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Parties Involved:
Ila I. Gail
Appellant
United States of America
Appellee

Document Text:

PUBLISH 

UNITED STATES COURT OF APPEALS 

TENTH CIRCUIT 

ILA I. GAIL, ) 

) 

Plaintiff-Appellant, ) 

) 

v. ) No. 

) 

UNITED STATES OF AMERICA, ) 

) 

Defendant-Appellee. ) 

FILED 

Ualtecl StaMI tout of Appeab 

Tntll Clrc•it 

JUN 2 7 1995 

PATRICK FISHER 

Clerk 

93-4234 

APPEAL FROM THE UNITED STATES DISTRICT COURT 

FOR THE DISTRICT OF UTAH 

(D.C. No. 92-CV-979) 

J. Franklin Allred of Salt Lake City, Utah, for PlaintiffAppellant. 

Patricia M. Bowman, Department of Justice, Tax Division, 

Washington, D.C., (Loretta C. Argrett, Assistant Attorney General, 

and David English Carmack, Department of Justice, Tax Division, 

Washington D.C., with her on the brief). 

Before KELLY, BARRETT, and HENRY, Circuit Judges. 

HENRY, Circuit Judge. 

Taxpayer Ila Gail appeals the district court's summary 

judgment order characterizing the proceeds of a judgment in a 

fraud and conversion action as income. We have jurisdiction 

pursuant to 28 U.S.C. § 1291. For the reasons set forth below, we 

reverse in part and remand to the district court. 

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Appellate Case: 93-4234 Document: 01019279877 Date Filed: 06/27/1995 Page: 1 
BACKGROUND 

Mrs. Gail is an elderly woman who owned an undivided one-half 

interest in ninety-six acres of real property in Trumball County, 

Ohio. When Mrs. Gail moved to Utah, the owner of the other onehalf interest forged her name on a power of attorney form and 

executed an oil and gas lease to a development company. The 

developer found that the land was rich in natural gas and 

extracted the gas. However, the owner of the other one-half 

interest did not tell Mrs. Gail about the development activities 

or pay her any of the proceeds. 

When she did become aware of the drilling activity, Mrs. Gail 

filed an action against the co-owner and the developer in Ohio 

state court. She alleged that the oil and gas lease was "invalid" 

and that it therefore did not convey her interest in the property. 

She further alleged that she had not received any royalties from 

the lease and that the defendants had converted the gas and 

royalties for their own use. Mrs. Gail sought to recover damages 

for "royalties not paid to plaintiff to date pursuant to the oil 

and gas lease, and for plaintiff's share of all other value which 

defendant . . . has derived from the oil and gas lease." Appl ts. 

App. at 78A. Finally, Mrs. Gail's complaint included a general 

prayer for compensatory damages for "trespass, fraud, oil and gas 

well royalties, and rental income under the lease." Id. 

During closing argument, Mrs. Gail's attorney asked the jury 

to compensate Mrs. Gail for unpaid royalties and for the loss of 

choice as to whether to develop the land in the future. "They 

didn't give her the right to decide whether [the gas] should 

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Appellate Case: 93-4234 Document: 01019279877 Date Filed: 06/27/1995 Page: 2 
remain; didn't give her the right to decide what should be done 

with it, whether the property should be sold with those reserved 

[sic] on it. They just took her gas and oil. 11 Id. at 104. At 

the close of the trial in the Ohio action, the trial court 

submitted fraud and conversion claims to the jury. Mrs. Gail 

prevailed, ultimately recovering $250,000 in compensatory damages 

and $65,000 in punitive damages.1 

When Mrs. Gail failed to declare the judgment as income, the 

government alleged a deficiency. Mrs. Gail paid the alleged 

deficiency and filed an action in United States District Court for 

the District of Utah seeking a refund pursuant to 28 U.S.C. § 

1346. Although the government and Mrs. Gail agreed that the 

punitive damages should be characterized as income, they disagreed 

as to whether the compensatory damages should be characterized as 

income or a capital gain. In its summary judgment order, the 

district court noted that proceeds from a conversion judgment for 

gas in place are characterized as a capital gain while the 

proceeds from the production of gas are characterized as income. 

See, e.g., Anderson v. Helvering, 310 U.S. 404, 407 (1940) ( 11 The 

production of oil and gas . . . is treated as an income-producing 

operation, not as a conversion of capital investment as upon a 

1 The jury returned verdicts of $250,000 in compensatory 

damages and $250,000 in punitive damages against the fraudulent 

co-owner and the developer. After the final judgment, the parties 

settled the matter for $315,000. Mrs. Gail and the government 

agree that only $65,000 of the settlement represents punitive 

damages. The government allowed Mrs. Gail to take a 15% depletion 

allowance on the $250,000 of compensatory damages, but not the 

punitive damages. 

3 

Appellate Case: 93-4234 Document: 01019279877 Date Filed: 06/27/1995 Page: 3 
sale."). The district court next observed that while the jury 

instructions in the Ohio action did not state whether the 

conversion was of gas in place or gas removed, Mrs. Gail's 

attorney had used language in closing argument suggesting that 

Mrs. Gail was asking to be compensated for the value of the gas 

produced from her land. Specifically, the district court noted 

that her attorney had asked for "royalties." Based upon the 

complaint and the closing argument, the district court held that 

the judgment compensated Mrs. Gail for unpaid royalties for gas 

removed from the property rather than for the diminution in the 

value of her property, and therefore characterized the judgment as 

income. 

DISCUSSION 

The only issue on appeal is whether the proceeds from the 

judgment should be characterized as income or a capital gain. 

This is a close question that few courts have examined in the oil 

and gas context. We review the district court's grant of summary 

judgment de novo. Boone v. Carlsbad Bancorporation. Inc., 972 

F.2d 1545, 1550 (lOth Cir. 1992). 

Our general rule for characterizing the proceeds of a 

judgment for tax purposes focuses upon what the judgment replaces. 

Gilbertz v. United States, 808 F.2d 1374, 1378 (lOth Cir. 1987). 

In making this inquiry, we ask: "In lieu of what were the damages 

awarded" and characterize the judgment accordingly. Id. (quoting 

Raytheon Prod. Corp. v. C.I.R., 144 F.2d 110, 113 (1st Cir.), 

cert. denied, 323 U.S. 779 (1944)). 

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The most relevant Supreme Court case is C.I.R. v. Gillette 

Motor Co., 364 U.S. 130 (1960). In Gillette, the government took 

control of a taxpayer's trucking business during World War II to 

advance the war effort. When the Federal Claims Commission 

awarded the taxpayer damages for the period in which the 

government controlled the company, the taxpayer characterized the 

damage award as a capital gain. The Gillette Court disagreed, 

holding that the damage award was more like rent than it was the 

sale of a capital asset. Id. at 135. The Court reasoned that 

11 [h) ad the Government taken a fee in those facilities, or damaged 

them physically beyond the ordinary wear and tear incident to 

normal use, the resulting compensation would no doubt have been 

treated as gain from the involuntary conversion of assets." Id. 

(citing Henshaw v. C.I.R., 23 T.C. 176 (1954)) (emphasis added). 

Henshaw is the leading oil and gas tax characterization case. 

In Henshaw, the taxpayers recovered a judgment when another party 

drilled on adjacent land connected to the same oil pool and 

destroyed the taxpayers' ability to recover oil from their 

property. The trial court that had presided over the conversion 

action had instructed the jury to determine the diminution of 

value to the taxpayers' property and the jury had found that the 

property had been damaged. Relying upon the rule that proceeds 

from oil and gas in place are considered capital assets rather 

than income, the tax court held that the judgment should be 

considered a capital gain because the other party's action 

destroyed the value of oil reserves still in the ground. Henshaw, 

23 T.C. at 181-82. 

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Appellate Case: 93-4234 Document: 01019279877 Date Filed: 06/27/1995 Page: 5 
The government relies mainly upon Henshaw for the proposition 

that the pleadings and language of the Ohio action control the 

characterization of a judgment for tax purposes. We cannot agree 

that the potentially confusing language of the Ohio proceeding is 

dispositive in characterizing the entire judgment as income, for 

two reasons. First, while it may have been proper at the time of 

Henshaw to rely upon "magic words" in a complaint, notice pleading 

under the rules of civil procedure and the tax code now emphasize 

function instead of form, and economic reality rather than labels. 

See, e.g .. Alexander v. City of Chicago, 994 F.2d 333, 340 (7th 

Cir. 1993) (holding that there is no need to plead magic words in 

notice pleadings); Kirchman v. C.I.R., 862 F.2d 1486, 1491 (11th 

Cir. 1989) ("[T]he general notion that courts should look at the 

substance of a transaction rather than just its form" has become 

accepted.); Carr Staley, Inc. v. United States, 496 F.2d 1366, 

1375 (5th Cir. 1974) ("Taxation should be based on the economic 

realities of the particular commercial transaction involved."), 

cert. denied, 420 U.S. 963 (1975) .2 

Second, the term "royalties" in the context of the conversion 

action is confusing and inconsistent with the district court's 

2 At oral argument, the government conceded that its entire 

argument was based upon the "magic words" that Mrs. Gail's 

attorney used in his pleadings and at trial in the Ohio action. 

In fact, the government represented that it would not have 

contested Mrs. Gail's characterization of the judgment but for her 

attorney's language. We find the government's position 

inconsistent with the prevailing approach emphasizing economic 

reality rather than self-serving labels and question the wisdom of 

concentrating upon statements made during the heat of trial 

advocacy. 

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Appellate Case: 93-4234 Document: 01019279877 Date Filed: 06/27/1995 Page: 6 
holding in this case. The government argues that Mrs. Gail used 

the term "royalties" in her complaint and that her attorney used 

the term three times in his closing statement in the Ohio action, 

suggesting that Mrs. Gail's suit sought royalties--which are 

clearly income--rather than compensation for the diminution of 

value for her property. 

However, the government's reliance on the "royalties" 

language to characterize the entire judgment is difficult to 

reconcile with the usual use of that term and the size of the 

judgment. One commentator notes that royalties on oil and gas 

leases generally range from 3/16 to 3/8 depending upon the 

jurisdiction, the bargaining power of the parties, and the amount 

of bonus payments. Richard W. Hemingway, Law of Oil and Gas § 

2.5, at 58 n.89 (3d ed. 1991). In this case, the jury awarded 

Mrs. Gail more than the fractional value of production she would 

have received as a royalty. It is therefore clear that the jury 

did not only award Mrs. Gail royalties. In addition, Gilbertz 

suggests that the issue in this case is not whether Mrs. Gail's 

attorney used certain magic words in the Ohio action; the issue is 

whether Mrs. Gail's judgment actually represents gas production or 

the diminution to the value of her real property.3 

3 Examining the purpose of the capital gains tax does not add 

much light to the issue. "[T]he purpose behind capital gains 

treatment is to avoid the hardship of taxing as income in one year 

the entire gain due to appreciation of value of a capital asset 

over a considerable period of time." Wood v. United States, 377 

F.2d 300, 304-05 (5th Cir.) (citing Burnett v. Harmel, 287 U.S. 

103, 106 (1932)), cert. denied, 389 U.S. 977 (1967). Ostensibly, 

this rationale would suggest that an oil and gas conversion action 

would produce income rather than capital gains. Indeed, in 

Burnett, the Supreme Court explicitly stated that the rationale 

behind the capital gains tax does not apply to the production of 

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Mrs. Gail makes two arguments in support of the proposition 

that she is entitled to characterize the entire judgment as a 

capital gain. She first argues that she is entitled to capital 

gains treatment because the conversion of her gas was involuntary 

like Henshaw. Mrs. Gail is inviting us to create a rule that all 

judgments in lieu of involuntary conversions be accorded capital 

gains treatment. We must decline this invitation because it is 

contrary to the more particularized inquiry we adopted in 

Gilbertz. 

Mrs. Gail's second argument is that the entire judgment 

represents the diminution to the value of her real property and 

oil and gas: 

It is an incident of every oil and gas lease, where 

production operations are carried on by the lessee, 

that the ownership of the oil and gas passes from. 

the lessor to the lessee at some time and the 

lessor is compensated by the payments made by the 

lessee . . . . But notwithstanding this incidental 

transfer of ownership, it is evident that the 

taxation of the receipts of the lessor as income 

does not ordinarily produce the kind of hardship 

aimed at by the capital gains provision of the 

taxing act. Oil and gas may or may not be present 

in the leased premises, and may or may not be found 

by the lessee. If found, their abstraction from 

the soil is a time-consuming operation and the 

payments made by the lessee to the lessor do not 

normally become payable as the result of a single 

transaction within the taxable year, as in the case 

of a sale of property. 

Burnett, 207 U.S. at 106. However, the judgment in this case 

is strikingly unlike the ordinary production of oil and gas 

that Burnett discusses because Mrs. Gail received all the 

proceeds of the gas production in a single year. For this 

reason, the tax consequences of this case seem more like 

those of a sale of land than a mineral lease. 

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that she is therefore entitled to characterize the judgment as a 

capital gain. Again, she invokes Henshaw, maintaining that both 

cases involve involuntary conversions of oil and gas and that the 

only difference between her judgment and the judgment in Henshaw 

is that her gas has been extracted while the judgment in Henshaw 

was based upon actions that made the gas unrecoverable.4 

In assessing this argument, it is helpful to consider the 

extraction of gas from Mrs. Gail's property in economic terms. 

Before the gas was extracted, if information were perfect, Mrs. 

Gail's property would have been appraised at roughly the value of 

the gas that could be produced from the land plus the residual 

value of the land for other purposes, minus production costs.5 If 

the jury awarded Mrs. Gail the value of the gas produced from her 

property as damages, she would then have had the value of the 

4 Mrs. Gail also cites Maixner v. C.I.R., 33 T.C. ~9~ (~959), 

for the proposition that an involuntary taking of private property 

that results in the diminution to the value of the land creates a 

capital gain rather than income. However, Maixner appears to be 

inconsistent with our decision in Gilbertz v. United States, 808 

F.2d ~374 (~Oth Cir. ~987). In Gilbertz, we held that damage to 

income-producing real property should be characterized as income 

because the damages replaced income. Id. at ~380 n.8. In fact, 

we specifically noted in Gilbertz that the taxpayers admitted that 

the damage to the land for which they had been compensated 

resulted in lower annual income. Id. at ~377. 

Mrs. Gail's claim, however, is not inconsistent with 

Gilbertz. Unlike the taxpayers in Gilbertz and Maixner, Mrs. 

Gail's land was an idle asset rather than income-producing 

property. Instead of losing annual income, Mrs. Gail lost the 

ability to sell her undeveloped land or develop her land as she 

chose in the future. 

5 We are aware that the uncertainty regarding gas development 

would likely discount the sale value of the land until the gas 

reserves are confirmed. However, in this peculiar case, the jury 

was entitled to value the property based upon the information the 

illegal development made available. 

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extracted gas and the value of the residual land. The only 

economic difference between the two scenarios would therefore be 

production costs, and production costs are irrelevant to our 

discussion. 

These economic considerations suggest that Mrs. Gail's 

attorney's reference to the extracted gas in his closing argument 

in the Ohio action may simply have been an attempt to explain the 

degree of diminution in the value of the land to the jury. We 

also believe that the term "royalty" is too ambiguous to be 

dispositive as to the entire judgment in this case. In addition, 

we cannot think of any superior method of appraising the converted 

property in this case that does not reference the extracted gas. 

Finally, we agree with Mrs. Gail's attorney in the Ohio action 

that what Mrs. Gail actually lost was an option to develop her 

land in the future and that the loss of this option diminished the 

value of her real property. Mrs. Gail lost the choice as to 

whether, when, and how she would develop her land.6 

We are therefore unwilling to conclude, as the government 

urges, that Mrs. Gail's successful prosecution of the Ohio action 

6 To a large degree, equitable considerations also support Mrs. 

Gail's argument for treating the judgment as a capital gain in 

this case. But for the fraud and conversion, Mrs. Gail could have 

produced gas while taking advantage of a number of tax-minimizing 

strategies. If Mrs. Gail was wealthy, for example, she may have 

utilized tax planning and reduced her tax burden by making 

charitable contributions. If she was of more modest means, she 

would likely have the advantage of lower marginal income tax rates 

as suggested in Burnett, because the gas would have been produced 

over a number of years. Regardless, she could have maintained the 

land without developing it during her life and devised it after 

her death. The devisee could then have sold the land containing 

the gas reserves--perhaps without paying any taxes at all. 

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should subject her to the highest marginal income tax rate for the 

production of oil and gas she did not choose to undertake, 

especially considering that the gas took a number of years to 

produce and that she had to accept the risks and costs of 

litigation to recover the judgment.? In our view, the 

government's approach would allow the government to benefit 

unjustly from Mrs. Gail's misfortune by acting as a free rider in 

her legal battle. 

Nevertheless, we cannot agree with Mrs. Gail that the entire 

judgment should be characterized as a capital gain. In her 

complaint in the Ohio action, Mrs. Gail clearly sought to recover 

royalties under the fraudulently executed oil and gas lease. In 

addition, in instructing the jury, the Ohio trial court expressly 

defined royalties under an oil and gas lease as personal property, 

7 We note that it is more difficult for a taxpayer to avoid a 

taxable event under 26 U.S.C. § 1033 for the conversion of 

minerals than it would be for the conversion of other assets. In 

the case of securities, for example, it is a simple thing to 

replace shares of stock because they are fungible--one share of 

General Motors stock is as good as any other. Minerals, however, 

are unique, much like the real property to which they are 

attached. See United States v. Peters, 777 F.2d 1294, 1304 (7th 

Cir. 1985) (Coffey, J., concurring and dissenting) (citing SA 

Corbin on Contracts § 1143, at 126 (1964), and noting that 

specific performance is an appropriate remedy in a breach of 

contract case involving real property because land is unique) . In 

addition to the difficulty of finding a suitable piece of land 

with comparable mineral resources, the transaction costs would 

likely be greater in the case of gas-producing land than it would 

be with securities. Whether Mrs. Gail could have avoided a 

taxable event under Section 1033 by investing in a fungible asset 

that does not distribute dividends, such as long-term gas futures, 

is an interesting question commentators may wish to consider. 

Such an approach would have the advantages of restoring the 

taxpayer and the government to the positions they formerly 

occupied. 

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which can be converted and for which Mrs. Gail would be entitled 

to compensation.8 Applts. App. at 87. Finally, the cash judgment 

provided Mrs. Gail with advantages, such as liquidity and the 

potential to diversify her investments, that an undeveloped tract 

of land does not.9 It thus seems clear that Mrs. Gail ratified 

the fraudulent lease and that some part of her judgment 

represented the royalties to which she was entitled under that 

lease. 

CONCLUSION 

Based upon the foregoing analysis, we believe that the 

judgment represents both unpaid royalties and compensation for the 

diminution to the value of real property. We therefore hold that 

Mrs. Gail must characterize the royalties she would have received 

from the lease at issue as income, but that she is entitled to 

characterize the remainder of the judgment as a capital gain. 

8 Ohio provides a constructive trust remedy in connection with 

forgery and fraud. See Jacobsen v. Jacobsen, 131 N.E.2d 833, 835 

(Ohio 1956) (citing Seeds v. Seeds, 156 N.E. 193 (Ohio 1927)). It 

is therefore possible to conceptualize the Ohio action as having 

created a constructive trust to hold the royalties to which Mrs. 

Gail is entitled and then treating those royalties as income. 

9 One could argue that Mrs. Gail received a larger share of the 

profits from the Ohio judgment than she would have had she simply 

received royalties, and that she was thus not disadvantaged by the 

defendant's action. However, this argument is not convincing for 

two reasons. First, Mrs. Gail might never have become aware of 

the conversion and also had to accept the risks and costs of 

litigation in order to recover the judgment. Second, the parties 

involved in these two matters are different. The Ohio action 

resolved the distribution of proceeds among Mrs. Gail, the 

fraudulent co-owner and the developer. This case, on the other 

hand, regards the distribution of Mrs. Gail's proceeds between 

Mrs. Gail and the government. 

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This realistic approach to this difficult issue builds upon 

Henshaw, reconciles the confusing state court proceedings, 

recognizes the economic reality of the transaction, and has 

obvious equitable appeal as well. 

We therefore REVERSE and REMAND to the district court to 

allocate the judgment between royalties under the contract and the 

diminution in value to Mrs. Gail's land. 

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