Holly Dev. Co. v. Commissioner

*775 These proceedings have been consolidated and involve the redetermination of the following deficiencies in income tax:

The issues are: (1) What the proper bases for depletion and depreciation deductions are for the year 1923; (2) whether the sum of $116,876.50 received by petitioner in 1923 on a loan previously made to Argonaut by S. W. Sinsheimer constituted taxable income to the petitioner; (3) whether amounts received by Argonaut in 1923 and 1924 at the rate of $6,000 per month, aggregating $120,000. $54,000 of which was received in 1923 and $66,000 in 1924, constituted taxable income to the petitioner; and (4) whether the gross income upon which the 27 1/2 percent depletion deduction is to be computed under section 204(c)(2) of the Revenue Act of 1926 should be reduced by royalties paid by the petitioner to the land owners or lessors of the oil properties of which the petitioner was the operating lessee.

These proceedings*706 were submitted upon oral testimony and on a stipulation of facts which, together with exhibits thereto attached, is made a part of this report by reference.

FINDINGS OF FACT.

The petitioner is a corporation incorporated under the laws of the State of California on December 13, 1922, with an authorized capital stock of 1,000,000 shares of a par value of $1 per share, of which 900,000 shares are issued and outstanding. It maintains its principal office at Huntington Beach, California, and has filed its *776 income tax returns for all the years involved in this proceeding with the office of the collector of internal revenue, Los Angeles, California.

On December 28, 1922, the petitioner issued 500 shares of its capital stock to its incorporators for cash at par.

About November 1, 1922, S. W. Sinsheimer, who then resided at Denver, Colorado, was informed by telegram that the Argonaut Oil Co. was the owner of valuable properties but was in financial difficulties. This company owned and operated oil leases in Orange County, California. It was possible that these properties might be acquired under such conditions as would make then a good investment. Sinsheimer thereupon*707 went to California and communicated with the managing officers of the Argonaut Oil Co., hereinafter referred to as Argonaut. He found that it was deeply in debt and that there was a possibility of its forfeiting some of its valuable leases. He then called certain associates to his aid. An agreement, dated November 24, 1922, was entered into between Argonaut as party of the first part and Sinsheimer as party of the second part. This was supplemented by an explanatory agreement dated December 29, 1922. The pertinent provisions of these agreements were that Argonaut, in consideration of $10 and the covenants and agreements expressed in the agreements, granted, sold, assigned, and transferred to Sinsheimer certain oil leases subject to the terms contained therein, together with all the buildings, improvements, machinery, and equipment and other personal property of Argonaut, for and during the remainder of the terms mentioned in the leases. Argonaut agreed that immediately upon the execution of the agreement they would put Sinsheimer in possession of the premises, whereupon he should enter and take charge of the operation of the wells existing thereon, and perform all the obligations*708 contained in the agreements. Argonaut agreed to execute and deliver such instruments as were necessary to transfer the title to the leases. Sinsheimer agreed that he would lend to Argonaut the sum of $130,000 - $60,000 immediately upon delivery of certificates of title by Argonaut to Sinsheimer, $50,000 thirty days subsequent to that date, and $20,000 sixty days subsequent to that date. This $130,000 was to bear interest at 6 percent from and after the respective dates on which the moneys should be turned over to Argonaut. It was further agreed that if the $130,000 was not fully repaid, principal and interest, to Sinsheimer out of oil production by January 1, 1927, the amount then due and any unpaid interest thereon should become due and payable to Sinsheimer in cash. Sinsheimer agreed immediately to commence operations to deepen two of the wells, to commence drilling a new well on one of the leases, to continue such drilling and redrilling with due diligence, and to operate all of the wells then existing *777 or which might thereafter be drilled in a proper and economical manner. These wells were to be drilled with no profit to Sinsheimer. Out of the production under*709 said leases, payments should be made in the following order: first, rentals and royalties; second, payment of operating, overhead and maintenance charges; third, payments to Argonaut of $6,000 per month until it should have received an aggregate of $120,000; fourth, payments to Sinsheimer until he shall have been repaid and reimbursed the amount of his loan ($130,000) and interest thereon and all actual expenditures charged or incurred by him in the drilling above mentioned. All the remainder of the proceeds less the cost of additional development should be distributed 60 percent to Sinsheimer and 40 percent, "including said monthly payment of $6,000", to Argonaut. It was further provided that should the drilling expenses incurred by Sinsheimer exceed $120,000, then the respective interest of the parties in the surplus should be 65 percent to Sinsheimer and 35 percent to Argonaut. The agreements further provided that, in the event Sinsheimer failed to perform his covenants in the agreements, Argonaut might, upon 30 days' notice, terminate the agreement, in which case the moneys paid or advanced by Sinsheimer should inure to the benefit of Argonaut, and that in event of default by*710 Argonaut it should pay to Sinsheimer the amount of advances and expenditures incurred by him with interest thereon at 6 percent and thereupon the agreement should be terminated. At the time and just prior to the making of the above agreements Argonaut was indebted in large sums. Creditors representing $130,000 of its indebtedness refused to be postponed and the $130,000, above mentioned, was to be advanced by Sinsheimer to Argonaut to pay them. Other creditors to the extent of $120,000 agreed to be paid in installments and the provision for the advancement of the $120,000 from oil at the rate of $6,000 per month was made to take care of them.

On January 4, 1923, Sinsheimer, who had been operating as the representative of his syndicate, made the following proposition to the petitioner:

For myself and as trustee for others for whom I am authorized to act, I hereby offer to purchase Nine Hundred thousand (900,000) shares of the stock of your corporation, Holly Development Company, of the par value of One (1) Dollar each, at the full par or face value thereof, certificate therefor to be issued to S. W. Sinsheimer, Trustee, and to make payment therefor to your corporation, as follows:

*711 (a) By the payment to your corporation of the sum of One Hundred and Seventy Thousand (170,000) dollars in cash; and

(b) By the assignment, transfer and conveyance to your corporation, at a valuation in excess of seven hundred and thirty thousand (730,000) dollars, of any and all oil, gas, mineral and other rights and interests whatsoever, conveyed to and acquired by me under a certain contract in writing between *778 Argonaut Oil Company and S. W. Sinsheimer, dated November 24, 1922, and recorded in the Recorder's Office of Orange County, California on November 28, 1922, and under a certain other contract in writing between Argonaut Oil Company and S. W. Sinsheimer, in amplification and confirmation thereof, dated December 29, 1922, and recorded in said Recorder's Office on January 3rd, 1923, which said contracts are to be taken together and concern oil, gas and mineral leases, rights and interests as to certain lands situated in said Orange County, California, and described or referred to in said contract first above mentioned; to which said contracts and each of them, and such record thereof respectively, reference is hereby made with the same effect as if said contracts*712 respectively were herein set out particularly and in full;

PROVIDED, HOWEVER, that execution and delivery of such assignment, transfer and conveyance to your corporation having been made, with subrogation of your corporation to all rights of the present owner or owners of the indebtedness of the loan made to said Argonaut Oil Company of the sum of One hundred thirty thousand (130,000) dollars under the provisions of said contract first above mentioned, to the repayment of said loan, principal and interest, then and thereupon, in consideration of such subrogation and the right thereby accrued to your corporation to receive and to enforce the payment to it of the full amount of said loan, principal and interest, your corporation shall execute and deliver to me as trustee for the present owners of the whole of said indebtedness, the unsecured note of your corporation in the principal sum of One Hundred and fifty thousand (150,000) dollars, to mature five (5) years after its date, with interest at the rate of six (6) per cent. per annum, payable annually.

On January 24, 1923, the board of directors of petitioner accepted Sinsheimer's offer of January 4, 1923, and authorized the transfer*713 to him of $899,500 shares of its capital stock and also the execution of its promissory note to Sinsheimer or his nominees in the aggregate of $150,000. The issue of 899,500 shares of stock to Sinsheimer instead of 900,000 shares was occasioned by the reduction of the cash payment of $170,000 by Sinsheimer to $169,500.

By deed dated January 24, 1923, Sinsheimer assigned and conveyed to petitioner all the oil, gas, and mineral leases referred to in his contracts above set forth, subject to all the terms and provisions of said contracts except the lending of $130,000 to Argonaut, which it was agreed should be made by Sinsheimer himself or his legal representatives. Sinsheimer made this loan to Argonaut. The note of $150,000 was executed by the petitioner to Sinsheimer and by it petitioner promised to pay him or his representatives said sum of $150,000 with 6 percent interest from date, with the right to pay the note in installments. Said note was made subordinate to other obligations of the petitioner unless they were in the same form as this particular note.

In July 1924, there arose a misunderstanding between Argonaut and the petitioner involving many complaints by Argonaut, *714 among which was that the petitioner had failed to pay it in the month of June 1924, the sum of $2,413.44 being a part of the $6,000 payment *779 due it under the original contracts for that month. These complaints were settled by a compromise agreement entered into August 16, 1924, between these parties. Among the provisions of that compromise agreement were agreements by the petitioner forthwith to pay Argonaut the sum of $26,413.44, which amount was agreed to be the balance of the $120,000 referred to in the contract of November 24, 1922, and that the petitioner was to loan Argonaut the further sum of $10,000. In order to secure the petitioner in these advancements and loans the compromise agreement provided that the proceeds from the production of oil from the wells should be applied as follows: (a) rentals and royalties, (b) all operating, overhead and maintenance charges, with a limitation not material here, on item of overhead, (c) to the petitioner until it should have recovered the sum of $26,413.44, (d) to petitioner until it should have recovered its expenses for drilling certain wells, (e) thereafter 35 percent to Argonaut and 65 percent to petitioner. Argonaut*715 further agreed that any sums of money thereafter payable to it from its 35 percent interest should be applied by the petitioner upon the payment of the interest and principal of the $10,000 loan.

During the year 1923 Argonaut received nine monthly payments of $6,000 and during 1924 it received the balance of said payments aggregating $66,000, thus completing the aggregate sum of $120,000 payable to Argonaut under the above contracts. Respondent has included these amounts, $54,000 in 1923 and $66,000 in 1924, as part of the petitioner's taxable income for the respective years and has computed a tax thereon.

During the year 1923 the petitioner received on the loan of $130,000 made by Sinsheimer to Argonaut, as above set forth, the amount of $116,876.50. The respondent has included this amount in petitioner's taxable income for the year 1923 and has computed a tax thereon.

Before petitioner could accept Sinsheimer's offer for its capital stock it was necessary for it to make application to the Corporation Commissioner of the State of California. This permission was received by petitioner on January 23, 1923.

In the stipulation the parties have agreed as follows:

Should*716 the Board find that the petitioner is entitled to use as a basis for computing its depreciation and depletion deduction for the year 1923, the fair market value on the date of acquisition, viz., January 24, 1923, of assets acquired by the petitioner from S. W. Sinsheimer as aforesaid, the petitioner is entitled to a deduction for depreciation and depletion in the following amounts respectively:

*780 Under the terms of the leases under which the petitioner operated its oil properties, the petitioner was required to pay and did pay to the landowners for the use of said properties, certain royalties in each of the years 1925, 1926, and 1927, respectively, as follows:

The respondent has, for purposes of computing a 27 1/2 percent depletion allowance, to which petitioner is entitled under section 204(c)(2) of the Revenue Act of 1926, reduced petitioner's gross income for each of the years 1925, 1926, and 1927 by the respective amounts of the above mentioned royalties. Should the Board determine that petitioner's gross income should be*717 reduced by the sums aforesaid in computing its depletion allowance, then the amount of depletion allowed by the respondent for the years 1925, 1926, and 1927 is correct.

Should the Board determine that petitioner's gross income should not be reduced by said royalties in computing its depletion allowance, then the depletion deduction to which petitioner is entitled for each of the years 1925, 1926, and 1927, respectively, is as follows:

OPINION.

LEECH: The various issues will be discussed in the order in which they have been stated.

For the year 1923 petitioner claimed depletion and depreciation in the respective amounts of $422,571.71 and $107,024.47. The respondent has allowed these items in the respective amounts of $63,221.15 and $60,563.04. It is stated on brief by counsel for both parties that the petitioner claimed these deductions on the basis of fair market value as of January 24, 1923, which, it claims, was the cost of the property to it. On the other hand respondent has based his computation on the cost of the property to Sinsheimer.

*718 The petitioner had no assets at the time it issued all its stock to Sinsheimer and his associates in exchange for $169,500 and the contracts between Sinsheimer and Argonaut. Thus, since this issue is to be determined under the Revenue Act of 1921, it is clear that the cost of petitioner's stock was $169,500 plus the fair market value of the contracts paid in for the stock. ; ; . This cost furnishes the basis for the computation of both depletion and depreciation. At this point counsel for respondent argues *781 that since we can not determine what the fair market value of the assets which were subject to depletion and depreciation was, the petitioner has failed. We do not think that the respondent is entitled to make this contention on this record. He has stipulated that if we find that the petitioner is entitled to use as a basis for computing depreciation and depletion deductions, the fair market value on the date of the acquisition of the assets acquired from Sinsheimer, then petitioner is entitled to deduct the following*719 amounts: depreciation, $44,444.97, and depletion, $164,783.62. No evidence has been introduced to show what these values were. But, on the present record, in our judgment, we are not required to determine what they were. It was evidently for the purpose of eliminating the necessity of such evidence by limiting this phase of the controversy to the question of whether the proper basis was cost to Sinsheimer or to the petitioner, that the respondent has stipulated that if the basis is the fair market value of the property on the date of acquisition (cost to the petitioner), then the deductions should be allowed in the specified amounts. We have determined that issue as submitted. We have found that such is the proper basis. Therefore, the petitioner is entitled to the stipulated deductions.

It is stipulated that the $116,876.50 received by petitioner in 1923 on the loan made to Argonaut by Sinsheimer, the collection of which was assigned by him to petitioner, has been included by the respondent in the petitioner's income for that year. Reference is made in the stipulation to the deficiency notice. That notice discloses that the above sum was not added to the petitioner's*720 income by the respondent. The deficiency notice states that the information at hand discloses that the loan of $130,000 was made by Sinsheimer to Argonaut for the purpose of liquidating certain indebtedness of the latter and was made in accordance with the agreement between Argonaut and Sinsheimer. Further, it there appears that under the agreement the loan was to be paid out of earnings of the property acquired from Argonaut by Sinsheimer and subsequently transferred to the petitioner, and that, since no part of such earnings accrued to the credit of Argonaut, it was held that the loan, in reality, represented a part of the cost of the property. From this we deduce that the petitioner has returned the $116,876.50 as income and now seeks to have that item eliminated. Thus, the question rresented is whether that sum of moeny is a part of the gross income of the petitioner.

*782 Argonaut owned certain oil, gas, and mineral leases, subject to the payment of specific royalties. It assigned by contract all its title, in those leases, to Sinsheimer. He assumed Argonaut's royalty liability to the original lessors, agreed to repay his $130,000 loan to Argonaut, if possible, *721 from the proceeds of the oil, and, after certain deductions, to pay to Argonaut, in addition, $6,000 per month from the proceeds of the oil. This contract was assigned by Sinsheimer to petitioner, which became subrogated, thereby, to Sinsheimer's rights, including the collection of the loan. This issue has to do with that portion of the oil proceeds petitioner collected and applied under that assigned contract to the repayment of Argonaut's obligation to Sinsheimer, assigned to petitioner. The fact that this portion of the oil proceeds was retained by petitioner as a credit on Argonaut's debt of $130,000 to Sinsheimer, now owned by petitioner, is not material here. The present picture, for tax purposes, is the same as though Argonaut's debt was owed to another than petitioner, and petitioner had paid the portion of the oil proceeds, allocable to that debt, to Argonaut or, upon Argonaut's order, to its creditor direct. Such payments would have been in the nature of an overriding royalty - a part of the cost of the leases to petitioner which it bought from Sinsheimer. They would not lose that character because of the use to which Argonaut put them. Nor do they lose that character*722 here merely because petitioner, which pays the overriding royalty, happens to be Argonaut's creditor, to which they are paid by petitioner's retaining and crediting them to Argonaut's loan account.

Thus, we think the payment of this assumed obligation of Argonaut's to Sinsheimer was the same, for present purposes, as the payment of an overriding royalty to Argonaut on the assigned leases. Such royalty would have been taxable income to Sinsheimer, and, a fortiori, was so to his assignee, petitioner.

As was stated by the Circuit Court of Appeals for the Eight Circuit, in affirming :

We think the statute makes plain distinction between rentals or other payments for the continued use or possession of property to which the taxpayer has not taken title or in which it has no equity on the one hand, and rentals or other payments for the continued use or possession of property to which the taxpayer has taken title or in which it has an equity on the other hand. The former rentals are deductible; the latter are not.

* * *

In the case at bar, it is clear that title to the property was taken by the petitioner.

*723 It follows that the presently disputed amounts were likewise so taxable to petitioner. .

*783 III.

Upon authority of those last cited cases, we are also of opinion that all of the payments on account of the $120,000 were merely overriding royalties and are taxable income to the petitioner. The fact that, in 1924 in settlement of its controversy with Argonaut, the petitioner paid Argonaut the sum of $26,413.44 in cash, does not alter the situation in so far as the question involved here is concerned. At that time the petitioner was in arrears in payments on account of these overriding royalties in the sum of $2,413.44. Obviously, from what has been said, as such royalties it was taxable income to petitioner. The difference between the two latter amounts was in the same category as the loan of $130,000 to Argonaut involved in issue II and, upon the same reasoning and authorities relied upon there, was also taxable as income to petitioner.

This issue is resolved in favor of the respondent on the authority of *724 .

Judgment will be entered under Rule 50.