T.C. Mem o. 2 01 3- 27 2

UNITED STAT ES TAX COURT

MIC HAEL H. DUDEK AND BRENDA M. DUDE K, Peti ti on ers v. COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No . 95 99 -1 2. Fil edDecem be r 2, 2 01 3.

Mi ch ael H. Dud ek

an d B ren daM. Dud ek , pro se. Carr ie L. Klein

jan an d Em eral d G. Sm ith, fo r res po nd en t.

MEMORANDUM FINDINGS OF FACT AND OPINION RUWE , Ju dg e: Res po nd en t d et erm in eda $1 47 ,39 7 d efi ci en cy in pe ti ti on ers ’ 20 08 Fed eral in co m e ta x a nda $2 9,4 79 .40 accu racy-rela te d p en al ty- 2 -

[* 2] un de r se ct io n 6 66 2( a). The i ss ue s fo r de ci si on are: (1) whet he r th e p aym en t 1
rece iv edby pet it io ne rs pu rs ua ntto anoi l an d g as lea se ag reem en t i s t ax ab le as or di na ry in co m e o r as a cap it al ga in ; (2 ) whe th er p et it io ne rs are en ti tl edto a de pl et io n d educ ti on ; an d (3 ) whe th er p et it io ne rs are l iabl e fo r anaccu racy-rela te d pe na lty un de r se ct io n 6 66 2( a) fo r a s ub st an ti al un de rs ta te m en t o f in co m e ta x.

FINDINGS OF FACT So m e o f th e fac ts ha ve be enst ip ul at edan d a re s o fo un d. Th e st ip ul at io n o f fact s an d t he att ach edex hi bi ts are i nc or po rat edhe rei n b y

th is refe ren ce. At the ti m e th e p et it io n was fil ed , pet it io ne rs res id edinPen ns y lv an ia
. Mi ch ael H. Dud ek

(pe ti ti on er) i s a c ert ifi edpubl ic acco un tantli cen se d i n Pen ns y lv an iaan d a n a tt orne y li cen se d t o p ract ic e la w inPen ns y lv an ia
. On J anua ry

24 , 19 96 , pet it io ne rs pu rch as ed10 0 a cres inPen ns y lv an iafor $4 7,0 00 . This pro pe rty was s ub ject t o a n o il an d g as lea se with t he Ohi o Lea se Dev el op m en t Co . whi chex pi redon or abo utMarc h 1 4, 2 00 2. OnJan ua ry 24 , 19 96 , pet it io ne rs pu rch as ed20 1.5 acre s i n P en ns y lv an iafor$1 48 ,00 0. Th is pr op erty was a ls o s ub

ject t o a n o il an d g as lea se with t he Ohi o Lea se Deve lo pm en t Co . whi chex pi redon or abo utMarc h 1 4, 2 00 2. OnMay 27, 1 99 8, p et it io ne rs Unl es s o th erwi se in di cat ed , all sec ti on refe ren ces are t o t he Int ern al 1 Rev enue Co de ineffe ctforth e y ear i n i ss ue , andall Ru le refe ren ces are t o t he Tax Co urt Ru le s o f Prac ti ce an d P ro cedur e.- 3 -

[* 3] pu rch as ed51 .8 ac res inPen ns y lv an iafor$3 0,0 00 . In t ot al , pet it io ne rs own ap pr ox im at el y

35 3.3 acre s i n P en ns y lv an ia
. On Oct ob er 2 3, 2 00 8, p et it io ne rs en te redin to anoi l an d g as lea se ag reem en t (Ag reem en t) wi th EOG Reso ur ces , Inc . (EOG), inco nn ect io n wi th pe ti ti on ers ’ 35 3.3 acre s i n P en ns y lv an ia(pr op erty ). Und er the term s o f th e Agr eem en t, EOG
cande ve lo p t he pro pe rty anddri ll for , ext ract , andsel l an y ga s an d o il di sc ov ered
on th e p ro pe rty. E OG bea rs th e en ti re co stof e xp lo rat io n, d ev el op m en t, an d op erat io n o f th e p ro pe rty with res pe ctto th e p ro du ct io n o f oi l an d g as . Und er the te rm s o f th e Agr eem en t, p et it io ne rs are en ti tl edto a ro y al ty paym en t equa l t o 1 6% of th e n etpro fit s o f an y

oi l an d g as ex tra ct edfro m th e p ro pe rty. The pri m ary te rm

of the Agre em en t i s fi ve y ears . The t erm of t he Agr eem en t i s au to m at ic al ly ext en de d a s l on g the reaf te r as eit he r oi l o r ga s i s b ei ng pr oduc edfro m

th e p ro pe rty. T he term

of t he Agre em en t wi ll als o b e ex te nd edif EOG shut s i n an y

of t he well s. If any well i s s hu t i n, EOG m us t p ay pe ti ti on ers 2 $1 pe r acr e p er y ear. Parag rap h 1 7 o f th e Agr eem en t p ro vi de s tha t the term m ay be ex te nd edfor

anad di ti on al fiv e y ears . To ex erci se th e o pt io n fo r th e fi ve -y ear
A “ sh ut -in ” is th e te m

po rary clo su re o f a p ro du ci ng well , forrep ai r, 2 cl ean in g o ut , bu il di ng up res erv oi r pr es su re, o r a l ackof am ark et . See Ho wardR. W il li am s & Ch arl es J. Me y ers , Manua l o f Oil an d Gas Term s 1 05 8 (1 2t h e d. 20 03 ).- 4 -

[* 4] ex te ns io n, EOG wou ldbe requi redto pay pe ti ti on ers anex te ns io n p aym en t o f $2 ,50 0 p er ac re co ve redby the ex te nd edterm . In20 08 T.S. Calk in s & Ass oc ia te s (C al ki ns ), onbe ha lf o f EOG, ten de redto pe ti ti on ers a pa ym en t o f $8 83 ,25 0 t o i nduc e th em to en te r in to th e Agr eem en t. The paym en t was no t d ep en de nton an y ex tra ct io n o r pr oduc ti on of o il or g as . Cal ki ns tra ns m it te d aFo rm 10 99 -MI SC, Mi sc el lane ou s In co m e, to res po nd en t, whi chrep orte d t ha t Ca lk in s h adpa idpe ti ti on ers $8 83 ,25 0 i n 2 00 8. Pe ti ti on ers rep orte d t he $8 83 ,25 0 p aym en t as a lo ng -te rm cap it al ga in on th ei r 20 08 Fed eral in co m e ta x re tu rn . On J anua ry

17 , 20 12 , res po nd en t i ss ue d t o p et it io ne rs a no ti ce o f de fic ie nc y fo r 20 08 . Peti ti on ers ti m el y fil eda pe ti ti on di sp ut in g t he de te rm in at io ns inth e no ti ce o f de fic ie nc y . OPINION The Co m m is si on er’s d et erm in at io ns ina no ti ce o f de fic ie nc y are g en eral ly pr es um edco rrec t, an d t he tax pa y er b ears th e b ur de n o f pr ov in g tha t the de te rm in at io ns are i n e rro r. Ru le 14 2( a); W el chv. Hel ve rin g, 2 90 U.S. 11 1, 1 15 (1 93 3)
.- 5 -

[* 5] 1. Whethe r th e $ 88 3,2 50 Paym en t Is Ordi na ry Inc om e o r Cap it al Gain Pet it io ne rs arg ue th atth e $ 88 3,2 50 pa ym en t (h erei na fte r bo nu s p aym en t ) 3 th ey rece iv edas a n i nduc em en t t o e nt er i nt o t he Agre em en t s ho ul d b e ta xe d a s a lo ng -te rm cap it al ga in . Res po nd en t ar gu es th atth e b on us paym en t co ns ti tu te s or di na ry in co m e. The Supr em e Co urt h as he ldth atth e rec ei ptof abo nu s p aym en t b y a le ss or pu rs ua ntto anoi l an d g as lea se is tax ab le as o rd in ary in co m e, no t as ga in fro m th e sa le of c ap it al ass et s. Bu rn etv. Harm el , 28 7 U.S. 1 03 , 10 4, 1 12 (19 32 ). To av oi d o rd in ary in co m e tr eat m en t fo r th e b on us pay m en t, p et it io ne rs arg ue th atth e Agr eem en t was no t a l eas e b utwas i n s ub st an ce a s al e o f th ei r ri gh ts to an y oi l an d g as onth e p ro pe rty. W e m us t d et erm in e if

th e Agr eem en t was a le as e.

“ Whe re the own er o f th e la ndret ai ns aneco no mic in te res t i n t he de po si ts , th e tr an sa ct io n i s re ga rd edas alea se an d t he pro ceed s ar e ta xabl e as ord in ary in co m e”. Lau de ns la ge r v. C omm is si on er, 3 05 F.2d68 6, 6 90 (3dCir . 19 62 ), aff’g T.C. Mem o. 1 96 1- 85 ; s ee al so Co x v . Uni te d S ta te s, 4 97 F.2d34 8, 3 52 (4t h C ir. 19 74 ). A les so r ha s an eco no m ic in te res t “ if, b y vi rtu e o f th e le as in g t ran sa ct io n, A bo nu s i n t he oi l an d g as in du stry is de fin edas a“pa ym en t tha t i s m ad e in 3 ad di ti on to royalt ie s an d re ntas a n i nc en ti ve fora le ss orto si gn anoi l-a nd -g as le as e”. Bl ack ’s Law Dict io na ry 20 6 (9 th ed . 20 09 ).- 6 -

[* 6] he ha s re ta in eda ri gh t t o s ha re i n t he oi l p ro du ced .” Pal m er v . Ben de r, 28 7 U.S. 55 1, 5 57 (19 33 ). Ret en ti on of a n e co no m ic in te res t d oe s n ottu rnon th e dr aft sm an sh ip of t he co nt ractbu t i ns te adon th e eco no m ic real it ie s o f th e tra ns act io n. Se e Des ki ns v. Co m m is si on er, 8 7 T.C. 3 05 , 31 4 (1 98 6)
. Und er the Agre em en t, p et it io ne rs are en ti tl edto royalty pa ym en ts equa l t o 16 % of t he ne t p ro fit s o f an y oi l o r ga s ex tra ct edfro m th e p ro pe rty. Peti ti on ers ’
ro y al ty int eres t re ta in s fo r th em th e ri gh t t o s ha re i n t he pro ceed s o f an y oi l o r ga s ex tra ct edfro m

th e p ro pe rty. “ The pri nc ip le is well set tl edth atth e h ol de r of a 4
ro y al ty int eres t i n n atur al res ou rces po ss es se s an eco no m ic in te res t i n t he m in eral s in pl ace.” Kit tl e v . Comm is si on er, 2 1 T.C. 7 9, 8 7 (1 95 3) , aff’d, 2 29 F.2d31 3 (9 th Ci r. 19 56 ); s ee al so Pal m er, 2 87 U.S. at 5 57 . Pet it io ne rs ’ ro y al ty int eres t co ns ti tu te s an eco no m ic in te res t b ecau se it be st ows onth em

th e ri gh t t o s hare i n t he pro ceed s o f an y oi l an d g as ex tra ct ed fro m th e p ro pe rty. A s a r es ul t, the tra ns act io n i s re ga rd edas alea se . Furt he rm or e, we no te th atth e Agr eem en t d oe s n otrefl ectth e eco no m ic real it ie s o f a s al e. A
sa le wou ldbe ev id en cedby an ex ch an ge of ade te rm in ab le qu an ti ty of oi l an d g as fo r a d et erm in ab le pri ce. The Agre em en t d oe s n otsp eakto th e qua nt ity of o il an d

“ A royalty

in te res t i s a r ig htto rece iv e a s pe ci fie d p erce nt ag e o f al l o il an d 4 ga s p ro du ceddu rin g t he lea se .” Co x v . Uni te d S tate s, 4 97 F.2d34 8, 3 50 n.1 (4t h Ci r. 19 74 ).- 7 -

[* 7] ga s t o b e tr an sf

erre d t o t he les se e. In st ead , th e Agr eem en t p ro vi de s tha t the le ss ee (EOG) m ay

ex tra ctoi l an d g as for

a pe rio d o f ti m e inex ch an ge forroyalty pa ym en ts ba se d o n t he oi l an d g as th atis actua ll y ex tra ct eddurin g t he term of t he Agr eem en t. Anag reem en t tha t p ro vi de s the tra ns fero r with abo nu s p aym en t an d
ro y al ty paym en ts forth e m in eral s ex tra ct edis pro pe rly clas si fie d a s a l eas e, no t a sa le . See Lau de ns la ge r v. C omm is si on er, 3 05 F.2dat 6 91 (“ [A] tran sa ct io n i s n ot co ns id ereda sa le wher e, fo r ex am pl e, th e tr an sf

ero r res erv es a ro y al ty of a pe rcen ta ge of the min eral s t o b e p ro du ced , or wh ere, i n a dd it io n t o re se rv in g a ro y al ty, he rece iv es a cas h b on us paym en t.”) . As a res ul t, we fi ndth atth e Agr eem en t p et it io ne rs an d EOG en te redin to is pro pe rly clas si fie d a s a l eas e. Acco rd in gl y , we ho ldth atth e $ 88 3,2 50 bo nu s p aym en t i s t ax ab le as o rd in ary in co m e, no t capi ta l g ai n. 2. Dep le ti on Dedu ct io n Inth e p et it io n, p et it io ne rs arg ue th atif the Co urt d et erm in es th e $ 88 3,2 50 bo nu s p aym en t i s t ax ab le as o rd in ary in co m e, th enth e Co urt s ho ul d h ol d t ha t the y are e nt it le d t o ape rcen ta ge de pl et io n d educ ti on of $ 13 2,4 88 . Res po nd en t ar gu es th atpe ti ti on ers are n oten ti tl edto a de du ct io n fo r pe rcen ta ge de pl et io n o r fo r co st de pl et io n.- 8 -

[* 8] Sect io n 6 11 (a) p ro vi de s tha t u nd er the reg ul at io ns pre sc rib edby the Secr et ary, a reas on ab le all owa nc e fo r de pl et io n i s t o b e al lo wedinco m pu ti ng th e ta xabl e in co m e d eri ve d fr om oi l an d g as well s. Ord in ary in co m e fro m anoi l an d ga s wel l m ay

be eli gi bl e fo r co stde pl et io n u nd er s ect io n 6 12 or p erce nt ag e de pl et io n u nd er s ect io n 6 13 A. Sect io n 6 13 A(d )(5 ) pr ov id es th atpe rcen ta ge de pl et io n fo r in co m e fro m oi l
an d g as well s d oe s n otap pl y to “ an y lea se bo nu s, ad va nc e ro y al ty, orot he r am ou nt pa y ab le witho utreg ardto pro du ct io n fr om pro pe rty.” See al so sec . 1.6 13 A-3 (j), In co m e Tax Reg s. Th e $ 88 3,2 50 bo nu s p aym en t p ai d t o p et it io ne rs was t o i nduc e th em to en te r in to th e Agr eem en t; itdi d n otrel at e to an y ex tra ct io n o r pr oduc ti on of oi l an d g as . As a res ul t, the $8 83 ,25 0 p aym en t i s n oteli gi bl e fo r pe rcen ta ge de pl et io n. Bo nu s p aym en ts are el ig ib le forco stde pl et io n. Se e se c. 1.6 12 -3 (a)( 1) , In co m e Tax Reg s. Th e am ountof t he co stde pl et io n i s ca lc ul at edfro m th e ta xp ay er’s b as is forde pl et io n, the am ou ntof t he bo nu s p aym en t, an d t he royalt ie s th e ta xp ay er ex pe ct s t o re cei ve . See i d. Pe ti ti on ers di d n otpro vi de an y ev id en ce as to th e am ou ntof r oyalt ie s the y ex pe ctto rece iv e. As a re su lt , itis no t p os si bl e fo r th e Co urt t o c al cu la te th e am ou ntof p et it io ne rs ’ co stde pl et io n. Deduc ti on s are am at te r of

leg is la ti ve gra ce, an d t ax pa y ers be ar the bu rd enof p ro vi ng th atth ey- 9 -

[* 9] are e nt it le d t o a ny deduc ti on cla im ed . Rul e 1 42 (a); INDOPCO, In c. v. Co m m is si on er, 5 03 U.S. 79 , 84 (19 92 ); Ne w Col on ia l Ic e Co . v. Hel ve rin g, 2 92 U.S. 43 5, 4 40 (19 34 ). Pet it io ne rs ha ve fai le d t o m eetth is burd en . Accor di ng ly, we ho ldth atpe ti ti on ers are n oten ti tl edto a de du ct io n fo r co stde pl et io n. 3. Accu racy-Rel at edPen al ty Res po nd en t d et erm in edth atpe ti ti on ers were l iabl e fo r a s ect io n 6 66 2( a)
accu racy-rela te d p en al ty of $2 9,4 79 .40 forth e ta xabl e y ear 2 00 8. Se ct io n 6 66 2( a) im po se s anaccu racy-rela te d p en al ty equ al to 20 % of t he un de rp aym en t t o wh ic h
se ct io n 6 66 2 app li es . Sect io n 6 66 2 app li es to th e p orti on of a ny un de rp aym en t whi chis attrib ut ab le to , in te r al ia , a subs tant ia l u nd ers tate m en t o f in co m e ta x. Sec. 6 66 2( b) (2 ). Sect io n 7 49 1( c) p ro vi de s tha t the Co m m is si on er b ears th e “bu rd enof pr oduc ti on ” wit h re ga rdto pe na lt ie s an d m us t co m e fo rwardwith s uf fic ie nt ev id en ce i nd ic at in g t ha t i t i s ap pr op ria te to im po se th e p en al ty. See Hi gb ee v . Co m m is si on er, 1 16 T.C. 43 8, 4 46 (20 01 ). Once th e Co m m is si on er m eet s h is

“bu rd enof p ro du ct io n” , ho wev er, the “burd enof p ro of ” rem ai ns with t he ta xp ay ers , in cl ud in g the burd enof p ro vi ng th atth e p en al ty is i napp ro pr iate be cau se of r eas on ab le cau se un de r se ct io n 6 66 4. Se e Ru le 14 2( a); Hig be e v . Co m m is si on er, 1 16 T.C. at 4 46 -4 47
.- 10 -

[* 10 ] There is a subs tant ia l und ers ta te m en t o f in co m e ta x fo r any tax ab le y ear i f th e am ou ntof t he un de rs ta te m en t ex ceed s the gre at er o f 10 % of t he tax requi redto be sh ownon th e return fo r th e ta xabl e y ear o r $5 ,00 0. Se c. 66 62 (d )(1 )(A). On th ei r 20 08 joi ntFed eral in co m e ta x re tu rnpe ti ti on ers rep orte d t ax of $ 10 3,4 22
. Pet it io ne rs ’ de fic ie nc y

inin co m e ta x fo r th e ta xabl e y ear 2 00 8 i s $ 14 7,3 97 . Thu s, th e und ers ta te m en t o f in co m e ta x ($ 43 ,97 5) ex ceed s the gre at er o f 10 % of t he tax requi redto be sh own on pe ti ti on ers ’ return ($ 10 3,4 22 tax rep orte d o n the return + $1 47 ,39 7 d efi ci en cy

= $2 50 ,81 9; 10 % of $ 25 0,8 19 = $2 5,0 82 ) or$5 ,00 0. The refo re, p et it io ne rs ’ un de rs ta te m en t i s s ub st an ti al . Con se qu en tl y , we con cl ud e th atres po nd en t h as m ethi s b ur de n o f pr oduc ti on with re sp ectto pe ti ti on ers ’
subs tant ia l u nd ers ta te m en t o f in co m e ta x. Sect io n 6 66 4( c)(1 ) pr ov id es th atth e p en al ty und er s ect io n 6 66 2( a) s ha ll no t ap pl y to an y po rti on of a n u nd erp aym en t i f itis sh own th atth ere was reas on ab le
cau se forth e ta xp ay er’s p os it io n a ndth atth e ta xp ay er ac te d i n g oo d fa ith wi th
res pe ctto th atpo rti on . See Hig be e v . Comm is si on er, 1 16 T.C. at 4 48 . The de te rm in at io n o f whe th er the tax pa y er ac te d wi threas on ab le cau se an d i n g oo d fai th is m ad e o n acas e-b y -cas e b as is , tak in g i nt o a cco un t al l the pe rti ne ntfact s an d c irc um st an ces . Sec. 1 .66 64 -4 (b )(1 ), In co m e Tax Reg s. Pet it io ne rs ha ve th e bu rd enof p ro vi ng th atth e p en al ty is i napp ro pr ia te be cau se of r eas on ab le cau se- 11 -

[* 11 ] un de r se ct io n 6 66 4. Se e Ru le 14 2( a); Hig be e v . Comm is si on er, 1 16 T.C. at 44 6- 44 7. Pe ti ti on ers ha ve fai le d t o p ro ve th atth e p en al ty is i napp ro pr ia te be cau se of reas on ab le cau se . Acco rd in gl y , we ho ldth atpe ti ti on ers are l iabl e fo r th e acc ur acy-rela te d pe na lty un de r se ct io n 6 66 2( a) fo r th ei r un de rp aym en t o f ta x fo r th e 2 00 8 t ax y ear. Inreac hi ng ou r de ci si on , we hav e co ns id eredall arg um en ts m ad e b y th e pa rti es . To th e ex te ntno t m en ti on edor a dd res se d, the y are i rrel ev an t o r witho ut
m eri t. To re fle ctth e fo reg oi ng , Deci si on wil l b e en te redfor
res po nd en t.