner, although questioning the soundness of our decision in the Barnett case, further contends that it is not controlling in the instant case because the facts in the instant case are distinguishable from those in the Barnett case.

Petitioner contends that although separate leases were made in 1926 covering separate tracts of land, nevertheless, since petitioner's ranch was "one property" as defined in the Commissioner's regulations, and since that property has sustained a substantial amount of depletion during the period 1926 to 1936, inclusive, from wells drilled on other leases located on the Sneed ranch, the petitioner is entitled to retain the benefit of all the depletion allowed to him in prior years. In other words, petitioner contends that he is entitled to an aggregate of percentage depletion allowance over the entire productive life of his property, equal to 27 1/2 per centum of his gross income therefrom, and that the right to this does not depend upon the existence or nonexistence of any particular lease. We do not agree with this contention. Petitioner, in support of his contention, points out that the statutory language granting the depletion refers not to leases, but to property. The language is: "The allowance for depletion * * * shall be 27 1/2 per centum of the gross income from the property."

Article 23(m)-1(j) of Regulations 94, following substantially similar regulations under earlier acts, defines "the property" as follows:

"The property", as used in section 114(b)(2), (3) and (4) and articles 23(m)-1 to 23(m)-19, inclusive, means the interest owned by the taxpayer, freehold or leasehold, in any mineral property. The taxpayer's interest in each separate mineral property is a separate "property"; but, where two or more mineral properties are included in a single tract or parcel of land, the taxpayer's interest in such mineral properties may be considered to be a single "property", provided such treatment is consistently followed.

In order to better understand the meaning of the foregoing regulation, we think it will be well to consider article 23(m)-1, (b), which defines the meaning of the words "mineral property" as follows:

A "mineral property" is the mineral deposit, the development and plant necessary for its extraction, and so much of the surface of the land only as is necessary for purposes of mineral extraction. The value of a mineral property is the combined value of its component parts.

We think paragraphs (b) and (j) of article 23(m) -1, when construed together, mean that where a taxpayer is operating two or more separate mineral properties included in a single tract or parcel of land as a common enterprise, the two or more mineral properties may be considered as a single property. In Vinton Petroleum Co. of Texas,28 B.T.A. 549">28 B.T.A. 549; affd., 71 Fed.(2d) 420, the taxpayer was contending that it was entitled, under law and regulations similar to those quoted above, to combine the gross income from wells located on several different leases and compute the depletion deduction as if there were one single property. We denied this contention and held that the depletion deduction should be made with respect to each property separately.

Petitioner contends that in the Vinton Petroleum case, supra, there was no contention that the several tracts were part of one single tract, such as is present in the instant case in the Sneed ranch, that they were being operated by the taxpayer as one common enterprise. The facts show that Sneed was operating the cattle ranching business as one single business enterprise, but he was not operating any oil or gas wells at all. What he did do was to lease the land included in his ranch to various individuals and corporations by separate leases and received a separate bonus for each separate lease. In such circumstances we have heretofore treated each separate lease as a separate property.

See Allie M. Turbeville,31 B.T.A. 283">31 B.T.A. 283, at pages 292, 293. In that case, the taxpayer was the owner of the Copper Mine Ranch and leased the several tracts included in the ranch to various parties. Bonuses were received as well as agreement to pay royalties from each separate lease. The taxpayer claimed percentage depletion on all the bonuses received. The Board granted percentage depletion on bonuses received from those leases where oil and gas had been produced during the taxable year and denied it as to those leases where there had been no production, following Lizzie H. Glide,27 B.T.A. 1264">27 B.T.A. 1264. That was before the Supreme Court decided in Herring v. Commissioner,293 U.S. 322">293 U.S. 322, that percentage depletion was allowable on leasehold bonuses even where there had been no production during the taxable year. In the Turbeville case, the taxpayer argued that the Copper Mine Ranch should be treated as one single property for the purpose of determining percentage depletion on the bonuses and that the several different leases should not be treated as separate properties. Discussing the point raised by the taxpayer in that case, we said:

Respecting leases made after the discovery of oil on the ranch but under which no production was obtained in the year the bonuses were paid, petitioner argues that an allowance for depletion should nevertheless be made since there was production from "the property", being the whole ranch, which, it is stipulated, was one tract. With this we disagree. The term "the property" applies to the particular acreage covered by each of the several leases. [Citing Vinton Petroleum Co., supra. ]

While it is true that we were in error in the Turbeville case in denying percentage depletion on the bonuses where there had been no production from the particular leases during the taxable year, it was not because of our holding that the acreage covered by each separate lease must be treated as a separate property. It was because of the Supreme Court's later decision in the Herring case. So far as the point we are now discussing is concerned, the Turbeville case still stands. It was in no way affected by the Supreme Court's decision in the Herring case. Therefore, following the Turbeville and the Vinton Petroleum Co. cases, we hold against petitioner's contention that all the tracts and parcels of land covered by the several leases must be treated as one single property because they are parts of the Sneed ranch.

Third, petitioner also contends that although the 26 leases involved in this proceeding had terminated without oil or gas having been produced therefrom, nevertheless, by virtue of production on other leases on his land (not here involved) as well as by production on adjoining lands belonging to other, the leases in question have sustained depletion through drainage. "Therefore" says petitioner, "the percentage deductions granted petitioner in 1926 should not be restored to income in 1936, because the lands involved have been actually depleted though not by any oil or gas wells drilled on the particular leases." We do not think the contention of petitioner on this point can be sustained.

The testimony shows that quite a number of producing wells, mostly gas wells, have been drilled on lands which petitioner leased in 1926, and large amounts of commercial gas have been extracted therefrom. The Commissioner has not restored to petitioner's income any of the percentage depletion deductions granted petitioner in 1926 by reason of bonuses received from these leases. These particular deductions not only remain deducted but petitioner is receiving percentage depletion deductions from the royalties which he receives annually from these wells, as he properly should. It is only in case of the leases which reverted to petitioner in 1936, without any production having been had thereon, and were surrendered to petitioner by their hitherto owners in that year, that the Commissioner has restored to income the depletion deductions granted petitioner in 1926. If the Commissioner's action in this respect is sound from the point of view discussed by us in the Barnett case, supra, then we do not think the action of the Commissioner is affected by the fact that there has been some incidental drainage of gas from under the lands because of wells drilled on other leases adjacent to those involved in this proceeding.

Experts, who apparently were well qualified to testify on the subject, testified that by reason of gas production on petitioner's ranch and the Panhandle Field in general, the gas pressure had been lowered on petitioner's land and that this lowering of the gas pressure meant a diminution of the gas which underlies the ranch. By means of computations which these experts made, they reached the conclusion that the gas underneath the leases here involved had been drained off on an average of 11 percent between 1926 and 1936, inclusive, by production from adjoining lands including those of petitioner, and from the field in general.

We have no independent knowledge of our own on the subject and we have made findings of fact in accordance with the testimony of these experts. However, as we have already stated, these facts, in our opinion, should not affect our decision. Accepting as true that certain diminution of gas has actually occurred by drainage from wells on other properties, it has not occurred from any production on any of the leases here involved. Neither the revenue laws nor the regulations provide for a depletion deduction based on drainage from wells drilled on contiguous tracts. Depletion, we think, is the term commonly used to describe the exhaustion of natural deposits by the extraction and sale of a part thereof. Fundamentally, the depletion allowance is granted for the purpose of allowing a return of capital, tax free. With respect to the leases here involved, there had been no extraction of oil or gas up to the date of their surrender in 1936. Only by accepting petitioner's theory that his entire ranch should be treated as one property could we grant his contention on this point. That theory we have rejected in Allie M. Turbeville, supra, on the authority of Vinton Petroleum Co., supra.Petitioner's contention on this point is therefore rejected.

Reviewed by the Board.

Decision will be entered under Rule 50.

ARUNDELL and VAN FOSSAN dissent.