CITE AS: Crooks v. Commissioner, 92 T.C. 816
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RICHARD WAYNE CROOKS AND MAXINE L. CROOKS, PETITIONERS v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Docket No. 2055-87. Filed April 17, 1989.
Petitioners owned a farm under which oil was discovered in 1981. In
1982, petitioners conveyed all of their interest in the minerals
underlying the farm to Henry Energy Corp. in consideration for four other
farms, new farm equipment, and a one-fourth royalty interest in all oil
and gas produced from the conveyed mineral interest. Held: Petitioners
retained an economic interest in the minerals underlying the farm by
retaining a right to receive a specified percentage of all the oil and gas
produced. Petitioners looked solely to the extraction of the minerals
underlying the farm for a return of their capital (sec. 1.611-1(b), Income
Tax Regs.) and, as such, the four farms and the farm equipment received by
petitioners are considered a lease bonus for Federal income tax purposes
and will be taxable to petitioners as ordinary income. Held further, there
was no "sale or exchange" and no "gain or loss" within the meaning of sec.
1031, I.R.C. 1954, to permit nonrecognition of the value of the four farms
received by petitioners.
William C. Jones, for the petitioners.
Michael W. Bitner, for the respondent.
GOFFE, Judge: The Commissioner determined deficiencies in petitioners'
Federal income taxes for the following taxable years:
Taxable year Deficiency
------------ ----------
1982 $733,357.81
1983 3,128.85
Petitioners have conceded the Commissioner's adjustments in
disallowing, in 1983, utility expenses in the amount of $1,515.60,
gasoline expenses in the amount of $520, and depreciation expense in the
amount of $3,222, and have conceded an increase in the investment tax
credit for 1983 in the amount of $500.30. There are no issues remaining
for our decision for the taxable year 1983. After concessions, the issues
remaining for decision are: (1) Whether petitioners retained an economic
interest in the minerals underlying the Brown County farm; and, (2)
whether the conveyance of the minerals underlying the Brown County farm in
consideration for four parcels of real property is a like-kind exchange
under section 1031. <>
OPINION
This case was submitted fully stipulated under Rule 122. The
stipulation of facts and accompanying exhibits are incorporated by this
reference.
Petitioners resided in La Prairie, Illinois, at the time of the filing
of the petition in this case.
In 1981, oil was discovered in Brown County, Illinois. Petitioners
owned, and continue to own, a 160-acre farm located in Brown County. As a
result of the discovery of oil, petitioners entered into an agreement on
October 15, 1982, with Henry Energy Corp. whereby petitioners agreed to
convey all of their mineral rights in the 160-acre farm to Henry Energy
Corp. in consideration for four farms located in Adams County, Illinois,
and new farm equipment. Upon consummation of this transaction and pursuant
to the agreement, Henry Energy Corp. also agreed to convey to petitioners
one-fourth of any oil or gas, on and under, and to be produced and saved
from the mineral interest underlying the Brown County farm. The four Adams
County farms and the new farm equipment described in the agreement had a
value, as of October 15, 1982, of $1,676,800 and $235,804.34,
respectively.
The conveyance of the minerals was completed by way of a mineral deed
dated December 13, 1982. In addition, on December 13, 1982, Henry Energy
Corp. conveyed to petitioners by quitclaim deed the four Adams County
farms and the new farm equipment. On that same date, pursuant to the
agreement, Henry Energy Corp. executed a conveyance of the one-fourth
royalty interest to petitioners.
On their 1982 joint Federal income tax return, Schedule D, petitioners
reported a long-term capital gain (as "mineral ownership in 160 acres") in
the amount of $235,804.34, with a taxable gain of $94,322. The former
amount represented the value of the items of farm machinery received by
petitioners from Henry Energy Corp. pursuant to the October 15, 1982,
agreement. Petitioners did not report the receipt of the four Adams County
farms nor the royalty from Henry Energy Corp. on their 1982 joint Federal
income tax return on the theory that petitioners' receipt of the four
Adams County farms was a like-kind exchange for the mineral interest in
the 160-acre Brown County farm.
The Commissioner determined that the October 15, 1982, agreement
between petitioners and Henry Energy Corp. was a lease, and that the value
of the property received by petitioners from Henry Energy Corp. (the four
Adams County farms and the new farm equipment) was a lease bonus, taxable
to petitioners as ordinary income. The Commissioner increased petitioners'
1982 taxable income in the amount of $1,818,282 (i.e., $1,676,800 +
($235,804 - $94,322)).
The first issue for our decision is the characterization, as ordinary
income or capital gain, of the value of the property received by
petitioners. This characterization depends upon whether the agreement is a
sale or a lease for Federal income tax purposes, which is ultimately
determined by whether petitioners retained an economic interest in the
minerals underlying the Brown County farm.
When a mineral interest is assigned for a lump-sum cash consideration
and the assignor retains a right to receive a specified percentage of all
oil and gas produced for the economic life of the mineral deposit, the
transaction is a lease and payments received under such lease are ordinary
income. Burnet v. Harmel, 287 U.S. 103 (1932). The cash or other
consideration paid to the lessor upon execution of the lease and before
actual production is treated as an advance royalty or bonus and is
ordinary income subject to depletion. Herring v. Commissioner, 293 U.S.
322, 325 (1934). However, when a mineral interest is assigned for a cash
consideration and no interest is reserved, the transferor has alienated
his economic interest therein. In that instance, the cash payment cannot
be considered an advance royalty, but rather is consideration for the
transferor's assignment of all of his interest. Commissioner v. Fleming,
82 F.2d 324 (5th Cir. 1936), affg. 31 B.T.A. 623 (1934); Day v.
Commissioner, 54 T.C. 1417, 1423 (1970) (relying upon principles of oil
and gas taxation); Glenn v. Commissioner, 39 T.C. 427, 443 (1962). Thus,
the interest retained by the transferor is the primary distinction between
a sale and a lease. Whether the instrument creating the interest is a
lease, a sublease, or an assignment has not been deemed significant in
deciding whether or not the taxpayer had an economic interest in the oil
in place. Palmer v. Bender, 287 U.S. 551, 557, 558 (1933).
The standard defining the interest retained was set forth in Palmer v.
Bender, supra. A taxpayer need not have legal title to the property to
have an economic interest. "It is enough if, by virtue of the leasing
transaction, he has retained a right to share in the oil produced. If so
he has an economic interest in the oil, in place, which is depleted by
production." Palmer v. Bender, supra at 557. Section 1.611-1(b), Income
Tax Regs., has codified this economic interest standard.
An economic interest is possessed in every case in which the taxpayer has
acquired by investment any interest in mineral in place or standing timber
and secures, by any form of legal relationship, income derived from the
extraction of the mineral or severance of the timber, to which he must
look for a return of his capital.
The parties in the instant case do not dispute that petitioners possessed
an interest in the minerals in place. We must, therefore, decide whether
petitioners retained an economic interest in the minerals underlying the
Brown County farm and, if so, whether they may look to some source other
than income derived from extraction of the minerals as a source of return
of their capital. By "return of their capital" we refer to the portion of
petitioners' cost of the Brown County farm allocable to the minerals which
they conveyed to Henry Energy Corp. However, before we decide this
question, we will address the preliminary issues raised in petitioners'
brief.
Petitioners contend that we must look to the law of the State of
Illinois in deciding whether petitioners retained an economic interest in
the minerals conveyed. We need only point out that State law is not
controlling in deciding this issue. Bankers' Pocahontas Coal Co. v.
Burnet, 287 U.S. 308 (1932); Burnet v. Harmel, supra at 110.
Petitioners point out that other opinions of the Supreme Court and of
this Court that have considered this sale-versus-lease issue have only
addressed the economic interest question with respect to cash payments
being received. They point out that, in the instant case, in consideration
for the mineral interest, petitioners received four parcels of real
property and, therefore, such property should not be considered a lease
bonus. Although the issue of whether real or personal property constitutes
a lease bonus has not been previously decided, we do not feel that a
distinction exists. Section 61(a) defines gross income as "all income from
whatever source derived." Therefore, if an economic interest is retained
in property, and cash or other consideration is received prior to
production of minerals from such property, the cash or other consideration
will be a lease bonus taxable as ordinary income.
Petitioners also contend that we should look to the following factors
in deciding whether the agreement is a sale or a lease: (1) All of the
minerals underlying the Brown County farm were conveyed; (2) Henry Energy
Corp. was under no obligation to exploit or develop the Brown County farm
for oil, gas, or other minerals; (3) it was the intention of petitioners
in executing the agreement and the mineral deed to acquire the four
parcels of real property and not to receive royalties; (4) petitioners
imposed no development duties upon Henry Energy Corp. and possessed no
right of reversion to the minerals; and (5) words denoting a sale or
exchange were used in the agreement.
In short, petitioners would have us decide the instant case based upon
a quantitative analysis of whether the agreement is a sale or a lease.
Whether the agreement is a sale or a lease may be indicative of the
result, it is by no means determinative for Federal income tax purposes.
The distinction between a sale and a lease for Federal income tax purposes
depends upon whether the transferor retains an economic interest in the
property transferred. This economic interest concept was enunciated and
refined by the Supreme Court in cases involving hydrocarbons. Herring v.
Commissioner, supra, Palmer v. Bender, supra, Bankers Pocahontas Coal Co.
v. Burnet, supra, Murphy Oil Co. v. Burnet, 287 U.S. 299 (1932); Burnet v.
Harmel, supra. However, in cases involving solid mineral interests, it
appears that many courts have been reluctant to follow the economic
interest approach and have based their decisions upon factors which
petitioners would have us look to in deciding the instant case. Wood v.
United States, 377 F.2d 300, 304 n. 7 (5th Cir. 1967); P. Maxfield & J.
Houghton, Taxation of Mining Operations, sec. 8.03[1][a] (1988). The test
to be applied in hydrocarbon cases in deciding the Federal income tax
treatment of cash or other consideration received before actual production
in a sale-versus-lease context is whether an economic interest is
retained.
In the instant case, we must decide whether petitioners retained an
economic interest in the minerals underlying the Brown County farm. If
petitioners retain a royalty in this mineral property, Kirby Petroleum Co.
v. Commissioner, 326 U.S. 599 (1946) (net-profits interest); Palmer v.
Bender, supra (royalty); Hogan v. Commissioner, 141 F.2d 92 (5th Cir.
1944), affg. a Memorandum Opinion of this Court (overriding royalty), and,
if they have no alternate source of recovery of their capital in the
minerals underlying the Brown County farm, Anderson v. Helvering, 310 U.S.
404 (1940), the economic interest test will be satisfied. Petitioners have
sought to divest themselves of this economic interest through two
transactions: (1) They purportedly sold the mineral interest underlying
the Brown County farm to Henry Energy Corp.; and (2) they received a
royalty from this mineral interest. Although couched in terms of a sale of
minerals with a subsequent conveyance of a one-fourth royalty to
petitioners, we cannot ignore the substance of the transaction: for
Federal income tax purposes petitioners leased their interest in the
minerals underlying the Brown County farm and retained a one-fourth
royalty of any and all production of oil and gas.
In addition, petitioners must look solely to the extraction of the
minerals underlying the Brown County farm for a return of their capital.
Anderson v. Helvering, supra. Thus, if petitioners do not bear the
ultimate risk of loss for failure of production, regardless of the form of
the transaction, no economic interest will exist. In Anderson, the leading
case in this area, the Supreme Court decided that the taxpayer did not
have an economic interest in the minerals in place because the taxpayer
had the right to receive the production payment, not only from the oil and
gas produced, but also from the sales proceeds of another property
interest. In a further refinement of this principle, the Seventh Circuit
Court of Appeals decided that additional security in the form of sales
proceeds from the disposition of the mineral estate is too unlikely to be
availed of to count against the existing economic interest. Standard Oil
Co. (Indiana) v. Commissioner, 465 F.2d 246 (7th Cir. 1972), affg. 54 T.C.
1099 (1970). Thus, if petitioners do not have to look solely to production
for a return of their capital, they have disposed of their economic
interest.
Petitioners contend in their brief that they could look to sources
other than the extraction of oil or gas attributable to the royalty
interest for a return of their capital. These other sources include the
four Adams County farms and the farm machinery received by petitioners in
consideration for the mineral interest underlying the Brown County farm.
We find petitioners' argument untenable. Petitioners rely upon Anderson
in their contention that they may look to other sources for a return of
their capital. The issue in Anderson, as in the instant case, was whether
the owner of a mineral interest had made an outright sale or had made a
lease, retaining an economic interest in production. The Supreme Court
decided that no economic interest was retained because the contract
between the parties provided for payment to the taxpayer out of proceeds
which might be derived from oil and gas produced from the properties and
"from sales of the fee title to the land conveyed." Anderson v. Helvering,
supra at 412 (emphasis supplied). Decisions following Anderson have
followed this principle and have disqualified an economic interest when an
additional source of payment was provided as a supplement or an
alternative to production. Gibson Products Co. v. United States, 637 F.2d
1041 (5th Cir. 1981); Christie v. United States, 436 F.2d 1216 (5th Cir.
1971); Scofield v. LaGloria Oil & Gas Co., 268 F.2d 699, 708-709 (5th Cir.
1959). In Anderson and the hydrocarbon decisions following it, unlike the
instant case, the taxpayers were given the right to a supplemental or
alternative source for a return of their capital. Petitioners' receipt of
the four farms and farm equipment did not constitute supplemental or
additional security guaranteeing payment of the royalty. The agreement
entered into by petitioners merely reflects that the four farms and farm
equipment would be conveyed for the interest in the minerals underlying
the Brown County farm and, upon consummation of this transaction,
petitioners would receive a one-fourth royalty interest in such minerals.
There is a complete absence of any language in the agreement to the effect
that the proceeds from the four farms and farm equipment transferred to
petitioners shall be used in lieu of, or in the absence of, a royalty
payment. The facts clearly show that petitioners must look solely to the
extraction of the minerals underlying the Brown County farm for a return
of their capital in the minerals underlying the Brown County farm.
The language of the mineral deed suggests that petitioners transferred
an interest in real property. The Supreme Court held long ago that
although an oil and gas lease may constitute a conveyance of title to the
minerals under State law, cash received by the grantor is, nevertheless, a
lease bonus because the transaction as a whole is an oil and gas lease,
not the sale of a capital asset. Burnet v. Harmel, supra.
Petitioners retained an economic interest in the minerals underlying
the Brown County farm by retaining a right to receive a specified
percentage of all the oil and gas produced. Petitioners looked solely to
the extraction of the minerals underlying the Brown County farm for a
return of their capital. Therefore, the transaction between petitioners
and Henry Energy Corp. constituted an oil and gas lease.
Having decided that petitioners granted an oil and gas lease to Henry
Energy Corp., we must decide whether granting of the lease in
consideration for four parcels of real property is a like-kind exchange
under section 1031. Central to this issue is whether the granting of the
lease in consideration for the real property received is a "sale or
exchange of property" for purposes of section 1031.
Petitioners contend that the receipt of property by them in
consideration for their conveyance of a mineral interest to Henry Energy
Corp. is an exchange of property of like kind. Petitioners concede that
the fair market value of the farm equipment is taxable to them as ordinary
income.
For petitioners to prevail, they must show that, within the meaning of
section 1031, there was a sale or exchange. Section 1031 applies only when
the taxpayer has sustained a gain or loss from a sale or exchange. Having
held that the total transaction constituted a lease, it follows that there
has not been a sale or exchange. Petitioners realized no gain or loss. In
Pembroke v. Helvering, 23 B.T.A. 1176 (1931), affd. 70 F.2d 850 (D.C. Cir.
1934), the taxpayer was the owner of real property located in Ohio. In
1925, the taxpayer leased the property for a term of 99 years in
consideration of an annual rental and a conveyance of a fee interest in
other real estate. The taxpayer contended that the property received by
him was a like-kind exchange for the granting of the lease. The Board of
Tax Appeals decided that the transaction in question was not an "exchange
of properties" and that section 203 of the Revenue Act of 1926, a
predecessor of section 1031 of the 1954 Internal Revenue Code, did not
apply to the transaction. The Board decided, instead, that the transaction
was a lease for which the taxpayer received annual rent plus a lease bonus
represented by the real property received by him. Pembroke v. Helvering,
23 B.T.A. at 1178.
The facts in Pembroke are indistinguishable from the facts in the
instant case. In the instant case, having decided that the transaction
constituted a lease, it follows that the farms received from the lessee,
Henry Energy Corp., are a lease bonus and there has been no sale or
exchange within the meaning of section 1031.
We reaffirmed this portion of the Pembroke holding in Koch v.
Commissioner, 71 T.C. 54, 70 (1978). <> In Koch, the taxpayer
exchanged fee simple interests in real estate for real estate encumbered
by 99-year leases. Section 1.1031(a)-1(c), Income Tax Regs., provides that
the exchange of a leasehold with 30 or more years to run for a fee simple
interest in land is an exchange of property of like kind. The Government
contended that if the lessee's interest is equal to a fee interest then,
by negative inference, the lessor's interest is less than a fee interest.
The Court rejected the Government's argument, holding that section 1031
does not require that the exchanged property interests be equal. Although
the lessor's interest was not equal to that of the fee simple owner of
property not subject to a lease, the Court held that the lessor
nevertheless held fee simple title to the real estate. Relying upon
Pembroke, the Court stated, "The reason for the rule is that owner-lessor
does not part with his real property but merely transfers the right to use
it for a period of years. The execution of a long-term lease is not the
conveyance of a fee." Koch v. Commissioner, supra at 70.
The same rule applies in the instant case. When petitioners granted the
lease to Henry Energy Corp. they did not part with an interest in real
property for Federal income tax purposes, but merely transferred the right
to use such property. This holding is consistent with the prior decision
of the Board of Tax Appeals in Butler v. Commissioner, 19 B.T.A. 718, 728
(1930), when, in explaining the tax results of creating a lease, the Board
stated "that a lessee under a 99-year lease, renewable forever, does not,
by virtue of the execution of the lease, acquire any ownership of the
property which is the subject of the lease, despite the fact that such
leases are treated locally as in many respects like conveyances of the
fee."
Petitioners rely upon Crichton v. Commissioner, 42 B.T.A. 490 (1940),
affd. 122 F.2d 181 (5th Cir. 1941). In Crichton, the taxpayer conveyed an
undivided three-twelfths interest in the "oil, gas, and other minerals in,
on and under and that may be produced from" certain lands in consideration
for an undivided three-sixths interest in real property. The Board of Tax
Appeals decided that the exchange of a royalty interest in minerals for a
fee qualified as a like-kind exchange.
In the instant case, however, we do not have a situation in which a
taxpayer-lessor exchanged a royalty interest for real property.
Petitioners, as lessors, granted a lease of a mineral interest while
reserving a royalty in such interest in consideration for real property.
As we previously decided, the reservation of the royalty interest
characterizes the transaction as a lease rather than a sale of the mineral
interest. There is no gain or loss to which section 1031 could apply. The
execution of a lease does not give rise to a gain or loss. Had
petitioners, subsequent to the transaction with Henry Energy Corp.,
conveyed all or a portion of the one-fourth royalty interest in exchange
for an interest in real property, the exchange would then fall within the
ambit of Crichton and section 1031.
This analysis is consistent with section 1.1031(a)-1(c), Income Tax
Regs., which provides: "No gain or loss is recognized if * * * a taxpayer
who is not a dealer in real estate exchanges * * * a leasehold of a fee
with 30 years or more to run for real estate." The regulation contemplates
the transfer of an existing leasehold by the lessee, not the creation of a
leasehold. Only a lessee can transfer a leasehold interest, as
contemplated by the regulations, because the lessee owns the leasehold and
the lessor's property is subject to the leasehold. Petitioners, as
lessors, created a leasehold interest in favor of the lessee, Henry Energy
Corp. If Henry Energy Corp., subsequent to the transaction involved here,
exchanged the leasehold interest it acquired for a fee interest in real
estate, the Commissioner has held that such exchange would be nontaxable
under section 1031. Rev. Rul. 68-331, 1968-1 C.B. 352.
In accordance with this analysis, when a mineral interest is assigned
for real property and the assignor retains a right to receive a specified
percentage of all oil and gas produced for the economic life of the
mineral deposit, the transaction is a lease for Federal income tax
purposes. The granting of an oil and gas lease does not give rise to a
gain or loss. The real property received from the lessee as part
consideration for the lease is not an "exchange of property" under section
1031 and will, therefore, be taxable as a lease bonus as ordinary income.
Because our decision for the taxable year 1982 affects the amount of
the deficiency for the taxable year 1983 which was not taken into account
in the statutory notice of deficiency for such year,
Decision will be entered under
Rule 155.
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1/ Unless otherwise indicated, all section numbers refer to the
Internal Revenue Code in effect for the taxable year 1982, and all rule
numbers refer to the Rules of Practice and Procedure of this Court.
2/ Stahl v. Commissioner, T.C. Memo. 1987-323.
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