Parris v. Commissioner , 20 B.T.A. 320 ( 1930 )

WILLIAM PARRIS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Parris v. Commissioner

Docket No. 29437.

United States Board of Tax Appeals

20 B.T.A. 320; 1930 BTA LEXIS 2151;

July 25, 1930, Promulgated

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1. The respondent's determination that an amount of $38,860.95, representing accrued oil royalties was constructively received in the taxable year is approved.

2. A promissory note received by petitioner as partial payment for a royalty interest sold had no fair market value and the unpaid balance thereof should not be included in computing profit from the sale.

3. Depletion deductions should be revised as to the north half of the northwest quarter of section 20 in accordance with our holding that petitioner owned only a one-sixteenth plus 885/1250 of one-sixteenth royalty interest.

Hal. M. Black, Esq., for the petitioner.

L. A. Luce, Esq., and Phil M. Clark, Esq., for the respondent.

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LANSDON

The respondent has asserted a deficiency in income tax for the calendar year 1920 in the amount of $73,429.17. Only that portion of the deficiency is in controversy which arises from the respondent's determination that certain oil royalties in the amount of $38,860.95 were constructively received in the taxable year although not actually received until 1923, and that the unpaid balance of a promissory note amounting to $30,000 should be included at its face value in computing profit from the sale of an oil and gas royalty interest.

At the hearing the respondent was permitted to amend his answer by alleging affirmatively (1) that he has allowed excessive depletion deductions with respect to the north half of the northwest quarter of section 20 based upon a one-eighth royalty interest, whereas, in fact, petitioner's royalty interest was one-sixteenth plus 885/1250 of one-sixteenth; and (2) that if the Board finds the respondent erred in including as income constructively received in 1920, the amount of $38,860.95, then the sum to be eliminated is that amount reduced by the applicable depletion deductions heretofore allowed.

FINDINGS OF FACT.

Petitioner is an individual residing at Glendale, Calif. During the taxable year and for many years prior thereto he resided in Kansas.

On January 24, 1916, the petitioner executed an oil and gas lease to one S. M. Thorpe, covering a 320-acre farm in Butler County, Kansas, which he had owned since 1889. The lease which was in the regular form reserved to petitioner a one-eighth royalty in all oil and gas produced from the premises. Thorpe at once assigned the lease to the Butler County Oil Co., which in turn assigned it to the Rose Hill State Bank of Rose Hill, Kansas, as security for a loan. On July 16, 1918, the lease was sold at auction by the bank to one Jones, the Butler County Oil Co. having defaulted on its note. Jones assigned the lease on the south 240-acre tract to Smith & Richardson, which firm sold the operating interest to the Arkansas River Valley Gas Co., hereinafter sometimes referred to as the Arkansas Co.

Early in 1917 petitioner brought an action against Thorpe and the various assignees claiming under him to have the lease set aside and canceled, alleging that the lessors had failed to pay rental and that the lease had been obtained by misrepresentation. From that time until March, 1923, the lease was in constant litigation, numerous suits being filed by and against the petitioner. In March, 1923, the petitioner entered into a settlement with the Arkansas Co. whereby he received $35,000 cash as consideration for the execution of a new lease.

Oil was discovered on petitioner's land in the latter part of 1919 and a substantial production was obtained in 1920. The operating lessee of the south 240-acre tract disposed of all the oil produced, including petitioner's royalty, to the White Eagle Oil & Refining Co., hereinafter sometimes called the White Eagle Co. In accordance with the custom of refining and pipe-line companies, payment for oil purchased was made only after a "division order" had been signed. The material portions of the division order required in the instant case are as follows:

DIVISION ORDER

192

WHITE EAGLE OIL AND REFINING COMPANY

The undersigned certify and guarantee that they are the legal owners of wells Nos. 1 and up on the farm located in State, County and until further notice you will give credit for oil received from said wells as per directions below:

(Credit to) (Division of interest) (Post-office address)

Tank Nos.

White Eagle Oil and Refining Company is hereby authorized until to receive oil from said wells for purchase from said parties severally in the proportions named, subject to the following conditions:

FIRST - The oil run in pursuance of this division order shall become the property of the White Eagle Oil and Refining Company as soon as the same is received into its custody.

SECOND - Said oil shall be paid for to the owners or their assigns in proportion to their respective interest shown above, at . * * *

* * *

FOURTH - It is understood and agreed in case of adverse claim of title to the land from which any such oil may be produced, or adverse claim of title of any oil sold and purchased in pursuance of this division order, White Eagle Oil and Refining Company may retain the purchase price of such oil until such adverse claim is fully settled and determined or until the party or parties claiming to be owners thereof shall furnish satisfactory indemnity.

WITNESS:

The petitioner did not sign a division order until the litigation was settled in 1923, when he received the royalties herein involved amounting to $38,860.95. Throughout the litigation it was not disputed that petitioner was the owner of the royalty interest, excepting such portion thereof as he may have sold. He could have obtained the royalty by executing a division order but he believed and was advised that he would, by implication at least, be admitting that he was not entitled to the entire oil runs from the land as he was contending.

The petitioner sold a one-sixteenth royalty interest in the south 240-acre tract, which was being operated by the Arkansas Co., to W. R. Jones, Fred B. Stanley, W. H. Stanley, and Clarence R Sowers for a total consideration of $130,000. On January 20, 1920, $86,666.66 in cash was paid and a note was given by Sowers for the balance of $43,33.33, which represented a one-third interest in the royalty. Two assignments were executed dated December 31, 1919, and January 20, 1920, respectively, each covering a one thirty-second interest. Each assignment contained the following clause which was inserted to prevent any interference with petitioner's lawsuit and to protect the parties if he was successful in having the lease canceled:

It is further understood and agreed between the parties hereto that if the above mentioned oil and gas leases or either of them should at any time lapse or be forfeited by the owner or owners thereof, that the first parties shall have sixty (60) days from the date of such lapse or forfeiture to execute a new oil and gas lease on said premises, and shall receive as their own property any bonus they may be able to secure for the execution of same; and that if such new lease provide for a greater royalty either of oil or gas, than the leases above mentioned, that said first parties shall be entitled to have and receive as their own property all of such excess royalty; provided and it is expressly understood that in any event, said second parties herein shall be entitled to and receive the one thirty-second part of all oil which may be produced from said premises by any person, firm, or corporation operating under any such lease or other wise and an undivided one fourth (1/4) of all gas royalties under any such new leases;

It is further understood and agreed that if the lease first herein mentioned should at any time lapse or be forfeited and the first parties fail to execute a new lease within said period of sixty days, then said second parties or assigns shall have the right to execute a new lease on said premises to such persons as they see fit, and first parties shall be entitled to and receive all bonuses and all the royalties provided for in such new lease or leases after paying to the second parties one thirty second (1/32) royalty for all the oil produced from said premises as aforesaid and an amount equal to one fourth (1/4) of the gas royalty now provided for in the above mentioned lease.

Sowers was a practicing attorney in Wichita, Kans., who had represented petitioner throughout the litigation involving the lease and who secured the purchasers for the royalty interest. He had received no fee for his services. In order to partially compensate him for his efforts in petitioner's behalf, he was permitted to purchase a onethird interest in the one-sixteenth royalty and give his promissory note in payment. It was understood at the time that if the royalty did not prove to be of sufficient value to pay the note, collection would not be pressed and Sowers' one-third interest would be returned to petitioner. Aside from the royalty, Sowers was worth between two and three thousand dollars. The one-sixteenth royalty was assigned to a trustee and 7,200 royalty units having a par value of $50 each were issued. Sowers received 2,400. In June, 1920, he paid $13,333.33 on the principal, which was credited to the note, leaving a balance of $30,000. In 1921 he turned back to petitioner 2,000 of the royalty units because he could not dispose of them profitably and could not pay the balance of the note. He kept 200 units and disposed of the others to his mother. During 1920 there were several dry holes drilled on petitioner's land and several of the wells were ruined by salt water. The royalty interest was at all times highly speculative and particularly so in the latter part of the taxable year. The note for $43,333.33 had no fair market value during the taxable year.

On his income-tax return for 1920 the petitioner claimed and has been allowed depletion deductions based upon a one-eighth royalty interest in the north half of the northwest quarter of section 20, the lease on which was held by the Phillips and Vickers interests. The petitioners disposed of a one-sixteenth royalty interest to the National Bank of Commerce of Wichita, on September 5, 1919. The respondent concedes, however, that 885/1250 of such interest was held by the bank for petitioner and agrees that depletion deductions should be allowed on that basis.

The petitioner kept no books during the taxable year but made his income-tax return on a cash receipts and disbursement basis.

OPINION.

LANSDON: The respondent has determined that certain oil royalties were constructively received in 1920 and has included the amount thereof in petitioner's gross income, although payment was not actually received until some time in 1923. In this appeal from such determination the petitioner contends that the royalties were not constructively received inasmuch as they were not available without substantial limitation or restriction as to the time or manner of payment, and were not unqualifiedly subject to his demand within the meaning of the respondent's regulations which provide:

REG. 45, ART. 53. - Income not reduced to possession. Income which is credited to the account of or set apart for a taxpayer and which may be drawn upn by him at any time is subject to tax for the year during which so credited or set apart, although not then actually reduced to possession. To constitute receipt in such a case the income must be credited to the taxpayer without any substantial limitation or restriction as to the time or manner of payment or condition upon which payment is to be made. A book entry, if made, should indicate an absolute transfer from one account to another. If the income is not credited. but is set apart, such income must be unqualifiedly subject to the demand of the taxpayer. * * *

The petitioner's income-tax return was filed on a cash receipts and disbursements basis, so that the royalties constitute income for 1920 only if they were constructively received.

The petitioner alleges that he could not receive the royalties without signing a division order, and that by so doing his position in the litigation would have been prejudiced. He testified that reputable legal counsel advised him not to sign the division order, since he might, by implication at least, admit the validity of the lease which he was contesting in the courts. We need not determine whether petitioner was correctly advised and whether his position would have been prejudiced by signing a division order, for in any event our decision as to whether the income was constructively received is not affected. If he elected not to take possession of income which was subject to his demands because of some benefit which would thereby accrue to him, the amount is nevertheless constructively received. . The test as to constructive receipt is whether the debtor has funds standing to the credit of the taxpayer which the debtor is able to pay and which are available and subject to the taxpayer's demand. ; ; ; and . The division order is merely a form on which to make demand for payment which will serve as a justification for paying the purchase price to that particular person.

The petitioner's witness, Morgan, who was manager of the crudeoil and pipeline departments of the White Eagle Co. during the taxable year, testified that even if a division order had been signed by petitioner the accrued royalties would not have been paid without a bond of indemnity as provided in paragraph four of the division order. He makes a distinction between the petitioner's royalty and that accruing to the Jones, Stanley, and Sowers interests, which was paid to the Guaranty Title & Trust Co. and regular periods during the taxable year, on the ground that under the provisions of the royalty assignment they would have been entitled to one-half of the working interest if petitioner had succeeded in having the lease canceled. For this reason, he says, payment would not have been made to petitioner without a bond. We can see no legal basis for Morgan's conclusions. Title to the land was not in controversy and petitioner was at all times the undisputed owner of so much of the royalty interest as he had retained. The only dispute as to ownership of the oil produced related to the lessees' seven-eighths interest. If the petitioner had been successful in having the lease canceled, he would have been entitled to all the oil produced from his land, except, of course, that portion accruing to the royalty interest which he had sold. If he had been unsuccessful in his legal actions, he still would have owned the retained royalty interest which produced the $38,860.95 herein involved. We think it is clear that the White Eagle Co. was at all times liable to him for the royalties credited to his account. Perhaps that company might have required a bond of indemnity, as Morgan testified, but it would not have been legally justified in so doing under the fourth clause of the division order. When petitioner's portion of the oil was delivered and sold the petitioner became a creditor of the corporation and as such he had a right to demand payment of his debt in money. .

We can see nothing in the royalty assignments which might operate to defeat petitioner's right to one-sixteenth of the oil produced and sold. The clause, which we have quoted above, provides that in case of lapse or forfeiture of the original lease the petitioner and his wife shall have 60 days in which to execute a new lease and thereafter the parties of the second part may execute such new lease. In both assignments, however, there are expressly reserved to the petitioner and his wife all royalties in excess of that portion sold as well as any bonus.

The petitioner cites the case of , where the Court of Claims held that certain fees received by an executor in 1917 for services rendered in 1914 were not constructively received. The facts of that case are distinguishable from those of the instant proceeding. There proper demand was made and payment refused. Also, there was some doubt whether the taxpayer was entitled to the amount claimed. Here, there has been no demand for payment and there is no doubt that petitioner is entitled to the royalties.

We are of the opinion that the amount of $38,860.95 was available to petitioner without substantial limitation or restriction and that the petitioner merely failed, neglected, or refused to make proper demand therefor by signing a division order. The determination of the respondent is approved.

During the taxable year the petitioner sold a portion of his royalty interest for a total consideration of $130,000. He received $86,666.66 cash and a promissory note for the balance of $43,333.33, on which a cash payment of $13,333.33 was made. The facts disclose that the note was to be paid only if the royalty proved to be of sufficient value. We have found that the royalty was highly speculative and that promisor's ability to pay, aside from the royalty, would not have exceeded two or three thousand dollars. Section 202(b) of the Revenue Act of 1918 provides:

When property is exchanged for other property, the property received in exchange shall for the purpose of determining gain or loss be treated as the equivalent of cash to the amount of its fair market value, if any; * * *

We think the note had no fair market value and that the respondent erred in including the unpaid balance thereof in computing profit from the transaction.

The respondent has allowed depletion deductions as to the north half of the northwest quarter of section 20 based on a one-eighth royalty interest. The abstract of title discloses that petitioner had disposed of a one-sixteenth royalty interest to the National Bank of Commerce of Wichita. The respondent concedes, however, that 885/1250 of the one-sixteenth royalty was held by the bank for petitioner. Depletion deductions should be recomputed on the basis of a royalty interest of one-sixteenth plus 885/1250 of one-sixteenth.

Decision will be entered under Rule 50.