Kimbell v. Commissioner

*941 The respondent has determined deficiencies in income tax against petitioners for certain taxable years as follows:

The principal issue, which is common to all the dockets, is whether certain oil payments from oil produced during 1934 and 1935 were the income and property of the Fleming-Kimbell Corporation or whether such payments*1122 were constructively received as the community income and property of the individual petitioners. The second issue is common only to Docket Nos. 92957 and 92958, and is whether the respondent erroneously limited a loss sustained by the petitioners through the sale of a business property formerly occupied by them as their residence. The third issue is common only to Docket Nos. 92959, 94673, and 94674, and is whether in computing percentage depletion of oil wells the net income from the property, of which 50 percent is the limit of depletion, must be reduced by development expenditures which were deducted in computing taxable net income. The fourth issue is common only to Docket Nos. 94689 and 94690, and is whether two certain exchanges (later identified herein as the "Richter" and "Como" exchanges) are nontaxable as being exchanges of properties of like kind, and, if the Richter exchange is taxable, whether the respondent erred in determining the amount realized thereon. As an alternative, in the event the Como exchange is held to be a taxable exchange and if in addition thereto the principal issue is decided against petitioners, then a further issue is involved as to the basis*1123 to be used in determining the profit from the Como exchange. The petition filed by the corporation presented another issue, namely, assignment of error (a), which was waived at the hearing and will not be further noticed.

FINDINGS OF FACT.

At all of the times involved in these proceedings, petitioners Wm. Fleming and Anna Maud Fleming, were husband and wife, residing together in Texas. Their property and income were community property and income. For each of the years here involved they filed *942 separate income tax returns. The same is equally true as to Kay Kimbell and Velma Kimbell. The Fleming-Kimbell Corporation is a Texas corporation engaged in the oil business. It was organized in 1931 by Fleming and Kimbell, and at all times subsequent thereto it has been owned equally by them and they at all such times constituted its board of directors and its active officers, Fleming being in charge of its operations.

Prior to the organization of the Fleming-Kimbell Corporation, Fleming and Kimbell had been operating as partners in the oil business and they owned interests in six oil and gas leases in the East Texas oil field, known as the B. C. Christian, the Reynolds*1124 Christian, the J. E. Christian, the Flemister, the W. E. Jones, and the Thompson "A" leases. In 1931, after the Fleming-Kimbell Corporation was organized, Fleming and Kimbell transferred their interests in these six leases to the corporation. The written assignments of these leases to the corporation made no reference to oil payments, but the consideration and agreement was that the Fleming-Kimbell Corporation would pay to Fleming and Kimbell $15,512.70 in cash, which was done, and in addition thereto, would, beginning January 1, 1934, deliver to them certain fractions of the oil thereafter to be produced from these properties until each had received oil of the value of $114,250. This understanding was evidenced by a journal entry on the books of the Fleming-Kimbell Corporation made on or about January 1, 1932.

Shortly prior to January 1, 1934, a further agreement was made between Fleming and Kimbell on the one hand and the corporation on the other. The substance of this was that in lieu of receiving the fractions of the oil theretofore agreed upon beginning January 1, 1934, Fleming and Kimbell were to receive, beginning September 16, 1936, corresponding fractions of the oil*1125 thereafter to be produced and that this was to continue until each of them had received oil of the value of $114,250 and additional oil of the value of $15,000. This also was a verbal agreement and no written memorandum was made about it until September 15, 1936, at which time a formal agreement was entered into between Fleming and Kimbell and the corporation, in which, after first giving full recognition to all of the previous oral agreements, it was agreed as follows:

NOW, THEREFORE, in consideration of the premises and for the purpose of making the records reflect the true state of the title with respect to the oil, gas and mineral leasehold estate in and to the above described tracts of land, it is hereby recognized and agreed by all parties hereto that, by virtue of the reservation and exception above referred to, Wm. Fleming and Kay Kimbell are each the owner of an undivided interest in the oil and gas leasehold estate and the oil in and underlying the above described tracts of land, of such nature *943 and extent that each is entitled to have delivered to him into the pipe line, free of cost, as an overriding royalty 1/4th of 7/8ths of all oil which may be produced*1126 from and after 7:00 A.M. on the 16th day of September, 1936, from the tracts hereinabove described * * *; provided, however, that when, by reason thereof, there shall have been delivered to Wm. Fleming oil of the market value of $114,250.00, and to Kay Kimbell oil of the market value of $114,250.00, all of the right, title and interest of the said Wm. Fleming and Kay Kimbell in and to the oil, gas and mineral leasehold estate in and to the tracts of land above described shall terminate and shall thereupon vest in Fleming-Kimbell Corporation, its successors and assigns.

It is distinctly understood and agreed that said Fleming-Kimbell Corporation is not obligated to pay to the said Wm. Fleming or to the said Kay Kimbell any sum or sums of money whatsoever, but the said Wm. Fleming and the said Kay Kimbell are entitled to receive delivery of oil of the market value above specified only if, as and when produced.

Thereafter, on October 16, 1937, the corporation incorporated in its minute book a resolution outlining a complete and correct history of the transaction and confirming all that had previously been done, including the payment of the extra $15,000 each to Fleming and Kimbell. *1127 This transaction, as to receiving oil payments beginning September 16, 1936, in lieu of those which were to begin January 1, 1934, was entered into because the Fleming-Kimbell Corporation was in 1934 and 1935 in need of money to develop its properties, it being then indebted to banks and to Fleming and Kimbell for substantial amounts of money advanced to it, and to the F.H.E. Oil Co. for drilling and development work.

Throughout the taxable years here involved, the Fleming-Kimbell Corporation operated each of the six properties represented by the six leases acquired from Fleming and Kimbell in 1931 and produced large quantities of oil therefrom. Prior to September 16, 1936, neither Fleming nor Kimbell ever received anything from the Fleming-Kimbell Corporation to apply upon the oil payments reserved by them in connection with the six oil leases transferred to the corporation in 1931. Prior to September 16, 1936, the corporation reported as its own income that portion of the oil which would have gone to Fleming and Kimbell beginning January 1, 1934, but for the agreement which the corporation had made with them shortly prior to that date.

In his notices of deficiency against*1128 the individuals for the calendar years 1934 and 1935, the respondent determined that Fleming and Kimbell each constructively received as community income from the corporation certain amounts as representing their share of the oil payments reserved by them in connection with the six leases transferred to the corporation in 1931, against which amounts the respondent allowed percentage depletion of 27 1/2 percent. A summary *944 of the amounts thus determined by the respondent as having been constructively received, together with the depletion allowed, is as follows:

The parties have stipulated that, in the event the Board affirms the respondent's determination that the above amounts were constructively received by Fleming and Kimbell as the community income of themselves and their wives, respectively, then and in that event there should be eliminated from the corporation's income for the fiscal year ended*1129 April 30, 1935, the amount of $102,356.73 less the amount of depletion applicable thereto.

The Fleming-Kimbell Corporation paid corporate income taxes for the fiscal year ended April 30, 1935, to the collector of internal revenue at Dallas, Texas, on the following dates and in the following amounts:

About July 3, 1937, it filed a claim for refund of all of the taxes so paid.

Issue 2. - Prior to June 1, 1930, petitioner Fleming and his wife resided at Sherman, Texas, in a residence built in 1921 at a cost of more than $50,000. It ceased to be their residence on June 1, 1930, at which time it was rented. It then had a fair market value of $35,000. The property was sold in 1934 for $10,000. The respondent determined the allowable loss sustained on this sale by deducting from the value of the property on June 1, 1930, depreciation sustained in the sum of $2,450, arriving thereby at an adjusted basis of $32,550. From this he deducted the sale price and fixed the loss at $22,550 but limited this loss, under section 117 of the Revenue Act*1130 of 1934, to 30 percent thereof, or $6,765.

Issue 3. - Since it began business the Fleming-Kimbell Corporation has consistently followed the practice of charging off currently, as incurred, intangible drilling and development costs incurred in drilling oil wells, and Kimbell in his individual oil operations has always *945 consistently followed the same practice. In computing the deficiency against the Fleming-Kimbell Corporation, the respondent made allowances for depletion of oil properties based upon a percentage of income, and in computing the 50 percent limitation upon these allowances he took into consideration the intangible drilling and development costs currently charged off by that company, which reduced allowable depletion in several instances below what it would have been if the respondent had not so taken into consideration these intangible drilling and development costs; and in computing the deficiencies asserted against petitioner Kimbell and his wife for 1935, the respondent followed the same method of calculating the depletion limitation. It is agreed that the figures are in the record from which a correct computation of depletion can be made if the*1131 respondent erred in this respect.

Issue 4 - Richter exchange. - On November 30, 1936, an exchange was made between Fleming, the F.H.E. Oil Co., a corporation, and the Hardesty-Elliott Oil Co., a partnership, by which the F.H.E. Oil Co. and the Hardesty-Elliott Oil Co. assigned to Fleming an oil payment from a certain oil and gas lease known as the Richter "B" lease, and also an oil payment from a certain oil and gas lease known as the Richter "C" lease. The assignment of the oil payment in the Richter "B" lease is in part as follows:

* * * said Wm. Fleming shall have and own and shall be entitled to receive, when, as and if produced, three-eighths (3/8ths) of seven-eighths (7/8ths) of all of the oil which may be produced from the land above described (but not of the gas or casinghead gas, or the products or residue of such gas or casinghead gas) until the aforesaid three-eighths (3/8ths) of 7/8ths of such oil shall amount in value to Six Thousand Five Hundred ($6500.00) Dollars, whereupon the said Wm. Fleming shall have no further right, title, interest or estate in and to the land above described, or in and to the aforesaid oil and gas lease and leasehold estate, by virtue*1132 of this instrument.

The assignment of the oil payment in the Richter "C" lease is in part as follows:

* * * said Wm. Fleming shall have and own and shall be entitled to receive when, as and if produced, one-fourth (1/4th) of seven-eighths (7/8ths) of all of the oil which may be produced from the land last above described (but not of the gas or casinghead gas, or the products or residue of such gas or casinghead gas) until the aforesaid one-fourth (1/4th) of 7/8ths of such oil shall amount in value to Eight Thousand Five Hundred ($8500.00) Dollars, whereupon the said Wm. Fleming shall have no further right, title, interest or estate in and to the land above described, or in and to the aforesaid oil and gas lease and leasehold estate by virtue of this instrument.

In consideration of these two assignments, Fleming transferred and assigned to the F.H.E. Oil Co. and the Hardesty-Elliott Oil Co., in equal shares, an undivided one-fourth interest in and to a *946 specified oil and gas lease known as the Richter "A" lease together with all the leasehold equipment and personal property located thereon, subject, however, to the following reservation:

The said Wm. Fleming retains*1133 and reserves such an interest in the oil and gas lease and the leasehold interest and estate conveyed thereby, insofar as same pertains to the twenty (20) acre tract last above described, and in and to the oil in, under or upon said twenty acre tract of land as shall entitle him, the said Wm. Fleming, to receive, when, as and if produced (after seven o'clock A.M. on December 1, 1936) one fourth (1/4th) of seven-eighths (7/8ths) of all of the oil which may be produced from the twenty acres last above described until the one-fourth (1/4th) of seven-eighths (7/8ths) of said oil so produced shall amount in value to Four Thousand ($4000.00) Dollars, whereupon the said Wm. Fleming shall have, by virtue of this instrument, no further right, title, interest or estate in and to the lands last above described or in and to the aforesaid oil and gas lease and leasehold estate.

In determining the deficiencies asserted against petitioner Fleming and his wife for the year 1936, the respondent determined a taxable profit of $858.46 on the Richter exchange, computed as follows:

*1134 If the Richter exchange is a taxable transaction, the parties agree that the value of the three oil payments totaling $19,000, including the $4,000 oil payment reserved by Fleming, was $18,050, and that the adjusted cost of the Richter "A" lease was $17,191.54.

Como exchange. - On September 21, 1936, Fleming assigned all of his right to receive $59,000 of the $114,250 oil payments which he had reserved in the assignment of the six leases to the Fleming-Kimbell Corporation in 1931, mentioned herein under the principal issue, to the Como Oil Corporation in consideration for a certain assignment of even date from the Como Oil Corporation of a three-fourths working interest and a one-sixteenth royalty interest in eight acres of an oil and gas lease known as the Daisy Bradford lease, "together with all of the leasehold equipment and personal property located thereon and used or obtained in connection therewith, except a certain pumper's cottage located thereon," all of which was subject to an exception and reservation as follows:

There is hereby retained, excepted and reserved, however, unto the said COMO OIL CORPORATION, hereinafter referred to for convenience as "COMO", such*1135 right, *947 title and interest in and to all of said oil, gas and mineral leasehold estate and all of said one-fourth (1/4th) of the one-fourth (1/4th) royalty interest provided for under said lease above set out as will entitle COMO OIL CORPORATION, its successors and assigns, to receive all of the oil, gas and other minerals produced from said tract of land from and after seven o'clock A.M. on the 9th day of September, 1936, to the credit of said oil and gas leasehold interest and of said one-fourth (1/4th) of the one-fourth (1/4th) royalty interest and delivered to COMO OIL CORPORATION into the pipe line, free of cost, as an overriding royalty interest, until said oil, gas and other minerals shall have amounted to the total market value of Six Thousand, Five Hundred and No/100ths Dollars ($6,500.00), at which time the title, rights and interests to the oil and gas leasehold interest and to the royalty interest so retained, reserved and excepted by the said COMO OIL CORPORATION shall terminate and be extinguished, and the rights, titles and estates hereby granted WM. FLEMING shall be relieved fully and finally therefrom.

The assignment from Fleming to the Como Oil Corporation*1136 is, in part, as follows:

NOW, THEREFORE, the undersigned, Wm. Fleming, for the consideration hereinafter stated, has bargained, sold, assigned and conveyed, and does by these presents bargain, sell, assign and convey unto COMO OL CORPORATION, a Texas corporation, all of the right, title and interest of the undersigned, Wm. Fleming, in and to the oil and gas leasehold estate, and in and to the oil in and underlying the tracts of land above described, to the extent, and to the extent only, that the said Como Oil Corporation shall be, and it is hereby, vested with the right to demand and receive delivery of the first oil which may be produced, if, as and when produced, from the tracts of land above described, to the credit of the interest so reserved and excepted by Wm. Fleming as above described, from and after seven o'clock A.M. on the 16th day of September, 1936, until oil of the total market value of Fifty-nine Thousand Dollars ($59,000.00) shall have been delivered to said Como Oil Corporation, free of all cost, into the pipe line, as an overriding royalty, at which time all right, title and interest of said Como Oil Corporation shall terminate, and the right, title and interest*1137 of Wm. Fleming shall be free and discharged of the provisions of this assignment.

In determining the deficiencies asserted against petitioner Fleming and his wife for the year 1936, the respondent determined a taxable profit of $22,532.29 on the Como exchange, computed as follows:

If the Como exchange is a taxable transaction, and if the Board decides the principal issue in favor of the petitioners, the parties agree that the respondent correctly determined the cost of the $59,000 oil payment to be the amount of $3,669.28.

*948 OPINION.

BLACK: The issues will be considered in the order previously stated.

Issue 1. - The principal issue is whether petitioners Fleming and Kimbell and their respective wives during the years 1934 and 1935, constructively received any of the oil payments reserved by those petitioners in 1931 when they assigned to the Fleming-Kimbell Corporation the six leases*1138 mentioned in our findings of fact, or whether the corporation properly reported the income in question. The respondent has treated the income as belonging both to the corporation and also to the individuals, but now concedes that, if his determinations as to the individuals be sustained, the income which he proposes to tax to the individuals must, to the extent that it is also included in the corporation's income for the fiscal year ended April 30, 1935, be excluded therefrom.

The facts regarding this issue are fully set out in our findings. The issue turns on the recognition to be given the second oral agreement entered into late in 1933 whereby the time when Fleming and Kimbell were to share in the oil produced from the six leases assigned to the corporation in 1931 was extended from January 1, 1934, to September 16, 1936. It is only by giving recognition to the first oral agreement entered into at the time the leases were assigned to the corporation that the respondent has any semblance of reason for his determination that the individuals constructively received the income in question. If the parties had a right to make the first oral agreement, they had a right to make the*1139 second, and our only concern is whether these agreements actually existed and were intended as real, genuine, bona fide agreements between the parties. The agreements are supported by uncontradicted testimony of reputable and credible witnesses. This testimony is borne out by the conduct of the parties and is verified by written instruments subsequently executed which appear to be in all respects regular and trustworthy. Upon such a record, we know of no reason why from a tax standpoint full legal effect should not be accorded the second oral agreement referred to above, which was entered into prior to the date that any of the oil payments in question were to begin. Under that agreement Fleming and Kimbell were not entitled to receive any of the production which was to apply against their reserved interests until September 16, 1936. Until that time all of the production belonged to the Fleming-Kimbell Corporation, and we think it was correctly reported as income by that corporation. It may be proper also to say at this point that the evidence shows that both Kimbell and Fleming sold or exchanged their $114,250 oil payments in years later than 1935. Fleming's exchange of $59,000*1140 of his oil payment in 1936 is the subject of issue 4, later to be discussed *949 herein. The $15,000 extra oil payment which each was to receive as consideration for the extension of the time of payment was received by each in years later than the taxable years we have before us, and each reported that amount in his income tax return for taxation. It follows that the respondent was in error in determining that petitioners Fleming and Kimbell and their respective wives were in constructive receipt of income during 1934 and 1935 by virtue of the reservations of oil made at the time the six leases were assigned to the corporation in 1931. Cf. George P. Douglas,

1 B.T.A. 372. No change, therefore, will be made in the income reported by the corporation and approved by the respondent for the fiscal year in question.

In support of his determination, the respondent in his brief cites Herbert v. Commissioner, 81 Fed.(2d) 912; Hamilton National Bank of Chattanooga, Administrator,29 B.T.A. 63; *1141 Corliss v. Bowers,281 U.S. 376; John A. Brander,3 B.T.A. 231; Helvering v. Gordon, 87 Fed.(2d) 663; Security First National Bank of Los Angeles et al., Executors,28 B.T.A. 289, 316; Brooks v. Commissioner, 35 Fed.(2d) 178; American Trust Co.,21 B.T.A. 30; and Isadore Schuman,20 B.T.A. 1167. These cases could be in point only if no recognition were given to the second oral agreement. For reasons already given we think the question at issue is controlled by the second oral agreement, which we hold to be entirely valid, and on this issue we decide against the respondent.

Issue 2. - The second issue is whether the respondent erroneously limited a loss sustained by petitioner Fleming and his wife in 1934 through the sale of a business property formerly occupied by them as their residence. In 1921 petitioners constructed a residence at a cost in excess of $50,000. On June 1, 1930, they converted it into rental property, at which time it had a fair market value of $35,000. Petitioners sold the property in 1934 for $10,000. The depreciation sustained*1142 between June 1, 1930, and the date of sale in 1934 was $2,450. The respondent determined that the "loss recognized," as that term is used in section 117(a) of the Revenue Act of 1934, ² was *950 the amount of $22,550; that petitioners had held the property for more than ten years; and that under section 117(a) only 30 per centum of the loss recognized could be taken into account in computing net income.

*1143 At the outset petitioners concede that under Heiner v. Tindle,276 U.S. 582, the loss to be taken into account could in no event exceed $22,550, which is the difference between the fair market value of the property when rented on June 1, 1930, less depreciation; and the selling price. They contend, however, that the respondent erred in using the amount of $22,550 as the "loss recognized upon the sale" as the word "recognized" is used in section 117(a). Petitioners contend that the word "recognized" refers back to section 112(a) which provides that "Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except [for certain provisions not herein applicable]"; that the entire amount of loss determined under section 111 is the difference between the original cost of $50,000, less depreciation (no proof of which is in the record), and the selling price; that the result thus obtained is the "loss recognized" to be used in applying the percentages provided in section 117(a), which under this contention petitioners concede would be 30 percent; and that the result thus obtained would then be*1144 limited to the maximum amount of $22,550 computed under Heiner v. Tindle, supra.

We see no merit in this contention. It is our opinion that in the case of residential property which has been converted into business property and later sold at a loss, both the "loss recognized" under section 117(a), and the loss "determined under section 111" must be ascertained by applying the principles enunciated in Heiner v. Tindle, supra, and that in the instant case the loss so "recognized" to be taken into account in computing net income at the percentages mentioned is the above amount of $22,550.

As an alternative, petitioners contend that the period of holding should commence from June 1, 1930, so as to bring the percentage limitation within the 60 percent bracket instead of the 30 percent bracket. We think that under the plain provisions of section 117(b) the property in question had been "held" by petitioners since 1921, which was more than ten years prior to the sale thereof in 1934. In making his determination in this respect the Commissioner has followed his I.T. 3041, reported in C.B. 1937-1, p. 148. We think this determination is correct.

*1145 The respondent's determinations in Docket Nos. 92957 and 92958, in so far as they relate to the second issue, are sustained. Cf. Paul and Mertens, vol. 2, sec. 19.16.

*951 Issue 3. - The respondent must be sustained as to this issue upon the authority of Helvering v. Wilshire Oil Co.,308 U.S. 90, and F.H.E. Oil Co. v. Helvering,308 U.S. 104.

Issue 4 - Richter Exchange. - The assignment of error as to this issue in Docket Nos. 94689 and 94690, as far as it relates to the Richter exchange, is the same, namely: "Respondent erroneously determined that Petitioner and wife [husband in Docket No. 94690] received taxable income in the year 1936 in the sum of $858.46, by reason of an exchange of an interest in an oil and gas lease for an oil payment." The facts are set out in our findings and need not be repeated.

Petitioners contend that the exchange of their working interest (except for a reservation of one-fourth of seven-eights of production until oil of the value of $4,000 was received) in the Richter "A" lease, together with all the leasehold equipment and personal property located thereon, for two certain oil payments*1146 of $6,500 and $8,500 to be derived from oil when, as, and if produced from the Richter "B" and "C" leases, respectively, constituted a nontaxable exchange under section 112(b)(1) of the Revenue Act of 1936. This contention must be decided against petitioners, upon the authority of Midfield Oil Co.,39 B.T.A. 1154. All that we said in that case is substantially applicable here. Petitioners, however, further contend that:

There is an additional reason why taxable gain cannot be recognized from the Richter transaction. Mr. Fleming received a contingent oil payment depending entirely upon production of oil and cannot be required to treat the receipt of such an interest in property as taxable gain under Rocky Mountain Development Company v. Commissioner,38 B.T.A. 1303. Instead, he is entitled to apply all of his receipts from the oil payment to liquidate the cost of the property exchanged and is required to report only the excess when received as income.

The respondent objects to this further contention upon the ground that it is untimely, untenable, not raised by the pleadings and is presented for the first time in petitioners' brief.

*1147 We think petitioners' additional contention is within the assignment of error, and should be sustained. In Edwards Drilling Co.,35 B.T.A. 341; affd., 95 Fed.(2d) 719, we said: "The fact that the rights had a fair market value does not of itself require that the amount thereof be accrued as taxable income." In the instant proceedings, the respondent not only attempts to tax petitioners on what he terms as the value of the two oil payments to be received from the Richter "B" and "C" leases, when, as, and if produced, but also attempts to tax petitioners on the value of what they reserved in the Richter "A" lease. We think this constitutes error on the part of the respondent. Columbia Oil & Gas Co.,41 B.T.A. 38, 46. We decide this issue, in so far as it relates to the Richter *952 exchange, for the petitioners. There will be no taxable income from this exchange to petitioners until they have recovered from the contingent oil payments, the cost basis of the property which they gave in exchange for the contingent oil payments. Cf. *1148 Rocky Mountain Development Co., supra.

Como Exchange. - Very little need be said regarding this transaction. It should be noted, however, that petitioners in this transaction received in exchange for contingent oil payments an outright working interest in the Como lease. There was nothing contingent about this working interest which they received. In that respect it is unlike the contingent oil payments which petitioners received in the Richter exchange discussed above. Petitioners likewise contend that this exchange is nontaxable under section 112(b)(1) of the Revenue Act of 1936. They concede that Midfield Oil Co., supra, is adverse to such a contention but argue that the decision in that case is not warranted by the legislative history of the act. We will abide by our former decision. We hold, therefore, that the Como exchange was a taxable exchange, and, since petitioners have offered no evidence to show that the respondent erred in computing the taxable profit of $22,532.29 as set out in our findings, we affirm the respondent's determination on this point.

The deficiencies should be redetermined in accordance with this report.

*1149 Decisions will be entered under Rule 50.