James v. Commissioner , 17 B.T.A. 239 ( 1929 )

T. L. JAMES, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

M. JAMES, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

James v. Commissioner

Docket Nos. 20221, 20222.

United States Board of Tax Appeals

17 B.T.A. 239; 1929 BTA LEXIS 2328;

September 13, 1929, Promulgated

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Petitioners held not entitled to deductions for depletion on account of oil produced from property leased by them but as to which lease they made an absolute assignment in consideration of certain payments to be made by the assignee from such oil as might be discovered in and produced by the property covered by the lease so assigned.

C. M. Pasquier, C.P.A., for the petitioners.

A. George Bouchard, Esq., for the respondent.

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LITTLETON

The Commissioner has determined deficiencies against each of the petitioners for 1921 and 1922, in the amounts of $924.96 and $61.48, respectively. The petitioners aver that such determinations are in error, in that the Commissioner has refused to allow a deduction for each year for depletion based upon discovery value. On motion of counsel for the petitioners, duly granted, the cases were consolidated for hearing and decision.

FINDINGS OF FACT.

T. L. James and Mrs. M. James, husband ans wife, respectively, and residents of Ruston, La., filed separate returns of income for the years in question, upon the community property basis.

On April 28, 1920, J. G. Pratt and his wife, Willie May Pratt, leased to T. L. James a certain tract of land situate in Union County, State of Arkansas, more particularly described as the "NE. 1/4 of SW. 1/4 * * * of Section 8 Township 18 Range 15 and containing 40 acres, more or less," for a term of five years, "for the sole and only purpose of mining and operating for oil and gas, and laying pipe lines, and building tanks, powers, stations and structures thereon to produce, save and take care of said products." In consideration for the granting of this lease, T. L. James paid to the lessor the sum of $3,000 cash, and agreed "to deliver to the credit of the lessor, free of cost, in the pipe line to which he may connect his wells, the equal one-eighth part of all oil produced and saved from the leased premises," and to pay to the lessor "the sum of $200 each year, in advance, for the gas from each well where gas only is found, while the same is being used off the premises." The agreement contains the following further provision:

If the estate of either party hereto is assigned, and the privilege of assigning in whole or in part is expressly allowed - the covenants hereof shall extend to their heirs, executors, administrators, successors or assigns, but no change in the ownership of the land or assignment of rentals or royalties shall be binding on the lessee until after the lessee has been furnished with a written transfer or assignment or a true copy thereof; and it is hereby agreed that in this event this lease shall be assigned as to a part or as to parts of the above described lands and the assignee or assignees of such part or parts shall fail or make default in the payment of the proportionate part of the rents due from him or them, such default shall not operate to defeat or affect this lease in so far as it covers a part or parts of said lands upon which the said lessee or assigns thereof shall make due payment of said rental.

At the date of the lease no oil had been discovered or produced upon the leased premises, and the nearest property upon which there was any oil production was approximately a quarter of a mile away.

On April 6, 1921, the petitioners entered into an argument with the Ark-Rado Oil Corporation, which, omitting signatures and attestations, read as follows:

STATE OF ARKANSAS,

COUNTY OF UNION.

KNOW ALL MEN BY THESE PRESENTS; that I T. L. James, a resident of Dubach, Lincoln Parish, Louisiana, being a married man and having been but once married, whose wife is Mrs. Maggie Hodges James, living and not divorced from him, and a resident of Lincoln Parish, State of Louisiana, for and in consideration of the terms and conditions given in the succeeding paragraphs, do hereby sell, assign, transfer, and convey unto Ark-Rado Oil Corporation, a corporation incorporated under the laws of the State of Arkansas with domicile in El Dorado, Ark., the following described oil, gas and mineral lease, with all the rights conditions and obligations therein contained, located and bearing upon property situated in Union County, Arkansas, to wit:

A certain oil, gas and mineral contract executed by J. G. Pratt, dated April 28, 1920, in favor of the said T. L. James, in as far as said lease applies to the 20 acres described as the E1/2 of the NE1/4 of SW1/4 Section 8, Township 18 South, Range 15 West, and which contract is recorded in Book 86 page 392 of the Conveyance Records of Union County, Arkansas.

To have and to hold unto the said Ark-Rado Oil Corporation his successors and assigns with full and complete right to all of the conditions contained in the said lease, subject thereto; and it is further understood that there is reserved in favor of the said T. L. James, a Seven-Sixteenths (7/16ths) right and interest in all of the oil and gas located in, on or under the said premises or produced in the event of production from the said tract, in addition to the One-eighth (1/8th) royalty reserved by the original lessor herein, and leaving to the present Assignee of this contract, Seven-Sixteenths (7/16ths) of all oil and gas produced upon said premises.

Now the consideration of this assignment is that the said Ark-Rado Oil Corporation agrees to drill and complete upon the said 20 acres described above two test wells, and which said test wells shall be drilled to a depth of Two Thousand Five Hundred (2,500) feet unless oil or gas be found in paying quantities at a lesser depth. And it is further understood that Assignee shall begin the first test well by the erection of a derrick on said premises within 10 days from the date of this Assignment and to continue said operations by beginning actual drilling operations 20 days from this date and to continue said operations as diligently as possible in his search for oil or gas, subject to delays from accidents and fortuitous events; and that the second well shall be begun within 10 days after the completion of the first test well, whether the first well be productive or dry.

It is further understood and agreed that if any well with as much as One Hundred barrels of oil shall be brought in within Two Hundred (200) feet of the line of this tract during the life of this contract, that the said Assignee does agree to begin an offset well on this tract within 20 days after the completion of the said well on the adjoining tract.

Now in order to carry out the terms and obligations of this Assignment, it is agreed, and forms a part of this contract to this extent that the said Assignee in warranty and as a guarantee to the said T. L. James, that said Second well shall be drilled, that he does now execute a bond for the sum of Twenty-five Thousand ($25,000.00) Dollars, which bond is made the basis of a forfeiture for that amount in the event of the failure of the Assignee to drill said second well.

It is agreed that Assignee accept as a full consideration for the drilling of two wells on this property, the above described 20 acres, the Seven-Sixteenths (7/16ths) of all the oil and gas found on said premises or produced therefrom, and the said T. L. James reserving his Seven-Sixteenths (7/16ths) of all said oil and gas, or having paid to him that amount, delivered in gauge tanks on the premises, free of cost to himself, as the consideration for parting with this lease and with full reservation of the additional Two-Sixteenths (2/16ths) or what is commonly called one-eighth (1/8th) royalty to the original lessor. And the said Mrs. Maggie Hodges James does now join her husband herein for the purpose of waiving all exemptions, Homestead and right of dower.

It is further understood that the Assignee agrees to develop the said property in a serious and skillfull manner and in the event of production in the first or the second of said test wells to follow said test wells such development and other wells and operations as will successfully develop the said tract, and that all expenses of development shall be borne by said Assignee, with full and complete interest of Seven-sixteenths (7/16ths), in all of the said wells producing oil or gas on said property in favor of the said Assignor, and agreeing to deliver to the said T. L. James his interest therein in oil in gauge tanks on the premises free of cost to himself.

Thus done and signed on this the 6th day of April, 1921, A.D. in the presence of the two undersigned witnesses of lawful age.

At the date of the foregoing agreement, no oil had been discovered or produced upon the premises to which the assignment related.

The Ark-Rado Oil Corporation began the drilling of the first well, known as Pratt No. 1, on April 23, 1921. At a depth of 2,170 to 2,171 feet, the well was tested and showed a production of 600 barrels. The well was further driven to a depth of 2,175 feet, and a test at that point showed a production of 6,000 barrels. Drilling of the second well, known as Pratt No. 2, was begun on June 6, 1921, and completed on August 2, 1921, at a depth of 2,160 feet, and with a production of 1,000 barrels. Two additional wells were driven and completed before the close of 1921.

In the deficiency notice, the Commissioner advised the petitioners that "Owing to the low price of oil and the small amount of reserves your claim for discovery on the J. G. Pratt property has been denied because the discovery value will not be disproportionate to cost to an operation owner. No depletion is allowed on this property as the cost was deducted from lease sale."

OPINION.

LITTLETON: The petitioners complain that the Commissioner has refused to allow a deduction for depletion, for each of the years 1921 and 1922, based upon discovery value, in connection with the properties leased to T. L. James by J. G. Pratt and his wife under the lease agreement of April 28, 1920.

The statutory provisions which are controlling in the disposition of petitioners' complaint are found in paragraph (10) of subdivision (a) of section 214, Revenue Act of 1921, and are as follows:

In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted: Provided, That in the case of such properties acquired prior to March 1, 1913, the fair market value of the property (or the taxpayer's interest therein) on that date shall be taken in lieu of cost up to that date: Provided further, That in the case of mines, oil and gas wells, discovered by the taxpayer, on or after March 1, 1913, and not acquired as the result of the purchase of a proven tract or lease, where the fair market value of the property is materially disproportionate to the cost, the depletion allowance shall be based upon the fair market value of the property at the date of discovery, or within thirty days thereafter: And provided further, That such depletion allowance based on discovery value shall not exceed the net income, computed without allowance for depletion, from the property upon which the discovery is made, except where such net income so computed is less than the depletion allowance based on cost or fair market value as of March 1, 1913; such reasonable allowance in all the above cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. In the case of leases the deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee.

It is entirely clear from these provisions of the statute, that the allowance for depletion, whatever the basis, is extended to only such persons as have an equitable interest in the properties of the character described, by reason of ownership, in fee simple, or of lesser estates. Unless the petitioners are within this category of taxpayers, there is no basis for their claim to an allowance for depletion based upon discovery value, or to an allowance for depletion upon any other basis. Our examination of the agreement entered into by the petitioners with the Ark-Rado Oil Corporation, under date of April 6, 1921, made in the light of the provisions of the grant of April 28, 1920, of J. G. Pratt and wife to T. L. James, has convinced us that as to the 20-acre tract which is the subject of the assignment the petitioners retained no interests such as would entitle them to a depletion allowance.

These proceedings were submitted entirely upon depositions, in which we find no reference whatever as to the circumstances surrounding the parties to the two agreements described or quoted in full in the findings of fact, or any expression as to the constructions which the parties themselves have given to the agreements. We have been left to make our own constructions of the agreements and to draw our own conclusions as to the intentions of the parties thereto.

The grant of Pratt and his wife to T. L. James, of April 28, 1920, made specific provision as to the rights of the parties upon the assignment of the estate of either party, in whole or in part. It was clearly contemplated that the grant could be made divisible into two or more parts. Upon assignment all of the covenants of the grant are made binding upon the assignee, and in the event of failure of compliance therewith by the assignee, the right of distress or forfeiture extends only to the estate assigned, and such failure can not operate to defeat or affect the estate retained in the lessee. We believe that a fair construction of these provisions of the grant is, that upon assignment of a part of the estate by the lessee, privity of contract, between the lessor and lessee, is entirely terminated so far as it related to the subject of the assignment; that in the event of failure of compliance with the covenants of the grant, upon the part of the assignee, the lessor must look to it for redress and no remedy lies against the lessee or assignor; and that the assignee occupies the same position in relation to the lessor as that formerly occupied by the lessee, or assignor - figuratively speaking, it stands in his shoes.

Looking to the agreement of April 6, 1921, between the petitioners and the Ark-Rado Oil Corporation, we find there an absolute assignment of the lease, so far as it applies to a distinct portion - by metes and bounds - of leased premises. The grant is for the entire term of the lease. The right of reentry, upon the default of the assignee, is not reserved; the posting of a bond by the assignee to insure full compliance with the covenants appears to have been deliberately adopted in lieu of any reservation of reentry in case of such default. There is neither a probability nor a possibility of reversion. Throughout the entire agreement, the language and expressions employed indicate an intent of alienation by the petitioners of all right, title and interest in the lease so far as it applied to a distinct portion of the leased premises - an intent of absolute assignment.

The consideration for the assignment of a part of the lease was the agreement by the Ark-Rado Oil Corporation to drill and complete two test wells, and to pay over to the lessor and the assignees, the petitioners, one-eighth and seven-sixteenths, respectively, of all of the oil and gas produced from the premises. The fact that the consideration was to be paid to the petitioners in oil, or its cash equivalent, as and when produced, left the petitioners with no vested interest such as would entitle them to a depletion allowance in respect of oil and gas wells discovered and developed upon the premises as to which the lease was assigned. In that respect the transaction does not differ from a sale on the installment plan or on a deferred payment basis.

Our conclusion is that the contract between the petitioners and the Ark-Rado Oil Corporation, of April 6, 1921, is an assignment, and that being the case, the petitioners are not entitled to any depletion allowance in respect of oil and gas wells located upon the 20-acre tract as to which the lease was assigned. Cf. .

There is no evidence in the record of discovery of oil or gar wells upon the other 20-acre tract as to which the petitioners appear to have retained a leasehold interest.

In view of the foregoing, we find no error in the Commissioner's action in refusing to allow deductions for depletion, based upon discovery value, in respect of the properties which are the subject of the lease agreement between Pratt and wife and these petitioners.

Reviewed by the Board.

Judgment will be entered for the respondent.