Allen v. Commissioner ( 1954 )

W. O. Allen, Petitioner, v. Commissioner of Internal Revenue, Respondent

Allen v. Commissioner

Docket No. 31798

United States Tax Court

22 T.C. 70; 1954 U.S. Tax Ct. LEXIS 239; 3 Oil & Gas Rep. 689;

April 20, 1954, Filed April 20, 1954, Filed

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Decision will be entered under Rule 50.

1. The petitioner was married and owned an oil and gas business on July 26, 1945, the effective date of the Oklahoma community property law. In 1946, a net loss was sustained. Held, for carry-back purposes the portion of the loss resulting from the cancellation of leases, which were property acquired by petitioner prior to July 26, 1945, was his loss, and the remainder, in the absence of any evidence tracing all or some portion of it to property acquired by him prior to that date, was a community loss as determined by the respondent.

2. The net loss sustained from the operation of the business in 1946 must be reduced by the excess of percentage depletion over cost depletion experienced in 1944, in accordance with the provisions of section 122 of the Internal Revenue Code, before being applied as a net operating loss deduction against 1944 income.

Graham Loving, Jr., Esq., and L. Karlton Mosteller, Esq., for the petitioner.

John P. Higgins, Esq., for the respondent.

Raum, Judge.

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RAUM

The respondent determined deficiencies in the income tax of petitioner in the amounts of $ 3,362.06 for the year 1944 and $ 1,038.03 for the year 1945.

Various issues raised by the pleadings are no longer in controversy by reason of concessions made at the trial. Two issues remain:

(1) To what extent may a loss from the operation of a business in 1946 be treated as a community loss in determining the net operating loss of the husband for purposes of carry-back to 1944 and 1945?

(2) Should the net loss sustained from the operation of the business in 1946 be reduced by the excess of percentage depletion over cost depletion experienced in 1944 before being applied as a net operating loss deduction against 1944 income?

FINDINGS OF FACT.

Since 1917 petitioner and his wife have been residents of Tulsa, Oklahoma. They filed separate income tax returns for the years 1944 and 1945 and a joint return for the year 1946 with the collector of internal revenue for the district of Oklahoma.

During the years 1944, 1945, and 1946, and for many years prior thereto, petitioner engaged in the oil and gas business, which consisted of trading and investing in mineral royalties and leases, developing and operating oil properties, and purchasing oil properties for major oil companies on a commission basis. His wife never invested any separate funds in this business. In operating the business petitioner used capital, judgment, and personal effort.

The capital investment in the foregoing business (measured by the difference between aggregate cost and outstanding liabilities) on pertinent dates was as follows:

	Capital investment
Date	(Net worth)
Dec. 31, 1944	$ 173,721.64
July 25, 1945	170,278.84
Dec. 31, 1945	167,621.53
Dec. 31, 1946	73,986.78

In 1945 petitioner withdrew $ 22,586.37 from the business for personal use and in 1946 withdrew $ 18,581.16 for personal use.

As of July 26, 1945, the business was owned entirely by petitioner and all investments in it as of that date were his separate property.

Petitioner has been borrowing money ever since he has been in the oil business. His notes payable as of December 31, 1944, amounted to $ 132,000 and as of December 31, 1946, to $ 185,000. During 1946, he borrowed $ 10,000 on some property which he owned in Illinois and undisclosed amounts on his insurance and on properties which he owned in Oklahoma. It was his intention to repay these borrowings from current income of the business. His wife joined with him on the note given for the Illinois loan because the laws of that State required her signature.

In a schedule attached to the joint return filed by petitioner and his wife for the year 1946 he reported "Income from Business Calendar Year 1946," as follows:

Income from oil and gas sales -- Schedule C-1 attached		($ 26,191.66)
Commissions earned		296.63
Lease sales		59,126.06
	Less -- cost of lease sales	(18,281.13)
Lease rentals received		843.32
Lease bonuses received		1,929.17
	Less -- 27 1/2% depletion thereon	(530.52)
Royalty sales non-producing		790.57
	Less -- cost of royalties sold	(166.67)
	Gross income	$ 17,815.77
Less -- Direct expenses
	Leases canceled and surrendered	$ 26,821.27
	Lease rentals paid	20,504.62
Commissions and participation of profits in lease sales		10,474.52
	Abstract expense	922.70
	General leasing expense	1,859.63
	Traveling	5,708.85
	Ad valorem taxes, business property	31.01
	Federal documentary stamp assessment Oklahoma leases	422.95
	Seismograph service, Oklahoma	525.00
	Dry holes drilled Schedule C-1b	12,081.92
	Indirect expenses Schedule C-1c	21,823.01
	Total expenses	$ 101,175.47
	Net operating loss	($ 83,359.70)
Add -- Income Rose L. Allen
	Schedule C-1d
		($ 78,546.97)

Schedule C-1, "Income from Oil and Gas Sales," discloses that net income after depletion was realized in varying amounts from oil and gas sales on 40 properties, but, because of net losses sustained on 4 leases on which operating and developing expenses substantially exceeded income, the net loss from oil and gas sales amounted to $ 26,191.66.

In their joint return for 1946, the petitioner and his wife reported a loss of $ 79,246.93, which was computed by adding to the foregoing loss of $ 78,546.97, a loss of $ 50.66 from the sale or exchange of a capital asset and claimed personal deductions in the amount of $ 649.30.

On December 11, 1947, petitioner and his wife each filed an application for tentative carry-back adjustment. These applications contained the following computation of operating loss carry-back to 1944 and 1945:

Net loss disclosed line 3, page 3, Form 1040, 1946						$ 79,246.93
	Less -- Personal deductions				$ 649.30
		Percentage depletion claimed			10,606.10
		Excess under section 117 (j) (Loss)			(50.66)
			Net adjustments			11,204.74
Net loss carry-back -- Calendar year 1944						68,042.19
	Less -- Net income reported year 1944, W. O.
	Allen				$ 32,862.73
		Net income reported year 1944, Rose
		L. Allen			3,472.31
			Total taxable income year 1944			36,335.04
Balance net loss carry-back to year 1945						$ 31,707.15
	Less net income reported year 1945:
		W. O. Allen		$ 4,487.03
		Rose L. Allen		3,777.65
		Total taxable income year 1945				$ 8,264.68
Balance net loss carry-over to year 1947						23,442.47
Taxes to be refunded:
	W. O. Allen year 1944 paid in 1945					15,035.77
	Rose L. Allen year 1944 paid in 1945					616.27
	W. O. Allen year 1945 paid in 1946					846.76
	Rose L. Allen year 1945 paid in 1946					669.41
Total to be refunded by carry-back						$ 17,168.21

In his deficiency notice, the respondent made 2 adjustments in the net loss reported in the joint return for 1946, which are not in controversy, and which reduced the amount of the net loss to $ 78,479.09. Respondent also adjusted the joint net loss for 1946 as follows:

Corrected joint net loss				$ 78,479.09
	Less: Adjustments sec. 122 (d), Internal Revenue Code.
		Excess of percentage depletion over actual	$ 10,625.73
		Personal deduction	649.30
		Total adjustment		11,275.03
Joint net operating loss carry-back				$ 67,204.06
Attributable to income and deductions of
	W. O. Allen (50%)			$ 33,602.03
	Rose L. Allen (50%)			$ 33,602.03

In his deficiency notice the respondent applied the net operating loss from 1946 as a deduction against the petitioner's 1944 net income with the following explanation:

(e) It is held that the joint net operating loss of $ 67,204.06 determined, as hereinafter explained, to have been sustained by you and your wife in 1946 for which year you filed a joint return, was attributable to your income and deductions to the extent of a loss of $ 33,602.03. This net operating loss carry-back when reduced in accordance with Section 122 (d) (1) Internal Revenue Code, by percentage depletion claimed in 1944 in excess of cost depletion, or $ 12,712.03, leaves a net operating loss deduction of $ 20,890.00.

Petitioner's income tax return for 1944 showed net income of $ 32,862.73. In arriving at the net income, the petitioner deducted $ 12,712.03 for allowable percentage depletion. The record discloses no basis for cost depletion.

The petitioner's correct net income for 1944, before computing the net operating loss deduction, as agreed between petitioner and respondent, is computed as follows:

Net income as disclosed by return			$ 32,862.73
Unallowable deductions:
	(a) Entertainment expense decreased	$ 288.00
	(b) Deduction for condemned royalty denied	618.75
	(c) Deduction for contributions decreased	211.88
	Total unallowable deductions		1,118.63
Net income as corrected			$ 33,981.36

The respondent determined that the net operating loss carry-back had to be reduced in accordance with the provisions of section 122 (d) (1) of the Internal Revenue Code, by percentage depletion claimed in 1944 in excess of cost depletion, or $ 12,712.03, before being applied as a net operating loss deduction against 1944 income.

The petitioner and his wife never elected to adopt the community property provisions of the Oklahoma Community Property Act of 1939.

The separate returns prepared and filed by petitioner and his wife for the year 1945 showed the income from the separate property of each as separate income to July 26, 1945, the effective date of the Oklahoma Community Property Act of 1945, and as community income from and after that date. During the year 1945 the net income from the business was $ 6,554.73, of which $ 1,427.68 was allocated to his wife as her share of the community income.

Of the loss sustained by petitioner in 1946, $ 25,050.07 represented the loss sustained from the cancellation or surrender of leases acquired by him prior to July 26, 1945.

Of the leases canceled or surrendered by petitioner in 1946, leases costing $ 6,563.39 were leases on properties outside of the State of Oklahoma and in noncommunity property States.

The net operating loss of the business, computed without including the $ 25,050.07 loss resulting from the cancellation of leases, was a community loss, only one-half of which may be attributed to petitioner. The $ 25,050.07 loss was petitioner's separate loss.

OPINION.

1. Petitioner filed separate returns for 1944 and 1945, but he and his wife filed a joint return for 1946 when a net operating loss in the amount of $ 67,204.06 was sustained. The tax years before us are 1944 and 1945, and the principal question is how much of the 1946 loss, if any, petitioner may take into account in computing the carry-back to be applied against his individual income for the 2 preceding years. Sec. 122, I. R. C. The mere fact that a joint return is filed does not entitle either spouse to utilize the composite net operating loss of both husband and wife for carry-back purposes. A net operating loss must be determined for each spouse measured by the income and deductions applicable to such spouse. See Treas. Regs. 111, sec. 29.122-4 (e). So much is not in dispute herein; the problem is one of determining what portion of the $ 67,204.06 net operating loss for 1946 may be attributed to petitioner.

The Commissioner, relying upon the Oklahoma community property laws, has taken the position that petitioner is entitled to the benefit of only one-half that net operating loss, namely, $ 33,602.03. The petitioner, on the other hand, argues that the loss grew out of the operation of a business which was his separate property when the Oklahoma community property law was adopted on July 26, 1945, and that therefore the entire loss is allocable to him. In the alternative, he contends that at least part of the loss ($ 25,050.07) was caused by the cancellation of oil leases which were his separate property and that such part may not be divided between the spouses.

After the abortive attempt, tax-wise, to provide its citizens with an optional community property law (see Commissioner v. Harmon, 323 U.S. 44">323 U.S. 44), Oklahoma enacted a new community property law, patterned after the law of Texas (see Swanda v. Swanda, 207 Okla. 186">207 Okla. 186, 190, 248 P. 2d 575, 579; John Miller Kane, 11 T. C. 74, 78), which became effective on July 26, 1945. ^*249 At that time petitioner had been engaged for some years in the business of buying, selling, and operating oil properties, as well as acting as a broker on a commission basis for the purchase and sale of such properties. His wife had no investment in that business or its assets as of July 26, 1945.

The parties have stipulated that $ 25,050.07, of the 1946 loss, represented a loss sustained from the cancellation or surrender of leases acquired by petitioner prior to July 26, 1945. These leases were his separate property prior to the effective date of the Oklahoma Community Property Act of 1945, and continued to be his separate property until canceled. Cf. Schwartz v. McDaniel, 202 Okla. 324">202 Okla. 324, 231 P. 2d 568, 571. Had they been disposed of at a gain in 1946, and that gain represented the natural enhancement in the value of the leases, it would have constituted petitioner's separate income for income tax purposes. Clanton v. Oklahoma Tax Commission, 208 Okla. 92">208 Okla. 92, 253 P. 2d 562; Midyett v. Midyett, 206 Okla. 312">206 Okla. 312, 243 P.2d 650">243 P. 2d 650, as explained in Swanda v. Swanda, supra;Harmon v. Oklahoma Tax Commission, 189 Okla. 475">189 Okla. 475, 118 P. 2d 205. Similarly, the $ 25,070.50 loss attributable to these leases must be regarded as petitioner's separate loss.

The remainder of the 1946 net loss represented the excess of expenses with respect to the conduct of the business over income from the business. Petitioner argues that the business was his separate property as of July 26, 1945, the effective date of the applicable Oklahoma community property law, that it continued to be his separate property thereafter, and that therefore the loss in question was his separate loss. We cannot agree that this conclusion is supported by the record in this case.

To the extent that a loss can be traced to separate property it is a separable loss, but to the extent that it grows out of community property it is chargeable against the community. The respondent determined that the 1946 loss was a community loss, and the burden was on the petitioner to prove otherwise. He has carried that burden only as to the $ 25,050.07 loss resulting from the cancellation of his separately owned leases. He has not carried that burden as to the remaining loss growing out of the general operation of the business. A brief examination of the manner in which the business was conducted will make this clear.

Although the business was petitioner's separate property prior to July 26, 1945, it was thereafter operated for the benefit of the community. Profits were realized from commissions, rentals, bonuses, the sale of oil and gas, etc. The earning of these profits depended upon petitioner's managerial skill, acumen, and personal efforts. But in Oklahoma, such profits are community property, since, in the absence of a statute providing otherwise, "community property includes all property acquired by either spouse, during marriage, by toil, talent, energy or productive faculty, and the fruits and profits of the separate property of either spouse." Swanda v. Swanda, 207 Okla. at p. 190, 248 P. 2d at pp. 579-580. See also Hammonds v. Commissioner, 106 F. 2d 420, 422 (C. A. 10); Harmon v. Oklahoma Tax Commission, 189 Okla. at 478, 118 P. 2d at 209. Indeed, petitioner himself regarded the business in that light beginning July 26, 1945: Both spouses treated the profits from the operation of the business for the period July 26-December 31, 1945, as community income and the expenses incident to the production of that income as community expenses in their 1945 returns, each reporting as net income one-half of the excess of income over expenses as community net income. Cf. Mellie Esperson Stewart, 35 B. T. A. 406, 410, affirmed, 96 F. 2d 822 (C. A. 5); Leo Sanders, 21 T.C. 1012">21 T. C. 1012.

In 1946, petitioner's efforts to increase the income of the community resulted in expenses exceeding income for that year, and the source of the funds used to pay these expenses is far from clear on this record. There is evidence of substantial outstanding indebtedness as of the end of 1946, and the expenses may well have been paid in large part from funds borrowed after July 26, 1945, for the use and benefit of the community, which were expected to be repaid from subsequent income (community) of the business. *255 there has been a commingling of separate and community property to such an extent that the component parts cannot be segregated, the commingled property is regarded as belonging to the community. W. D. Johnson, 1 T.C. 1041">1 T. C. 1041, 1053; Hamilton-Brown Shoe Co. v. Lastinger, 26 S. W. 924, 926 (Tex. Civ. App.); Gorman v. Gorman, 180 S. W. 2d 470 (Tex. Civ. App.); Trapp v. United States, 177 F. 2d 1, 6 (C. A. 10), certiorari denied 339 U.S. 913">339 U.S. 913.

As already noted, the burden of proof in this case is upon petitioner. It was incumbent upon him to show what portion, if any, of the payments which resulted in the net loss was made out of his separate property. That showing has not been made merely by establishing that the business was his separate property on July 26, 1945, for, as indicated above, community funds may well have been the source for such payments. Petitioner has not proved otherwise, and we cannot say on the record before us that the payments responsible for the net loss were made out of petitioner's separate property. Accordingly, we must hold that, apart from the $ 25,050.07 loss resulting from the cancellation of petitioner's separately owned leases, the net loss sustained in the operation of the business in 1946 was a community loss.

2. There remains the question whether the net operating loss sustained in 1946 should be reduced by the excess of percentage depletion over cost depletion experienced in 1944 before being applied as a net operating loss deduction against 1944 income. The pertinent provisions of section 122 of the Internal Revenue Code are set forth in the margin. *257

The parties agree that the amount of the net operating loss sustained in 1946 should be reduced by the percentage depletion (in excess of allowable cost depletion for that year) as provided in section 122 (d) (1) in arriving at the net operating loss carry-back to 1944. They also agree, in accordance with section 122 (b) (1), that if a net operating loss occurs in a year beginning before 1950, such loss must be carried back to the 2 preceding taxable years and be applied first to the earliest of those 2 years, and that, in accordance with section 122 (c), the amount to be applied as a net operating loss deduction for the earlier year is the amount of the net operating loss carry-back reduced by the amount, if any, by which the net income computed with the exceptions and limitations provided in section 122 (d) (1), (2), (3), and (4) exceeds the net income (computed without such deduction).

The petitioner urges that his net income for the year 1944 computed with the exceptions and limitations provided in section 122 (d) does not exceed his net income for that year computed without the net operating loss carry-back deduction. We do not agree. His net income for 1944 was $ 33,981.36. This figure includes no adjustment for the exceptions and limitations set forth in section 122 (d). Subsection (1) of that section limits the deduction for depletion to the amount which would be allowable if computed without reference to discovery value or to percentage depletion. When his net income for 1944 is computed applying this limitation, $ 12,712.03 must be added for percentage depletion, resulting in net income of $ 46,693.39. Since this net income (as adjusted pursuant to section 122 (b)) exceeds the net income computed without the net operating loss carry-back deduction by $ 12,712.03, the net operating loss for 1946 must be reduced by $ 12,712.03 before it can be applied to the net income for 1944.

Decision will be entered under Rule 50.

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Footnotes

• 1. This income was realized from several "tracts of producing royalty" which petitioner gave to his wife.↩

• 2. The complete text of the 1945 enactment is contained in Oklahoma Statutes, Supplement 1945, Title 32, Husband and Wife. It provides, in part, as follows:

  Section 66. Separate property of husband. -- All property of the husband, both real and personal, owned or claimed by him before marriage or before the effective date of this Act, whichever is later, and that acquired afterwards by gift, devise, or descent, or received as compensation for personal injuries, shall be his separate property. Laws 1945, p. 118, sec. 1.

  Section 67. Separate property of wife. -- All property of the wife, both real or personal, owned or claimed by her before marriage or before the effective date of this Act, whichever is later, and that acquired afterwards by gift, devise, or descent, or received as compensation for personal injuries, shall be her separate property. Laws 1945, p. 118, sec. 2.

  Section 68. Community or common property. -- All property acquired by either the husband or wife during marriage and after the effective date of this Act, except that which is the separate property of either as hereinabove defined, shall be deemed the community or common property of the husband and wife, and each shall be vested with an undivided one-half interest therein; and all the effects which the husband and wife possess at the time the marriage may be dissolved shall be regarded as common effects or gains unless the contrary be satisfactorily proved. Laws 1945, p. 118, sec. 3.

  * * * *

  Section 72. Liability for debts -- Exemptions. -- That portion of the community property under the management, control, and disposition of the wife or which stands in her name shall be liable for debts contracted by the wife and for torts of the wife committed in the course of acquiring, holding, or managing such community property, but not otherwise. That portion of the community property, which is under the management, control, and disposition of the husband shall be liable for debts contracted by the husband and for torts of the husband committed in the course of acquiring, managing, holding, or disposing of the community property, but not otherwise. The husband and wife, and each of them, shall be entitled to the exemptions to which they, or either of them, are entitled under existing laws. All debts created by the husband and wife after marriage or after the effective date of this Act, whichever is later, shall be regarded as community debts unless the contrary be satisfactorily proved. Laws 1945, p. 119, sec. 7.↩

• 3. To the extent of indebtedness contracted after July 26, 1945, section 72 quoted in footnote 2, supra↩, would seem to be applicable.

• 4. For example, the item of "income from oil and gas sales" on the 1946 returns shows a loss of $ 26,191.66, but an accompanying schedule reveals that net income was realized in varying amounts from 40 royalty interests, and the composite loss shown for that item was the consequence of high operating and development expenses on 4 leases. Thus, to the extent that petitioner's wife's share of the profit on any particular transaction was not distributed to her, the assets of the business must be regarded thereafter at least pro tanto as community property.↩

• 5. SEC. 122. NET OPERATING LOSS DEDUCTION.

  (a) Definition of Net Operating Loss. -- As used in this section, the term "net operating loss" means the excess of the deductions allowed by this chapter over the gross income, with the exceptions, additions, and limitations provided in subsection (d).

  (b) Amount of Carry-Back and Carry-Over. --

  (1) Net operating loss carry-back. --

  (A) Loss for Taxable Year Beginning Before 1950. -- If for any taxable year beginning after December 31, 1941, and before January 1, 1950, the taxpayer has a net operating loss, such net operating loss shall be a net operating loss carry-back for each of the two preceding taxable years, except that the carry-back in the case of the first preceding taxable year shall be the excess, if any, of the amount of such net operating loss over the net income for the second preceding taxable year computed --

  (i) with the exceptions, additions, and limitations provided in subsection (d) (1), (2), (4), and (6), and

  (ii) by determining the net operating loss deduction for such second preceding taxable year without regard to such net operating loss and without regard to any reduction specified in subsection (c).

  * * * *

  (c) Amount of Net Operating Loss Deduction. -- The amount of the net operating loss deduction shall be the aggregate of the net operating loss carry-overs and of the net operating loss carry-backs to the taxable year reduced by the amount, if any, by which the net income (computed with the exceptions and limitations provided in subsection (d) (1), (2), (3), and (4)) exceeds, in the case of a taxpayer other than a corporation, the net income (computed without such deduction), or, in the case of a corporation, the normal tax net income (computed without such deduction and without the credits provided in section 26 (h) and (i));

  (d) Exceptions, Additions, and Limitations. -- The exceptions, additions, and limitations referred to in subsections (a), (b), and (c) shall be as follows:

  (1) The deduction for depletion shall not exceed the amount which would be allowable if computed without reference to discovery value or to percentage depletion under section 114 (b) (2), (3), or (4);

  (2) There shall be included in computing gross income the amount of interest received which is wholly exempt from the taxes imposed by this chapter, decreased by the amount of interest paid or accrued which is not allowed as a deduction by section 23 (b), relating to interest on indebtedness incurred or continued to purchase or carry certain tax-exempt obligations;

  (3) No net operating loss deduction shall be allowed;

  (4) The amount deductible on account of losses from sales or exchanges of capital assets shall not exceed the amount includible on account of gains from such sales or exchanges. The deduction provided in section 23 (ee) shall not be allowed.

  * * * *

  (6) There shall be allowed as a deduction the amount of tax imposed by Subchapter E of Chapter 2 paid or accrued within the taxable year, subject to the following rules --

  (A) No reduction in such tax shall be made by reason of the credit for income, war-profits, or excess-profits taxes paid to any foreign country or possession of the United States;

  (B) Such tax shall be computed without regard to the adjustments provided in section 734; and

  (C) Such tax, in the case of a consolidated return for excess-profits tax purposes, shall be allocated to the members of the affiliated group under regulations prescribed by the Commissioner, with the approval of the Secretary.↩