T.C. Mem o. 2 01 3- 19 5

UNITED STAT ES TAX COURT

JI MASTOWL O OIL, LL C, ET AL. , JOHN J. PETITO, TAX MATTERS 1 PARTNER, Pet it io ne r v. COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No s. 1 13 16 -0 8, 1 13 32 -0 8, Fil edAug us t 2 6, 2 01 3.

21 58 6- 09 , 22 70 6- 09 , 11 26 3- 10
.
J an d OC ( LLCs) e ach pu rch as eda 7.9 3% wo rk in g i nt eres t i n anoi l an d g as lea se ho ld . Each d educ te d e xp en se s o n i ts returns for th e au di t years (2 00 4- 06 forJ, 2 00 4 a nd20 05 forOC) th atwere al le ge dl y ass oc ia te d wi th it s wo rk in g i nt eres t. R i ss ue d n ot ic es of fin al pa rtn ers hi p a dm in is tra ti ve ad jus tm en t (F PAAs) to th e LLCs de nyin g t he de du ct io ns , tre at in g re po rte d l os se s as pa ss iv e act iv ity
The fol lo win g c as es are co ns ol id at edhe rewi th : Oi l Co m in g We Are 1 Humm in g LLC, J oh n J . Pet it o, Tax Mat te rs Partne r, do ck etNo. 1 13 32 -0 8; Ji m as to wlo Oil , LLC, Jo hn J. Pet it o, Tax Mat te rs Partne r, do ck etNo. 2 15 86 -0 9; Oil Co m in g We Are Humm in g, LLC, J oh n J . Pet it o, Tax Mat te rs Partne r, do ck et No. 2 27 06 -0 9; an d J im as to wlo Oil LLC, Jo hn J. Pet it o, Tax Matte rs Partne r, do ck etNo. 1 12 63 -1 0.- 2 -

[* 2] lo ss es un de r I.R.C. s ec. 4 69 , andass ert in g a ccu racy-rela te d pe na lt ie s u nd er I.R.C . sec . 66 62 . After atri al ad dr es si ng th e is su es rai se d i n t he FPAAs ( subs ta nt iv e is su es ), we is su edanord er d ire ct in g th e p art ie s t o a dd res s o urco nc ernth atth e so -cal le d i nc om e p ro gr am s pu rch as edby the LLCs co ns ti tu te d p artne rs hi ps for Fed eral in co m e ta x p ur po se s s o t ha t we wer e wit ho utjuri sd ic ti on to co ns id er the m eri ts of wh atwou ldth enbe th e LLCs' p as s- th ro ug h d educ ti on s fr om a so ur ce p artne rs hi p (i .e., com pu ta ti on al ad

jus tm en ts ) atth e LLCs' (p artne r) l ev el , bef

or e th e p ro pr ie ty of th os e d educ ti on s h adbe en de ci de d a t the so ur ce p artne rs hi p l ev el , cit in g S en te Inv . Club P 'sh ip of Utah v. Co m

mis si on er, 9 5 T.C. 2 43 , 24 8 (1 99 0) ; M ax well v. Co m m is si on er, 8 7 T.C. 7 83 , 78 8 (1 98 6) ; an d Al ho us e v . Co m m is si on er, T.C. Mem o. 1 99 1- 65 2, af f'dsub n om . Berg fo rdv. Co m m is si on er, 1 2 F .3d16 6 (9 th Cir . 19 93 ). Bo th pa rti es m ov edto reo pe n t he reco rd , whi chwe di d, an d we c on du ct eda se co ndtri al to ad dr es s the juri sd ic ti on al is su e. R arg ue s tha t the in co m e p ro gr am s di d n otco ns ti tu te partn ers hi ps forFed eral tax pu rp os es an d t ha t, th eref or e, we ha ve juri sd ic ti on to de ci de th e subs ta nt iv e is su es . P arg ue s tha t the LLCs were m em be rs of " de fact o" pa rtn ers hi ps so th at we la ckjuri sd ic ti onto de ci de th e subs ta nt iv e is su es . 1. Hel d: EachLLC, to ge th er wi th th e o th er wo rk in g i nt eres t own ers inth e le as eh ol d, jo in edto ge th er t o c on du ctanun in co rp or at ed bu si ne ss , whi ch , forFed eral in co m e ta x p ur po se s, m us t b e cl as si fie d as a pa rtn ers hi p. 2. Hel d, furth er, the FPAAs i ss ue d t o the LLCs, t o the ex te nt th atth ey m ak e ad jus tm en ts on ly w ith re sp ectto th e subs ta nt iv e is su es (p artne rs hi p i te m s) , are i nv al idbe cau se th ere h av e b eenno so ur ce pa rtn ers hi p- le ve l p ro ceed in gs . 3. Hel d, furth er, we wil l, the refo re, o n o ur ownm ot io n d is m is s th es e co ns ol id at edcas es forlac k o f juri sd ic ti on in so far a s the in di vi du al FPAAs p ert ai n t o c om pu ta ti on al it em s.- 3 -

[* 3] Jo hn J. Pet it o, p ro se. The od or e Ro be rt Lei gh to n, Di an e R. Mi rab it o, An dr ew Ira Ou sl an de r, an d Deb or ahAlo of

, forres po nd en t i n d oc ke t No s. 1 13 16 -0 8, 1 13 32 -0 8, 2 15 86 -0 9, an d 22 70 6- 09
. The od or e Ro be rt Lei gh to n, Di an e R. Mi rab it o, An dr ew Ira Ou sl an de r, Deb or ahAlo of

, andJo sh uaNach m an , forres po nd en t i n d oc ke t No . 11 26 3- 10
.
MEMORANDUM FINDINGS OF FACT AND OPINION HALPERN, Ju dg e: Thes e co ns ol id at edcas es are p artne rs hi p- le ve l ac ti on s ba se d upo n p et it io ns fil edpu rs ua ntto sec ti on 62 26
. Ji m as to wlo Oil , LLC 2 (J im as to wlo ), an d Oi l Co m in g We Are Humm in g, LLC (Oi l Co m in g) , th e two 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 2 Rev enue Co de as a m en de d. Sec. 6 22 6 i s o ne of agro up of p ro vi si on s (c urren tl y co m pr is in g s ecs . 62 21
- 62 34 ) en ti tl ed"Tax Treat m en t o f Part ne rs hi p It em s" th atwas a dd edto th e In te rn al Rev enue Co de by the Tax Equi ty andFis cal Res po ns ib il ity Act o f 19 82 (TEFRA), Pub. L. No. 9 7- 24 8, s ec. 4 02 (a), 9 6 S ta t. at64 8 (TEFRA partn ers hi p p ro vi si on s)
. Inge ne ral , th os e p ro vi si on s es tabl is h s pe ci al pro cedur es forau di ti ng pa rtn ers hi p returns wher eb y

th e return i s s ub

ject t o asi ng le au di t i n wh ic h o ne pa rtn er ac ts for th e p artne rs hi p b utall pa rtn ers are b ou ndby the res ul ts of the au di t. The au di t res ul ts m ay

be co nt es te d i n c ourt i n aun ifi edpro ceed in g t he res ul ts of wh ic h a re al so bi nd in g upo n a ll pa rtn ers . See Bo ris I. Bit tk er & Lawre nc e Lokke n, Fe de ral Tax at io n o f In co m e, Est at es an d Gi fts , par a. 11 2.3 .1, atS1 12 -8 8 (C um . Sup p. No
. 2, 2 01 3)
.- 4 -

[* 4] en ti ti es in vo lv edinth es e co ns ol id at edcas es (to ge th er, LLCs ), are New Yo rk li mit edli ab il ity

co m pa ni es th at , pu rs ua ntto sec ti on30 1.7 70 1- 3( b) (1 )(i ), Pro ced . & Adm in . Reg s., co ns ti tu te pa rtn ers hi ps for Fed eral in co m e ta x p ur

po se s. Th e pe ti ti on er i n e ach cas e is Jo hnJ. Pet it o, p res en tl y tax m at te rs pa rtn er, wh o re si de d in New Yorkwhen he fil edth e p et it io ns . Co ns is te ntwith t he ir t ax cla ss ifi cat io n a s p artne rs hi ps , bo th Ji m as to wlo an d Oil Co m in g fi le d F orm s 1 06 5, U.S. Return o f Part ne rs hi p In co m e, fo r th e au di t y ears (20 04 -0 6 fo r Ji m as to wlo an d 2 00 4- 05 forOil Co m in g) . The p et it io ns were fil edinres po ns e to res po nd en t's no ti ces of f in al pa rtn ers hi p a dm in is tra ti ve ad jus tm en t (F PAAs) is su edto th e ta x m at te rs partn er fo r eac h LLC fo r eac h o f th e au di t years. Re sp on de nt 's FP AAs (1 ) di sa ll ow d educ ti on s cl ai m edby the LLCs i n co nn ect io n wi th th ei r pe rcen ta ge sh ares inwork in g i nt eres ts inoi l an d g as le as eh ol ds an d (2 ) de te rm in e acc ur acy-rela te d p en al ti es , un de r se ct io n 6 66 2, wi th
res pe ctto pa rtn ers hi p i te m s o f th e LLCs. Inad di ti on , inth e FPAA i ss ue d t o Ji m as to wlo for20 06 an d i n h is an swe r to th e p et it io n fi le d o n b eh al f of Oil Co m in g wi th res pe ctto 20 05 , res po nd en t as se rts th atth e p as si ve act iv ity lo ss li mit at io n ru le s o f se ct io n 4 69 ap pl y ; i .e., th atth e ex cep ti on to th os e ru le s af fo rd ed by sect io n 4 69 (c)( 3) for

work in g i nt eres ts inoi l an d g as pro pe rty is i napp li cab le to Ji m as to wlo for20 06 an d t o Oi l Co m in g fo r 20 05 . Peti ti on er d efen ds th e- 5 -

[* 5] ch al le ng edde du ct io ns , den ie s tha t s ect io n 4 69 ap pl ie s, d en ie s tha t the sec ti on 66 62 accu racy-rela te d p en al ty app li es , andass ert s, p res um ab ly as analt ern at iv e to th e ch al le ng edde du ct io ns , th at , bec au se bo th of t he LLCs i nv es te d i n wh atwas di sc ov ered , in20 06 , to be a "Po nz i s ch em e", ea chis en ti tl edto a 20 06 th eftlo ss de du ct io n fo r it s en ti re i nv es tm en t und er s ect io n 1 65 (e). We con du ct eda tr ia l (fi rs t tria l) i n S ep te m

be r 20 10 , aft er wh ic h t he pa rti es subm it te d b rie fs ad dr es si ng th e fo reg oi ng is su es (subs ta nt iv e is su es ). Dur in g o urco ns id erat io n o f th e subs ta nt iv e is su es , we bec am e co nc ern ed th atcert ai n s o- cal le d i nc om e p ro gr am s p ur ch as edby the LLCs (wh ic h g av e ri se to th e d is pu te d d educ ti on s) co ns ti tu te d p artne rs hi ps forFed eral in co m e ta x p ur po se s. As wi ll be m or e fu ll y

ex pl ai ne d b el ow, the term "i nc om e p ro gr am " was us edby a
co m pa ny nam edEner gytec, In c. (Ene rg yte c), t o i de nt ify a gro up of o il an d g as well s, an d t he pe rcen ta ge work in g i nt eres t the rei n, p ur ch as edby a part ic ul ar pu rch as er fro m

Ener gytec. If o urco nc ernwas b orne ou t, the subs ta nt iv e is su es wou ld , withi n t he m ean in g o f se ct io n 6 23 1( a)(3 ), co ns ti tu te "p artne rs hi p i te m s" , de te rm in ab le , pu rs ua ntto sec ti on 62 21 , at the pa rtn ers hi p l ev el . In tha t ev en t, we
wou ldbe witho utjuri sd ic ti onto de ci de th e subs ta nt iv e is su es inth e p artne r-l ev el pr oc eed in g b efo re u s. We ord eredsupp le m en ta l b rie fin g a dd res si ng (1) whet he r th e in co m e p ro gr am s i n wh ic h t he LLCs h adin ve st edco ns ti tu te d p artne rs hi ps- 6 -

[* 6] subjec t t o t he TEFRA partn ers hi p p ro vi si on s an d (2 ) if so , whethe r we sh ou ld di sm is s the se co ns ol id at edcas es on ou r own m ot io n fo r la ck of ju ris di ct io n. We al so di rect edth at , sh ou ldeithe r pa rty con si de r itne ces sary to in tro du ce ad di ti on al
ev id en ce i n o rd er t o p ro pe rly addres s tho se is su es , th atpa rty sh ou ldm ov e to
reo pe n t he reco rdforth atpurp os e. Bo th pa rti es so m ov ed , we gra nt edth e
m ot io ns , andwe co nduc te d afurth er tria l (s eco ndtri al ), at wh ic h t he pa rti es in tro du cedtes ti m on y

an d d oc um en ta ry

ev id en ce. Aft er the sec on d t ria l, the pa rti es subm it te d t he supp le m en ta l b rie fs th atwe ha d o rd ered . Res po nd en t ar gu es th atth e LLCs wer e n ot , onacco un t o f th ei r oi l an d g as in ve st m en ts , partn ers in
an y pa rtn ers hi ps , andso we sh ou ldno t d is m is s the se cas es for lac k o f juri sd ic ti on . Pet it io ne r arg ue s tha t the in ve st m en ts were i n " de fact o" pa rtn ers hi ps an d we sh ou lddi sm is s. It i s wi th in ou r au th or ity

to rai se th e is su e o f juri sd ic ti on . E.g., Gou ldv. Co m m is si on er, 1 39 T.C. 41 8 (2 01 2) . As th e p arty all eg in g juris di ct io n, res po nd en t b ears th e b ur de n o f pr ov in g juris di ct io na l fa ct s b y a pr ep on de ran ce o f th e ev id en ce. See Zun am on v. Br own , 41 8 F .2d88 3, 8 86 (8th C ir. 1 96 9) (ci ti ng McNu ttv. Gen . Mo to rs Accep ta nc e Co rp ., 29 8 U.S. 1 78 , 18 9 (1 93 6) ). W e fi ndth at , onacco un t o f eac h LLC's pu rch as e o f anin co m e p ro gr am , each was am em

be r of a pa rtn ers hi p fo r Fed eral in co m e ta x p ur po se s. We are- 7 -

[* 7] th eref

or e p recl ud edby sect io n 6 22 1 fr om co ns id eri ng th e subs ta nt iv e is su es , in cl ud in g t he ad di ti on al is su es rai se d b y res po nd en t o f whe th er, i f pa rtn ers hi ps do
ex is t, tho se pa rtn ers hi ps sh ou ldbe di sr eg ard edon acco un t o f a l ackof e co no m ic
subs ta nc e o r on acco un t o f so m e o th er an ti ab us e d oc tri ne . W e wil l d is mis s fo r la ckof ju ris di ct io n i ns of

ar as th e in di vi du al FPAAs p ert ai n t o c om pu ta ti on al it em s. FINDINGS OF FACT The LLCs' In ve st m en ts inth e Sch uyler an d J .B. Mi ls te adOil Leas es Ene rg yte c, a Nev ad a co rp or at io n, was org an iz edin19 99 to en ga ge inoi lan d g as -p ro du ci ng act iv it ie s thr ou ghth e acqui si ti on of o il an d g as lea se ho ld s tha t, pr ev io us ly, ha d b eenth e o bjec t o f ex pl or at io n a ndpro du ci ng act iv ity an d t ha t n o lo ng er were pro du ci ng or o pe rat in g b ecau se of aba nd on m en t o r ne gl ect . Ene rg yte c's rig ht s i n tho se lea se ho ld s co ns ti tu te d wh atare kno wn as "wo rk in g in te res ts ". 3 EachLLC pai d $ 10 2,7 20 forit s 7 .93 % sh are o f Ene rg yte c's work in g i nt eres t in cert ai n l eas eh ol ds . The wo rk in g i nt eres t i n wh ic h J im as to wlo sh aredin vo lv ed Bl ack 's Law Di ct io na ry

17 45 (9t h e d. 2 00 9) de fin es a worki ng in te res t i n 3 oi l an d g as as: "The rig ht s t o t he m in eral in te res t g ran te d b y anoi l-a nd -g as lea se , so cal le d b ecau se th e le ss ee ac qu ire s the rig htto workon th e le as edpro pe rty to se arch , dev el op , andpro du ce o il an d g as , as wel l as th e o bl ig at io n t o p ay all co st s."- 8 -

[* 8] 11 oi l wel ls on th e Sch uyler l eas eh ol d, Ru skCo un ty, Tex as (Sch uyler le as eh ol d) . The wo rk in g i nt eres t i n wh ic h Oi l Co m in g s ha redin vo lv edni ne oi l well s o n t he J.B. M il st eadlea se ho ld , Rus k C ou nt y , Texa s (M il st eadlea se ho ld ). EachLLC ob ta in edit s s ha re o f Ene rg yte c's work in g i nt eres t p ur su an t t o a n "As si gn m en t, Bi ll of S al e an d C on ve y an ce" fro m Ener gytec d at edApri l 2 6, 2 00 5, in Ji m as to wlo 's c as e, an d Ap ril 4, 2 00 5, i n Oi l Co m in g's cas e. The a ss ig nm en t t o Ji m as to wlo st at edth atitwas " to be effec ti ve as o f Decem be r, 20 04 , at 7 :0 0 a .m .",
an d t he on e to Oil Co m in g s ta te d t ha t i t was "t o b e eff ect iv e as of S ep te m

be r, 20 04 , at 7 a.m ." Bo th ass ig nm en ts were ex ecu te d o n b eh al f of Ener gytec b y

Don Lam be rt, As si st an t t o t he Pres id en t, En erg yte c, In c. The a ss ig nm en t t o J im as to wlo
was no t re co rd edun de r Tex as law u nt il Nov em be r 6, 2 00 6, an d t he re i s n o ev id en ce tha t the ass ig nm en t t o Oi l Co m in g was ev er re co rd ed
. Befo re re cei vi ng th e fo reg oi ng ass ig nm en ts , th e LLCs r ecei ve d e va lu at io n rep orts (ev al ua ti on rep orts ) with re sp ectto th e o il well s i nc lu de d i n t he work in g in te res ts inwhi chth ey

wou ldsh are. Th e ev al ua ti onrep orts , dat edDecem be r 20 04 in th e cas e o f th e Schuyler l eas eh ol d a ndSep te m be r 20 04 inth e cas e o f th e Mi ls te adlea se ho ld , were p rep aredforEner gytec b y Fran k W. Col e Eng in eeri ng (Co le Eng in eeri ng ). The ev al ua ti on rep ort wi th res pe ctto th e Sch uyler l eas eh ol d refe ren cedInc om e Pro gr am No. 1 05 , andth e ev al ua ti on rep ort wi th res pe ctto th e- 9 -

[* 9] Mi ls te adlea se ho ldrefe ren cedInc om e Pro gr am No. 7 0. As st at ed , th e te rm "i nc om e p ro gr am " was us edby E ne rg yte c to id en ti fy th e wel ls , andth e p erce nt ag e sh are i n t he work in g i nt eres t the rei n, o ffer edby it t o apa rti cu la r pu rch as er. Fo r ex am pl e, In co m e Pro gr am

No. 1 05 id en ti fie d the 11 well s o n t he Sch uyler le as eh ol d a ndth e 7 .93 % work in g i nt eres t the rei n t ha t J im as to wlo pu rch as edfro m Ene rg yte c, an d In co m e Pro gr am No. 7 0 i de nt ifi edth e 9 well s o n t he Mi ls te ad le as eh ol d a ndth e 7 .93 % work in g i nt eres t the rei n t ha t Oi l Co m in g p ur ch as edfro m Ene rg yte c. Oth er p ers on s, o r gr oups of p ers on s, i de nt ifi edinth e rec or d p ur ch as ed pe rcen ta ge work in g i nt eres ts inbo th th e Sch uyler l eas eh ol d a ndth e Mi ls te ad le as eh ol d. In co m e Pro gr am No. 1 07 id en ti fie d M or e in Oil LLC as the own er o f a 7.9 3% wo rk in g i nt eres t i n t he 11 well s o n t he Sch uyler l eas eh ol d, an d In co m e Pro gr am No. 7 0 i de nt ifi edRo be rt Ac ke rm anas t he own er o f a 7 .93 % work in g in te res t i n t he 9 wel ls on th e Mi ls te adlea se ho ld . Energ yte c ret ai ne d a6.5 75 %
worki ng in te res t i n t he well s o n e ach of tho se lea se s. Eachev al ua ti on rep ort d es cri be s the hi st ory of t he fie ldof wh ic h the le as eh ol d i n que st io n was a pa rt ( e.g ., nu m be r of well s, t ot al pro du ct io n t o d at e)
an d t he ge ol og ic al featur es of the lea se ho ldarea . Each re ci te s tha t En erg yte c acqui redth e le as eh ol d i n que st io n andop erat es th e wel ls on it . Each the n s ta te s th at"En erg yte c is off

eri ng to sel l a P ro gr am

of 1 6 u ni ts for

a to ta l p ric e o f- 10 -

[* 10 ] $1 02 ,72 0, wi thth e Pro gr am ha vi ng a 7.9 3% wo rk in g i nt eres t i n e ach of t he * * * [1 1 wel ls , inth e cas e o f th e Sch uyler l eas e, or9 wel ls , inth e cas e o f th e Mi ls te adlea se ]. " Each ev al ua ti on rep ort co nt ai ns pro jecti on s o f th e m on th ly pro rat a g ro ss in co m e, op erat in g e xp en se s, an d n etop erat in g i nc om e fo r eac h "Pr og ram " (i nv es to r), to ge th er wi th a tabl e sh owi ng th e p ro jecte d " 'tu rn -k ey ' co st s of acqui rin g a ndrewo rk in g t he * * * [1 1 o r 9 we ll s]." The e va lu at io n re po rts pr ojec t m on th ly netop erat in g i nc om e o f $3 ,44 0 fo r eac h i nv es to r in th e Schuyler le as eh ol d wel ls an d $ 3,6 00 foreachin ve st orinth e Mi ls te adlea se ho ldwell s. Th e ev al ua ti onrep ort wi th res pe ctto th e Schuyler l eas eh ol d s ta te s: "Effec ti ve da te of th e Ass ig nm en t i s Dec em be r 30 , 20 04 an d t he fir stdi sb ur se m en t wi ll be m ad e in Mi d- Apr il 20 05 ." The ev al ua ti on rep ort wi thres pe ctto th e Mi ls te adlea se ho ld st at es aneffe ct iv e d at e-o f-as si gn m en t o f Sep te m be r 1, 2 00 4, an d an i ni ti al di sb ur se m en t d at e o f "M id -No ve m be r 20 04 ." Each ev al ua ti on rep ort co nc lu de s with a"s umm ary" st at in g: "Thi s i s an ol d p ro du ci ng lea se with alo ng hi st ory of
sa ti sf act ory oi l p ro du ct io n. Th es e wel ls sh ou ldpro du ce ec on om ic al ly for the ne xt 10 to 15 y ears with am od es t d ecl in e rat e. Thi s s ho ul d b e anex cel le ntlo ng term in ve st m en t."- 11 -

[* 11 ] Oper at io n o f th e Wells Usu al ly, th e arr an ge m en t am on g the own ers of wo rk in g i nt eres ts inth e sa m e well or we ll s i s g ov ern edby the term s o f a joi ntop erat in g a gr eem en t ag reedto by al l o f th e o wne rs , whi chset s fo rth th e ri gh ts , du ti es , andob li ga ti on s o f eac h p arty to th e ag reem en t. Am on g o th er thi ng s, the op erat in g a gr eem en t d es ig na te s an op erat or , who co nduc ts an d c on tro ls op erat io ns of the well (i.e ., pro du ci ng th e o il
an d g as fro m

th e wel l, b il li ng th e n on op erat or s fo r co st s i nc urred , anddi st rib ut in g th e p ro fit s, i f an y). Duri ng th e au di t years, En erg yte c o pe rat edth e wel ls on th e Sch uyler an d M il st eadlea se ho ld s o n aco op erat iv e b as is (i.e ., as an eco no m ic act iv ity co ll ect iv el y

own edan d c oo pe rat iv el y ex pl oi te d) forth e worki ng in te res t
own ers , bu t i t d idso witho utbe ne fitof ajoi ntop erat in g a gr eem en t ex ecu te d b y th e worki ng in te res t o wne rs . To carry ou t the actua l o pe rat io n o f th e wel ls du rin g th e au di t years, En erg yte c em pl oyed, fi rs t, Co le Eng in eeri ng (un ti l Ap ril 1, 2 00 6) , an d, the reaf

te r, Co m m an ch e Well Se rv ic e Co rp . (Co m m an ch e), a wh ol ly owne d
subs id ia ry

of En erg yte c. Eachco ll ect edoi l fr om th e wel ls intan ks , so ldth e co ll ect edoi l, o ffs etop erat in g e xp en se s ag ai ns t s al e p ro ceed s, an d app orti on ed wha t p ro ceed s re m ai ne d a m on g t he work in g i nt eres t o wne rs inpro po rti on to th ei r pe rcen ta ge in te res ts . No worki ng in te res t o wne r co ul d t ak e in ki ndor s el l o n i ts
own it s s ha re o f an y

oi l p ro du ct io n.- 12 -

[* 12 ] InMay 200 6, En erg yte c p res en te d t he LLCs an d t he ot he r worki ng in te res t
own ers inth e Sch uyler an d M il st eadlea se ho ld s wi th dra ft jo in t o pe rat in g ag reem en ts form al ly des ig na ti ng Co m m an ch e as op erat orof the well s o n the
res pe ct iv e le as eh ol ds . Man y of t he lea se ho ldown ers , in cl ud in g t he LLCs, wo ul d
no t ex ecu te th e draftag reem en ts . Paym en ts to W orki ng Int eres t Own ers The pre di ct io ns inth e ev al ua ti on rep orts reg ard in g o il well pro du ct io n tu rn edou t t o b e wil dl y

op ti mis ti c. Fro m

th e in cep ti on of t he ir i nt eres ts un ti l Mar ch20 06 , Energ yte c d idm ak e m on th ly paym en ts to th e LLCs a s s ta te d i n t he
ev al ua ti onrep orts : $ 3,4 40 to Ji m as to wlo an d $ 3,6 00 to Oil Co min g. But , as 4 st at edinth e ev al ua ti onrep orts , th os e p aym en ts were b as edon"p ro jecte d" ne t in co m e fro m

dri ll in g o pe rat io ns , no t ac tu al ne t i nc om e, an d the in co m e p ro jecti on s were b as edon pro

jecte d p ro du ct io n, wh ic h was subs ta nt ia ll y inex ces s o f actua l pr oduc ti on . As of

May 15, 2 00 6, En erg yte c cat eg or iz edm an y of the well s in cl ud edinbo th th e Sch uyler an d M il st eadlea se s as "No n P ro du ci ng Oper at io na l Hol d"
.

The Marc h 2 00 6 andApri l 2 00 6 p aym en ts to Oil Co m in g wer e $ 1,5 32 .43

4 an d $ 1,2 42 .27 , res pe ct iv el y .- 13 -

[* 13 ] As a re su ltof the im ba la nc e b etweenne t i nc om e fro m pro du ct io n a nd pa ym en ts to work in g i nt eres t o wne rs in vo lv edinEner gytec's vario us dri ll in g op erat io ns , in cl ud in g t ho se with re sp ectto th e Sch uyler an d M il st eadlea se ho ld s, Ene rg yte c se nta "Work in g In te res t Re po rt" , dat edMay 22, 2 00 6, t o t he LLCs an d th e o th er wo rk in g i nt eres t o wne rs . The wo rk in g i nt eres t re po rts advi se of Co m m an ch e's rep la cem en t o f Co le Eng in eeri ng as o pe rat orof En erg yte c's oi l an d ga s i nt eres ts , andex hi bi t A at ta ch edto each rep ort s et s fo rtheach LLC's in ve st m en t i n i ts res pe ct iv e dril li ng pro gr am , th e to ta l am ou nt , as o f Mar ch31 , 20 06 , pai d t o e ach , andeach 's p ro rat a sh are o f th e actua l n etrev enue to th atda te fro m th e p ro gr am . Tho se pro rat a sh ares were the am ou nt s ea chLLC wou ldha ve rece iv edha d i t b eenpa idon ly its 7.9 3% wo rk in g i nt eres t s ha re o f ne t re ve nu es . The ex ces s o f th e p aym en ts to each ov er i ts pro rat a sh are o f ne t re ve nu e is de no min at edanam ou ntdu e Ene rg yte c. The wo rk in g i nt eres t re po rt e xp la in s tha t,
no rm al ly, in oi l an d g as op erat io ns of t he ki ndinwhi chth e LLCs wer e in vo lv ed (wh ic h t he rep ort ca ll s " Jo in t i nt eres t o pe rat io ns , so m et im es refe rredto as J oi nt Ven tures "), the op erat orbi ll s the work in g i nt eres t o wne rs for th ei r pr o ra tash ares of th e m on th ly exp en di tu res an d, m on th ly, rem it s t o the m th ei r pr o ra tash ares of th e n etrev enue s fr om

op erat io ns aft er ex pe ns es . The rep ort the n n ot es th at , inth e cas e o f Ene rg yte c's joi nt ly owne d o il an d g as dri ll in g o pe rat io ns ,- 14 -

[* 14 ] th e m ajor ity

of t he work in g i nt eres t o wne rs were re cei vi ng recu rri ng pa ym en ts th atdi d n otflu ctua te reg ard le ss of p ro du ct io n, o il an d g as pri ces , or l eas e o pe rat in g e xp en se s * * * [L] eas e o pe rat in g ex pe ns e an d c ap it al ex pe nd itur es on th e m ajor ity of t he lea se s h el d b y worki ng in te res t o wne rs ha s b eenpa idby E ne rg yte c wit h n o pr ov is io n fo r * * * [jo in t i nt eres t b il li ng s]. The eff ectof t he se recu rri ng pa ym en ts an d t he co st s b orne by E ne rg yte c was th e acce le rat io n o f th e return o n t he in ve stm en t b y work in g i nt eres t own ers to th e d etriment o f th e cas h p os it io n a ndearn in gs of Ene rg yte c. Afte r rei te rat in g t ha t " [i]n m an y cas es , th e rec urrin g p aym en ts * * * h av e ex ceed ed th e n etrev enue th atwas due to th e worki ng in te res t o wne rs ", th e rep ort s tate s: "If th is si tu at io n app li es to y ou , subs eque ntrev enue di st rib ut io ns wil l b e ap pl ie d ag ai ns t the ou ts ta nd in g b al an ce due to Ener gytec u nt il th e b al an ce i s co ll ect edin fu ll ." As an alt ern at iv e, th e aff ect edwork in g i nt eres t o wne rs were o ffer edth e rig htto "p ay

th e o ut st an di ng ba la nc e due Ener gytec an d s ub se qu en tl y rece iv e rev enue di st rib ut io ns ba se d upo n a ctua l re ve nu es les s ap pl ic ab le lea se op erat in g ex pe ns es ." Exh ib itA att ach edto th e worki ng in te res t re po rt s en t t o J im as to wlo li st s
am ount s p ai d t o J im as to wlo , as o f Mar ch31 , 20 06 , of $ 37 ,84 0 a ndne t re ve nu e, as of th atdate , fro m

actua l p ro du ct io n (g ro ss rev enue of $ 2,5 49 les s ac tu al expe ns es of $1 ,56 5) of $ 98 4, re su lt in g i n a n a m ou ntdu e Ene rg yte c o f $3 6,8 56 . The
co rres po nd in g fi gu res forOil Co m in g, as of M arch 31 , 20 06 , were p aym en ts of- 15 -

[* 15 ] $5 9,1 32 an d n etrev enue fro m actua l p ro du ct io n (g ro ss rev enue of $ 26 ,76 2 le ss actua l ex pe ns es of $ 6,7 62 ) of $2 0,0 00 , res ul ti ng in$3 9,1 32 du e Ene rg yte c. The reaf te r, bo thJi m as to wlo an d Oi l Co min g b eg anrece iv in g m on th ly st at em en ts of " Am ou ntDue To Ener gytec" fro m Ener gytec s ho win g a"Ba la nc e Fo rward " o f th e am ountdu e reduc edby each' s p ro rat a sh are o f th e n etrev enue fro m "Cu rren t M on th Acti vi ty", resu lt in g i n a n " End in g B al an ce" of t he am ou nt du e to be carr ie d o ve r to th e subs eque ntm on th . Stat em en ts of a cco un t s en t t o Ji m as to wlo sh ow an am ountdu e Ene rg yte c o f $3 6,8 56 as o f Nov em be r 30 , 20 09 (th e sa m e am ou ntdu e as setforth on ex hi bi t A o f th e May 22 , 20 06 , work in g in te res t re po rt s en t t o J im as to wlo ), in di cat in g t ha t the re was no ne t re ve nu e fro m pr oduc ti on ass oc ia te d wi th th e Sch uyler l eas eh ol d wel ls be twee n M ay 22 , 20 06 , an d No ve m

be r 30 , 20 09 . Stat em en ts of a cco un t s en t t o Oi l Co min g s ho w th at , by Decem be r 31 , 20 09 , Oil Co m in g's am ou ntdu e Ene rg yte c h adbe enreduc edfro m $3 9,1 32 to $2 6,1 01 by its pro rat a sh are ($ 13 ,03 1) of n etrev enue fro m pro du ct io n as so ci at edwith t he Mi ls te adlea se ho ldwell s. Lit ig at io n In st itut edby the W orki ng Int eres t Own ers Man y of t he work in g i nt eres t o wne rs (ot he r th anEner gytec) were u nh ap py with t he st at e o f affa irs de sc rib edinth e worki ng in te res t re po rts . They se ntlet te rs to Ener gytec o bjec ti ng an d d em an di ng to be pa idon th e b as is of m on th ly pro jecte d- 16 -

[* 16 ] pro du ct io n ra th er tha n a ctua l n etrev enue s fr om pro du ct io n, the form er b ei ng
co ns is te ntwith wh atth ey be li ev edto be th ei r ag reem en t o r un de rs ta nd in g wi th Fran k W. Col e (re pr es en ti ng bo th Co le Eng in eeri ng an d En erg yte c an d wh o, be fo re Ma rch 18 , 20 06 , was the ch ai rm anof t he bo ard , chi ef ex ecu ti ve off ic er, an d ch ie f fi na nc ia l o ffi cer o f Ene rg yte c) as to th e n atur e o f th ei r worki ng in te res ts . The reaf te r, on Octo be r 23 , 20 07 , Jo m ar Oi l, LLC (J om ar), a wo rk in g in te res t o wne r in vo lv edinon e o f Ene rg yte c's oi l wel l dril li ng pro gr am s, i ns ti tu te d
su itag ai ns t En erg yte c, Fran k W. Col e, an d o th er i nd iv idua ls inth e U.S. Dis tri ct Co urt fo r th e North ernDis tri ctof Tex as see ki ng res ci ss io n o f th e in ve st m en t an d
m on et ary da m ag es forall eg edm is rep res en ta ti on , frau d, v io la ti on of F ed eral an d St at e se cu rit ie s l aws , bre ach of c on tra ct , andco nv ers io n o f fu nd s o n t he pa rt o f th e de fen da nt s (J om ar l it ig at io n) . Jo m ar was joi ne d i n t ha t s ui t b y nu m ero us ot he r worki ng in te res t o wne rs in vo lv edinEner gytec dril li ng pro gr am s, i nc lu di ng th e LLCs, b y th e fi li ng of a n " Am en de d C on so li da te d C om pl ai nt " i n J un e 2 00 8 a nda "Co ns ol id at edCo m

pl ai nt " i n No ve m

be r 20 08 . Ji m as to wlo all eg ed , with re sp ectto "In co m e Pro gr am

10 5" (co ns is ti ng of i ts sh are o f th e worki ng in te res t i n t he Sch uyler l eas eh ol d wel ls ), th atEner gytec's ev al ua ti on rep ort an d t he purch as e ag reem en t kno win gl y

or r eck le ss ly "m ad e m at eri al m is rep res en ta ti on s an d fa ls e st at em en ts ". Inad di ti on , Ji m as to wlo in co rp or at edall eg at io ns co m m on to all of- 17 -

[* 17 ] th e co ns ol id at edpl ai nt iff s tha t En erg yte c o m it te d m at eri al fact s, i nc lu di ng th e fac t tha t " th e true na ture o f th e In co m e Pro gr am s was a 'Po nz i' s ch em e, orpa rt of a 'Po nz i' s ch em e b ei ng pe rp etrat edby * * * [Ene rg yte c] whereb y * * * the in ve st m en t re tu rn s p ro m is edto th e Pl ai nt iff s wer e il lu so ry ". Oil Co m in g m ad e es se nt ia ll y

id en ti cal all eg at io ns with re sp ectto "In co m e Pro gr am 70 " (co ns is ti ng of it s s ha re o f th e worki ng in te res t i n t he Mi ls te adlea se ho ldwell s) . In i ts an swe r, da te d Dec em

be r 17 , 20 08 , Energ yte c d en ie d t he all eg at io ns of t he va rio us pl ai nt iff s, i nc lu di ng th os e o f Ji m as to wlo an d Oi l Co m in g, s ou gh t re jecti onof a ll cl ai m s, an d a ss ert edco un te rcl ai m s fo r un rei m bu rs edam ou nt s p ai d i n e xc es s o f ne t
rev enue s. On J un e 2 6 a ndJu ly 10, 2 00 9, the co urt d en ie d m ot io ns by two o f th e in di vi du al de fen da nt s i n t he Jo m ar l it ig at io n t o d is m is s the co ns ol id at ed
co m pl ai nt . See J om ar Oi l, LLC v . Energ yte c, In c., No. 3 :0 7- CV-1 78 2- LECF, 20 09 W L 18 56 58 2 (N.D. Tex . Ju ne 26 , 20 09 ); J om ar Oi l LLC v . Energ yte c, In c., No. 3 :0 7- CV-1 78 2- L, 20 09 W L 20 02 91 8 (N.D. Tex . Ju ly 10, 2 00 9)
. Subs eque nt ly, in it s o rd er d at edFeb ru ary 19 , 20 10 , th e co urt, h av in g c on si de red th e p art ie s' s ta tu s re po rt andhavi ng st ay edth e cl ai m s ag ai ns t En erg yte c o n acco un t o f it s ch ap te r 11 ba nkrupt cy , det erm in edth at"i t i s ap pr op ria te to st ay th e rem ai ni ng cla im s b ro ug htby Plai nt iff s an d * * * Thi rd -Party Plai nt iff s" , andit- 18 -

[* 18 ] furth er d et erm in edth atth e cas e "s ho ul d b e, an d i s h ereb y , adm in is tra ti ve ly cl os ed ." The co urt d ire ct edth e p art ie s t o m ov e to reo pe n t he cas e wit hi n 3 0 d ay s of th e en d o f ba nkrupt cy

pro ceed in gs or upo n t he li ft o f th e b an krup tc y st ay . To da te , th ere h as be enno de ci si on on th e m eri ts inth e Jo m ar l it ig at io n. LLCs' Re tu rn s Non e o f th e Fo rm s 1 06 5 t ha t the LLCs fi le d fo r th e au di t years i nd ic at es th at ei th er was a m em

be r of an y pa rtn ers hi p o r joi ntve ntur e, no r do th os e returns id en ti fy an y gro ss rece ip ts or d educ ti on s at tri bu tabl e to an othe r (s ou rce) pa rtn ers hi p. Onli ne 3 o f Sch edul e B, Oth er In fo rm at io n, o f eac h o f th os e returns , each LLC ans weredno to th e que st io n wh ethe r itown edan y in te res t i n a no th er pa rtn ers hi p, n ordi d t ho se returns co nt ai n e nt rie s d eri ve d fr om a Sch edul e K-1 , Part ne r's Sh are o f In co m e, Deduc ti on s, Cr ed it s, et c., is su edto th e LLCs b y an y so ur ce p artne rs hi p. Mo st , if n otall , of the LLCs' d educ ti on s tha t re sp on de nt ch al le ng es he rei n (e .g., "o il & g as ex pe ns es -IDC" , "o il de pl et io n e xp ", "o il & g as pr oduc ti on ex pe ns es ", "qua l p ro du ct io n a ct iv it ie s" ) rel at e to th e p ro du ct io n (o r at te m pt edpro du ct io n) of o il . All o f th e Fo rm s 1 06 5 fo r th e au di t years s tate th e LLCs' p rin ci pa l b us in es s ac ti vi ty to b e m anuf actur in g a ndst at e it s p rin ci pa l pr oduc t o r se rv ic e to be oi l an d g as pro du ct io n.- 19 -

[* 19 ] Ener gytec's Returns The Fo rm s 1 12 0, U.S. Co rp or at io n In co m e Tax Return, fi le d b y Ener gytec fo r 20 04 -0 6 s ta te it s p rin ci pa l b us in es s ac ti vi ty as oi l an d g as ex pl or at io n. Th e Fo rm 11 20 for20 04 rep orts gro ss rece ip ts of o ve r $1 6 m il li on att rib ut ab le to "Di sp os it io n o f va rio us work in g i nt eres ts ". Non e o f th os e returns rep orts an y in co m e fro m

U.S. partn ers hi ps or " pa ss -th ro ug h" en ti ti es or ( fo r 20 06 ) fro m "n on in cl ud ib le [in it s co ns ol id at edreturn] U.S. ent it ie s." No Sch edul es K-1 are at ta ch edto an y

of t ho se returns . OPINION I. App li cab le Pri nc ip le s o f Law A. Defi ni ti on s o f Part ne rs hi p a ndPartne r Inpe rti ne ntpa rt, s ect io n 7 61 (a) d efi ne s a p artne rs hi p, fo r pu rp os es of
subt it le A (in co m e ta xe s) as i nc lu di ng a "s y nd ic at e, gr oup, p oo l, joi ntve ntur e, or ot he r un in co rp or at edorg an iz at io n thr ou ghor b y m ean s o f whi chan y

bu si ne ss * * * o r ve ntur e is carr ie d o n" . See al so sec ti on 1.7 61 -1 (a), In co m e Tax Reg s., whi chpro vi de s: "The term pa rtn ers hi p m ean s a p artne rs hi p a s d et erm in edun de r §§ 30 1.7 70 1- 1, 3 01 .77 01 -2 , and30 1.7 70 1- 3 o f th is ch ap te r." Inpe rti ne ntpa rt,
se ct io n 3 01 .77 01 -1 (a)( 1) , Pro ced . & Adm in . Reg s., p ro vi de s: "Whethe r an or ga ni zat io n i s an en ti ty sep arat e fro m it s o wne rs forfed eral tax purp os es is a- 20 -

[* 20 ] m atte r of

fed eral tax law an d d oe s n otde pe ndon whet he r th e o rg an iz at io n i s
reco gn iz edas a n e nt ity

un de r lo cal law." In p ert in en t p art , sec ti on 30 1.7 70 1- 1( a)(2 ), Pro ced . & Adm in . Reg s., ad ds : "A jo in t v en tu re o r ot he r co nt ractua l
arra ng em en t m ay

crea te a se pa rat e en ti ty for fed eral tax pu rp os es if the pa rti ci pa nt s ca rry

on a tr ad e, bu si ne ss , fin an ci al op erat io n, o r ve ntur e an d d iv id e th e p ro fit s the refr om ." Itcau ti on s, h owe ve r: " Nev erthe le ss , a joi ntun de rta ki ng
m erel y to sh are e xp en se s d oe s n otcrea te a se parat e en ti ty for fed eral tax pu rp os es ." Id . Sect io n 3 01 .77 01 -2 (a), Pr oc ed . & Adm in . Reg s., d efi ne s a bu si ne ss en ti ty as "an y

en ti ty recog ni zedforfed eral tax purp os es * * * tha t i s n ot * * * a tru st* * * o r ot he rwis e subjec t t o s pe ci al tre atm en t" . In p ert in en t p art , se ct io n 3 01 .77 01 -2 (c)( 1) , Pro ced . & Adm in . Reg s., s ta te s: "The term pa rtn ers hi p
m ean s a b us in es s en ti ty tha t i s n ota co rp or at io n * * * an d tha t h as at l eas t two
m em be rs ." See als o C omm is si on er v . Cul be rts on , 33 7 U.S. 7 33 , 74 0 (1 94 9) , in whi chth e Supr em e Co urt d efi ne d apa rtn ers hi p a s " anorg an iz at io n fo r th e pr oduc ti on of i nc om e to whi cheach pa rtn er co nt rib ut es on e o r bo thof t he in gr ed ie nt s o f in co m e-capi ta l o r se rv ic es ." A do m es ti c b us in es s en ti ty w ith t wo o r
m or e m em

be rs th atis no t fo rm edas aco rp or at io n u nd er St at e o r Fed eral law (ape r se co rp or at io n) an d t ha t h as no t el ect edto be cla ss ifi edas aco rp or at io n i s- 21 -

[* 21 ] cla ss ifi edas apa rtn ers hi p. Se e se c. 30 1.7 70 1- 3( a) an d (b )(1 ), Pro ced . & Adm in . Reg s. Sect io n 6 23 1( a)(1 )(A) g en eral ly defi ne s " th e te rm 'pa rtn ers hi p'" , for pu rp os es of t he TEFRA pro vi si on s, as "an y pa rtn ers hi p re qu ire d t o fi le a return un de r se ct io n 6 03 1( a)." Se ct io n 6 03 1( a) ap pl ie s t o p artne rs hi ps "as de fin edin
se ct io n 7 61 (a)"
. Sect io n 6 23 1( a)(2 )(A) d efi ne s a p artne r as "a p artne r in th e p artne rs hi p"
an d, i n p ert in en t p art , sec ti on 62 31 (a)( 9) de fin es a "p as s- th rupa rtn er" as " a pa rtn ers hi p * * * th ro ug h wh om ot he r pe rs on s h ol d a n i nt eres t i n t he pa rtn ers hi p with re sp ectto whi chpro ceed in gs un de r th is subc hapt er [the TEFRA pro vi si on s]
are c on du ct ed ." Sh ou ldwe fin d t ha t the op erat io n o f th e wel ls on th e Sch uyler
an d M il st eadlea se ho ld s (s om et im es , well op erat io ns ) fo r th e b en efi t o f Ene rg yte c
an d t he ot he r worki ng in te res t o wne rs , in cl ud in g t he LLCs, cre at edsep arat e en ti ti es cla ss ifi edas p artne rs hi ps forFed eral in co m e ta x p ur po se s (wi th th e LLCs
as pa rtn ers th erei n) , itis cle ar tha t, as LLCs t ax ab le as p artne rs hi ps , th e LLCs
wou ldco ns ti tu te "p as s- th ru " p artne rs un de r se ct io n 6 23 1( a)(9 ).- 22 -

[* 22 ] B. Ju ris di ct io n Ov er an d Def in it io ns of P artne rs hi p It em s an d Aff ect ed Ite m s Sect io n 6 22 1 p ro vi de s: SEC. 6 22 1. TAX TREAT MENT DETERMINED AT

PARTNERSHIP LEVEL. Exc ep t as othe rwis e p ro vi de d i n t hi s s ub ch ap te r, [e.g ., sec ti on s 62 23 (e)( 2) , 62 27 (d )(1 ), an d 6 23 1( b) , in vo lv in g s pe ci al cir cu m st an ces in whi chpa rtn ers hi p i te m s ar e tr eat edas n onpa rtn ers hi p i te m s] th e ta x tre atm en t o f an y

pa rtn ers hi p i te m

(an d t he ap pl ic ab il ity

of any pe na lty , add it io n t o t ax , or a dd it io na l am ou ntwhi chrel at es to an ad jus tm en t t o apa rtn ers hi p i te m) sh al l b e d et erm in edat t he pa rtn ers hi p l ev el
. Inpe rti ne ntpa rt, s ect io n 6 23 1( a)(3 ) de fin es a "p artne rs hi p i te m " as : "a ny it em requi redto be tak enin to acco un t fo r th e p artne rs hi p's tax ab le y ear * * * to th e ex te nt[IRS] reg ul at io ns * * * p ro vi de th at* * * s uc h i te m is m or e ap pr op ria te ly det erm in edat the pa rtn ers hi p l ev el th anat the partn er l ev el ." Sect io n 3 01 .62 31 (a)( 3) -1 (a), Pr oc ed . & Adm in . Reg s., i nc lu de s as pa rtn ers hi p i te m s " m or e ap pr op ria te ly det erm in edat t he pa rtn ers hi p l ev el th anat th e p artne r le ve l * * * [t]he partn ers hi p a gg reg at e an d e achpa rtn er's sh are o f" a
nu m be r of li st edit em s i nc lu di ng "[i ]tem s o f in co m e, ga in , lo ss , deduc ti on , or cred itof t he pa rtn ers hi p" an d a ls o i nc lu di ng "[t ]he d ep le ti onall owa nc e und er se ct io n 6 13 A with re sp ectto oi l an d g as well s" . Sec. 3 01 .62 31 (a)( 3) -1 (a)( 1) (i) , (v i)( D), Pro ced . & Adm in . Reg s.- 23 -

[* 23 ] Sect io n 6 23 1( a)(5 ) de fin es th e te rm "aff ect edit em " as "an y

it em to th e
ex te ntsu chit em

is affe ct edby a part ne rs hi p i te m ." The ex is te nc e o f anaffe ct ed it em no rm al ly resu lt s i n a"co m pu ta ti on al ad

jus tm en t" , def

in edas " th e ch an ge in th e ta x l iabi li ty of a p artne r whi chpro pe rly refle ct s the tre atm en t * * * of a pa rtn ers hi p i te m ." Sec . 62 31 (a)( 6) . In the cas e o f a co m pu ta ti on al ad

jus tm en t tha t do es no t re qu ire a partn er-l ev el de te rm in at io n, the Co m m is si on er i s n otrequi redto is su e a n ot ic e o f de fic ie nc y be fo re as se ss in g t he res ul ti ng tax de fic ie nc y ag ai ns t each pa rtn er. See sec . 62 30 (a)( 1) ; s ec. 3 01 .62 31 (a)( 6) -1 (a)( 2) , Pro ced . & Adm in
. Reg s. A co m

pu tati on al ad

jus tm en t tha t d oe s re qu ire a partn er-l ev el de te rm in at io n is subjec t t o the de fic ie nc y pro cedur es (se ct io ns 62 11 -6 21 6) . See s ec. 6 23 0( a)(2 );
se c. 30 1.6 23 1( a)(6 )-1 (a)( 3) , Pro ced . & Adm in . Reg s. Bec au se affe ct edit em s d ep en d upo n p artne rs hi p- le ve l d et erm in at io ns with
res pe ctto pa rtn ers hi p i te m s, an y is su an ce o f no ti ce o f de fic ie nc y or F PAA reg ard in g a ffec te d i te m s, an d a ny resu lt in g l it ig at io n, m us t awa itth e o ut co m e o f th e p artne rs hi p p ro ceed in g o r th e ex pi rat io n o f th e ti m e to in it ia te on e. See Max well v. Co m

m is si on er, 8 7 T.C. 7 83 , 79 2 (1 98 6) . Thatrul e ap pl ie s equa ll y to affe ct edit em s re po rte d b y a "p as s- th ru " p artne r th atwere d eri ve d fr om a lo wer t ie r or"s ou rce" pa rtn ers hi p. Se e Sen te Inv . Club P 'sh ip of Ut ahv. Co m m is si on er, 9 5 T.C. 24 3, 2 48 (19 90 ). See al so Rawl s Tra di ng , L.P. v. Co m m is si on er, 1 38 T.C.- 24 -

[* 24 ] 27 1 (2 01 2) , wher ei n t he Co m m is si on er s im

ul ta ne ou sl y

is su edFPAAs t o t wo lo wer t ie r "s ou rce" pa rtn ers hi ps an d o ne up pe r ti er o r "i nt eri m " (" pa ss -th ru ") pa rtn ers hi p. We hel d, o n o urownm ot io n, tha t, b ecau se th e FPAA i ss ue d t o t he in te rim partn ers hi p re fle ct edon ly com pu ta ti on al ad

jus tm en ts res ul ti ng fro m ad jus tm en ts to th e so ur ce p artne rs hi p re tu rn s, the FPAA is su edto th e in te rim pa rtn ers hi p was "i nv al id " an d d id"n otco nf er jur is di ct io n o n u s." Id. at28 8- 28 9. The pri nc ip le enun ci at edinMax well , Sen te Inv . Club P 'sh ip of Ut ah , and Rawl s Tra di ng , th atwe lac k juris di ct io n t o re de te rm in e aff ect edit em s at tri bu tabl e to a so ur ce p artne rs hi p b efo re the so ur ce p artne rs hi p- le ve l p ro ceed in gs ha ve be en co m pl et ed , app li es ev enwhen th e m em be rs of t he so ur ce p artne rs hi p h av e fai le d to reco gn iz e th atth ey

ha ve crea te d asep arat e en ti ty (i.e., a pa rtn ers hi p) for Fed eral in co m e ta x p ur

po se s an d h av e n ot , th eref or e, fi le d apa rtn ers hi p re tu rnon it s be ha lf, andth e Co m

m is si on er h as ne ithe r co nduc te d aso ur ce p artne rs hi p- le ve l
au di t n oris su edanFPAA to it . See Alh ou se v. Co m m is si on er, T.C. Mem o. 1 99 1- 65 2, af f'dsub n om . Berg fo rdv. Co m m is si on er, 1 2 F .3d16 6, 1 70 (9t h C ir. 1 99 3)
. Sect io n 6 22 9( c)(3 ) pr ov id es th at , if a p artne rs hi p fa il s t o fi le a return fo r an y ta xabl e y ear ( whi chwou ldbe th e cas e h erei n s ho ul d we d et erm in e th atth e wel l op erat io ns crea te d s ep arat e en ti ti es cla ss ifi edas p artne rs hi ps ), "an y tax- 25 -

[* 25 ] att rib ut ab le to a pa rtn ers hi p i te m (oraffe ct edit em) ari si ng insu chy ear m ay be ass es se d a t an y

ti m e." C. Treat m en t o f th e Sec ti on 46 9 Is su e Sect io n 4 69 pro vi de s ru le s l im it in g p as si ve act iv ity lo ss es an d c red it s. Sect io n 4 69 (c)( 3) pro vi de s tha t a wo rk in g i nt eres t i n a ny oil or g as pro pe rty is, p er se , no t a p as si ve act iv ity , pro vi de d t ha t the in te res t i s n othe ldth ro ug h a n e nt ity th atli m it s the in te res t h ol de r's li ab il ity with re sp ectto th atin te res t. Ass um in g t he well op erat io ns di d, i n fa ct , creat e se pa rat e en ti ti es cla ss ifi edas p artne rs hi ps for Fed eral in co m e ta x p ur

po se s, the is su e o f whe th er the m em be rs of t he LLCs co ul d
av oi d app li cat io n o f th e p as si ve act iv ity lo ss rul es pu rs ua ntto sec ti on 46 9( c)(3 ) sh ou ldbe co ns id eredanaffe ct edit em . Thatco nc lu si on is ba se d upo n the si mil ari ty betweenth atis su e (i .e., app li cab il ity of t he li m it edli ab il ity

pro vi so ) an d th e is su e o f whe th er p artne rs hi p l os se s ex ceedth e am ou nt s fo r whi chth e p artne rs are a t ri skun de r se ct io n 4 65 , whi chwe ha ve he ldto co ns ti tu te anaffe ct edit em . See R ob ert s v . Comm is si on er, 9 4 T.C. 8 53 , 86 1 (1 99 0)
. D. Treat m en t o f th e Pen al ty Issu e The accu racy-rela te d p en al ti es res po nd en t i m po se d a ga in stth e LLCs are d es cri be d a s ap pl y in g " to all un de r-p aym en ts of t ax attrib ut ab le to ad jus tm en ts of p artne rs hi p i te m s." There fo re, s ho ul d we d et erm in e th atth e- 26 -

[* 26 ] all eg edun de rp aym en ts he rei n re la te to partn ers hi p i te m s at tri bu tabl e to
so ur ce p artne rs hi ps inwhi chth e LLCs a re p artne rs , th e ap pl ic ab il ity of t ho se al le ge d p en al ti es wou ldha ve to be de te rm in edat t ha t s ou rce p artne rs hi p l ev el pu rs ua ntto sec ti on 62 21 . See al so sec . 62 26 (f) (g ran ti ng a rev ie win g c ou rt i n a TEFRA pr oc eed in g juris di ct io n t o " de te rm in e * * * th e ap pl ic ab il ity of a ny pe na lty , add it io n t o t ax , or a dd it io na l am ou ntwhi chrel at es to anad jus tm en t t o a pa rtn ers hi p i te m "). Sect io n 3 01 .62 21 -1 (d ), Pro ced . & Adm in . Reg s., s ta te s tha t p artne r-l ev el de fen se s t o a ny pen al ty or ad di ti on to tax , su chas t he reas on ab le cau se ex cep ti on of sec ti on 66 64 (c)( 1) (in th es e cas es , pet it io ne r's cla im th athe reas on ab ly reli edon "s up po rti ng do cu m en ta ti on "), " m ay no t b e as se rte d i n t he pa rtn ers hi p- le ve l pr oc eed in g, b utm ay

be ass ert edth ro ug h s ep arat e ref un d a ct io ns fol lo win g as se ss m en t an d p aym en t." Sect io n 3 01 .62 21 -1 (c), Pr oc ed . & Adm in . Reg s., al so st at es th at"[p ]artn er-l ev el de fen se s t o s uc h i te m s ca n o nl y be ass ert edth ro ug h refu ndact io ns fol lo win g a ss es sm en t an d p aym en t." See al so sec . 62 30 (c)( 1) (C), (4 ) (t og ethe r pr ov id in g t ha t a p artne r m ay fil e a cl ai m

forrefu ndass ert in g t he Co m m is si on er's im

pr op er i m po si ti on of a ny pen al ty or ad di ti on to tax at t he pa rtn ers hi p l ev el , in cl ud in g t he ass ert io n o f "an y pa rtn er l ev el de fen se s tha t m ay ap pl y "); New Mi ll en ni um Trad in g, LLC v . Comm is si on er, 1 31 T.C. 27 5, 2 84- 27 -

[* 27 ] (2 00 8) ("Whenco ns id eri ng th e d et erm in at io n o f pe na lt ie s atth e p artne rs hi p le ve l, the Co urt ca n c on si de r th e d efen se s o f th e p artne rs hi p b utno t p artne r-l ev el de fen se s o f in di vi du al pa rtn ers ."). Co urts ha ve de em editap pr op ria te , ho wev er, un de r certa in cir cu m st an ces , to co ns id er p artne r-l ev el de fen se s t o t he im po si ti on of pe na lt ie s an d a dd it io ns to tax inth e p artne rs hi p- le ve l p ro ceed in g. Se e, e.g ., Tig ers Ey e Trad in g, LLC v . Comm is si on er, T.C. Mem o. 2 00 9- 12 1, 2 00 9 WL 14 75 15 9, at*1 9 (p artne rs hi p- le ve l d efen se s " in cl ud e al l d efen se s tha t re qu ire factua l fi nd in gs th atare g en eral ly relev an t t o a ll partn ers or acla ss of p artne rs "); San taMo ni ca Pi ctur es , LLC v. Co m m is si on er, T.C. Mem o. 2 00 5- 10 4, 2 00 5 W L 11 11 79 2, at*9 4- *1 12 ; Kl am ath S tra te gi c In v. Fu nd , LLC v. Uni te d S ta te s, 47 2 F . Sup p. 2 d 8 85 , 90 3- 90 4 (E.D. Tex . 20 07 ), aff'd , 56 8 F .3d53 7 (5 thCir
. 20 09 ). In a ny even t, fo r rea so ns ex pl ai ne d abo ve , partn er-l ev el de fen se s t o t he im po si ti on of the sec ti on 66 62 accu racy-rela te d p en al ty may no t b e tr ie d i n a pa rtn er-l ev el pro ceed in g b efo re the ap pl ic at io n o f th atpe na lty to th e p artne rs hi p ha s b eende te rm in edina pa rtn ers hi p- le ve l p ro ceed in g. E. Dis reg ard in g aPartne rs hi p Ass um in g t he well op erat io ns di d, i n fa ct , creat e se pa rat e en ti ti es cla ss ifi ed
as pa rtn ers hi ps forFed eral in co m e ta x p ur po se s, the de te rm in at io n o f whe th er the pa rtn ers hi ps sh ou ldbe di sr eg ard edfortax pu rp os es un de r a l eg al do ctrin e su chas- 28 -

[* 28 ] sh am

or e co no m ic subs ta nc e is a pa rtn ers hi p i te m . Peta lu m a FX Partn ers , LLC v. Co m

m is si on er, 1 31 T.C. 84 , 93 , 97 (20 08 ), aff'don th is is su e, 59 1 F .3d 64 9, 6 53 -6 54 (D.C. Cir . 20 10 ); s ee al so RJ T Inv s. X v . Comm is si on er, 4 91 F.3d 73 2, 7 37 -7 38 (8t h C ir. 2 00 7)
. F. The ft Lo ss Dedu ct io n Lik ewis e, pe ti ti on er's alt ern at iv e cl ai m --tha t b ecau se itwas d is co ve redin 20 06 th atth e LLCs h adin ve st edina Po nz i s ch em e, eac h LLC i s en ti tl edto a th eft lo ss de du ct io n fo r th aty ear f orit s en ti re i nv es tm en t u nd er s ect io n 1 65 (e)-
- in vo lv es a pa rtn ers hi p i te m . In M ari ne v. Co m m is si on er, 9 2 T.C. 9 58 , 96 7- 97 7 (1 98 9) , aff'dwitho utpubl is he d o pi ni on , 92 1 F .2d28 0 (9 th Cir . 19 91 ), a p reTEFRA cas e, we st at edth at , when a ge ne ral pa rtn er em be zzl es li m it edpa rtn ers '
cas h c on tri bu ti on s, h e is no t ac ti ng inth is cap aci ty as a p artne r, si nc e h e h as no au th or ity to st eal . The p artne rs hi p a ndno t, d ire ct ly, th e in di vi du al pa rtn ers , is ab le to de du ctth e th eftlo ss as i f a n onpa rtn er h adco m m it te d t he em

be zzl em en t. Id . In Mi dc on ti ne ntDril li ng Ass oc s. v . Comm is si on er, T.C. Mem o. 1 99 4- 11 9, 1 99 4 W L 91 17 0, at*5 , a TEFRA cas e, we st at ed(onth e au th or ity of M ari ne ): " A pa rtn ers hi p m ay

be en ti tl edto de du ctanem be zzl em en t l os s." W e fo un d, h owe ve r, th at , alt ho ug h t he parti es ha d s ti pu la te d t ha t the ge ne ral pa rtn er h adem be zzl ed
su m s fr om

th e p artne rs hi p, the pa rtn ers hi p fa il edto pro ve su ffi ci en t d et ai ls to- 29 -

[* 29 ] jus ti fy

it s cl ai m edth eftlo ss . Im pl ic itinou r di sc us si on is th e as su m pt io n th atth e g en eral pa rtn er's m is ap pr op ria ti on of t he li m it edpa rtn ers ' cap it al
co nt rib ut io ns was apartn ers hi p i te m . W ere i t n ot , we wou ldha ve di sm is se d t ha t po rti onof t he pe ti ti on forlac k o f juri sd ic ti on . 5 Res po nd en t ar gu es th at , "s ho ul d p et it io ne r's Po nz i s ch em e al le ga ti on s 5 ev en tu al ly be p ro ve d c orrect , th enth e In co m e Pro gr am s an d t he all eg edso ur ce pa rtn ers hi ps are n otpa rtn ers hi ps forfed eral in co m e ta x p ur po se s." Res po nd en t's arg um en t ab ou t al le ga ti on s tha t m ig htev en tu al ly be p ro ve d c orrectis anarg um en t th ata ge nu in e is su e o f m at eri al factrem ai ns th atsh ou ldpre cl ud e a d eci si on at t hi s ti m e. W e rejectth atarg um en t. We reop en edth e rec or d a ndco nduc te d t he sec on d tri al so th atth e p art ie s co ul d i nt ro du ce ad di ti on al ev id en ce as to whet he r th e in co m e p ro gr am s co ns ti tu te d p artne rs hi ps . Res po nd en t h as , th us , hadad equa te op po rtu ni ty to p res en t ev id en ce o f frau d a ndto arg ue (pr es um ab ly) tha t fr au d i n th e in du cem en t t o b eco m e p artne rs ne ga te s the pa rtn ers hi p. We hav e n ei th er ad equa te ev id en ce o f frau d n ora fl es he d- ou t ar gu m en t o n b rie f. The re co rdis ag ai n c lo se d, an d we wi ll de ci de th e ex is te nc e-o f-a- pa rtn ers hi p i ss ue on th e rec or d an d a rg um en ts infro ntof u s. Inpa ss in g, we n ot e th atres po nd en t's lawyers h av e, pe rh ap s i nc on si st en tl y , de al t wi th a si m il ar ar gu m en t ad m in is tra ti ve ly. In a n IR S Fi el d S erv ic e Adv is ory , 19 97 W L 33 31 43 38 (Ju ne 3, 1 99 7) (FSA), the Ch ie f Co un se l re co ns id ereda pr ev io us FSA, 19 94 W L 18 65 98 8 (J un e 3 , 19 94 ). The two FS As ad dr es se d pr oc edur es forres ol vi ng th eftlo ss de du ct io ns cla im edby vic ti m s o f th e Po nz i sc he m es pe rp etrat edby the op erat or s o f TEFRA pa rtn ers hi ps . In the fir stFSA, th e Ch ie f Co un se l's Nati on al Offic e to okth e p os it io n t ha t the TEFRA partn ers hi p pr ov is io ns wou ldgo ve rnth e th eftlo ss es on ly if th e p artne rs hi p e nt it ie s d ire ct ly in cu rredth e lo ss es (whi chwou ldbe pa ss edth ro ug h t o t he pa rtn ers un de r th e pr ov is io ns of s ub ch . K (th e p artne rs hi p p ro vi si on s o f th e In te rn al Rev enue Co de )). If, o n the ot he r hand , th e in di vi du al in ve st or s wer e d efraud edin to in ve st in g i n t he pa rtn ers hi ps , th e FSA h el d, the TEFRA pro cedur es wou ldno t ap pl y . Whe th er the ge ne ral pa rtn ers ha d, i n fa ct , parti ci pa te d i n t he frau d b y in du ci ng in no cen t pa rtn ers to in ve stinth e "s ha m " p artne rs hi ps ha d n otbe ende te rm in ed , andth e (co nt in ue d...)- 30 -

[* 30 ] II. Ana lysis A. Whe th er Well Oper at io ns Crea te d En ti ti es Cla ss ifi edas P artne rs hi ps 1. In tro du ct io n Whe th er we ar e p recl ud edfro m de ci di ng th e subs ta nt iv e is su es inth es e co ns ol id at edcas es an d, the refo re, m us t d is m is s the cas es forlac k o f juri sd ic ti on de pe nd s o n wh ethe r fo r Fed eral tax pu rp os es th e wel l o pe rat io ns crea te d e nt it ie s se pa rat e fro m

th e co own ers (in cl ud in g LLCs ) of th e worki ng in te res ts . If th ey di d,
an d t he en ti ti es are p ro pe rly clas si fie d a s p artne rs hi ps , th enth e subs ta nt iv e is su es in vo lv e p artne rs hi p i te m s o r affe ct edit em s, an d a ll pa rtn ers hi p i te m s (i nc lu di ng whe th er the pa rtn ers hi ps are t o b e d is reg ard ed , e.g., as sh am s o r fo r la ck of (...co nt inue d) 5 is su e in th e se co ndFSA was whet he r th e IRS m us t i ss ue pro te ct iv e st atut ory no ti ces of d efi ci en cy

for de fic ie nc ie s at tri bu tabl e to th eftlo ss es cla im edby TEFRA pa rtn ers on th ei r own returns . The s eco ndFSA co nc lu de d t ha t the IRS ne edno t i ss ue th e p ro te ct iv e st atut ory no ti ces "b ecau se , irre sp ect iv e o f whe th er th e g en eral pa rtn er p art ic ip at edinth e frau d, the res ul ti ng lo ss is eithe r a pa rtn ers hi p i te m

or a n a ffec te d i te m

an d i s thu s p ro pe rly det erm in ab le at t he pa rtn ers hi p l ev el ." The sec on d F SA rel ie s p rin ci pa ll y on Mari ne v. Co m

m is si on er, 92 T.C. 95 8, 9 67 -9 77 (19 89 ), aff'dwitho utpubl is he d o pi ni on , 92 1 F .2d28 0 (9 th Ci r. 19 91 ), an d M id co nt in en t Dri ll in g As so cs . v. Co m m is si on er, T.C. Mem o. 19 94 -1 19 , inreac hi ng th atres ul t. The sec on d F SA ap pe ars to co nt rad ic t res po nd en t's po si ti on he re tha t, i f th e Po nz i s ch em e al le ga ti on s p ro ve co rrec t (wh ic h h as no t yet be ende te rm in ed ), th ere a re n o p artne rs hi ps . Res po nd en t d oe s no t i n h is arg um en t h ere a dd res s the qu es ti on of " as of wh en " the re wo ul d b e n o pa rtn ers hi ps : ab in it io or wh enth e Po nz i s ch em e was di sc ov eredor p ro ve d. Cf
. se c. 16 5( e).- 31 -

[* 31 ] eco no mic subs tanc e) m us t b e d et erm in edfir stina pa rtn ers hi p- le ve l pr oc eed in g, b efo re the co ns eque nc es of any partne rs hi p- le ve l d et erm in at io ns m ay be ap pl ie d t o t he LLCs (i .e., to th e p artne rs ). It i s tru e th at , hadso m eo ne at o r act in g o n b eh al f of

Ener gytec d et erm in edth atth e wel l o pe rat io ns di d c reat e pa rtn ers hi ps forit s m an y joi ntdri ll in g v en tu res (in cl ud in g t ho se to whi chth e LLCs wer e p art ie s) an d, o n a cco un t o f th atde te rm in at io n, d idfil e p artne rs hi p returns on be ha lf o f th os e rel at io ns hi ps , th enth e que st io n o f whe th er the well op erat io ns di d, i n fa ct , gi ve ris e to pa rtn ers hi ps forFed eral in co m e ta x p ur po se s wou ldap pr op ria te ly be d et erm in edinpa rtn ers hi p- le ve l p ro ceed in gs di rect edat t he pu ta ti ve pa rtn ers hi ps . See s ec. 6 23 3( a); sec . 30 1.6 23 3- 1( a), Pro ced . & Adm in
. Reg s. Th ere a re, h owe ve r, no pa rtn ers hi p re tu rn s fo r su chpu ta ti ve pa rtn ers hi ps (n oran y FPAAs) , andwe m

us t m ak e th atde te rm in at io n i n t hi s n on -p artne rs hi ple ve l p ro ceed in g. Se e Alh ou se v. Co m mis si on er, T.C. Mem o. 1 99 1- 65 2 (" Si nc e no pa rtn ers hi p re tu rnwas fi le d a ndno no ti ce o f fi na l p artne rs hi p a dm in is tra ti ve ad jus tm en t (F PAA) is su ed , if we fi ndth ata pa rtn ers hi p e xi st edwe m us t d is m is s fo r la ck of ju ris di ct io n i ns of

ar as th e in di vi du al no ti ces of d efi ci en cy pe rta in to pa rtn ers hi p i te m s o r (aff

ect edit em s) .").- 32 -

[* 32 ] 2. Res po nd en t's Argu m en t Inhi s o pe ni ng bri ef, res po nd en t ar gu es : Thu s, fo r 20 04 an d 2 00 5, wh il e Ji m as to wlo an d Oi l Co m in g no m in al ly hel d wo rk in g i nt eres ts , recei ve d c as h p aym en ts , and cl ai m edex pe ns es , th e who le arran ge m en t l ack edan y real eco no m ic co nn ect io n t o a n a ctua l b us in es s en te rp ris e. The c as h p aym en ts were un rel at edto pro du ct io n, an d the ex pe ns es cla im edwere u nr el at edto op erat io ns . * * * [W] hi le th e arrang em en ts be twee n J im as to wlo , Oil Co m in g, an d En erg yte c n om in al ly inv ol ve d jo in t o wne rs hi p o f worki ng in te res ts , insubs ta nc e th ere was ne ve r a co m in g t og ethe r to sh are p ro fit s an d l os se s. W e und ers ta ndres po nd en t's arg um en t t o b e th at , no twi th st an di ng th ateach LLC
was am on g t he co own ers of awork in g i nt eres t tha t en ti tl edth os e co own ers to
ex pl or e fo r an d e xt ractoi l an d g as , inne ithe r cas e d idth e co own ers actua ll y joi n to ge th er t o e xp lo itth ei r ri gh ts , and , th eref or e, th ei r st atus as c oo wne rs was in su ffi ci en t t o c reat e anen ti ty (a bu si ne ss en ti ty) clas si fie d a s a p artne rs hi p fo r Fed eral tax pu rp os es . W e d is ag ree t ha t the co own ers di d n otactua ll y joi n t og ethe r to ex pl oi t the ir r ig ht s, an d we f urth er d is ag ree t ha t the y

fai le d t o c reat e anen ti ty cl as si fie d a s a p artne rs hi p. Ou r rea so ns fol lo w.

3. Co own ers of aW orki ng Int eres t Co ns is te ntwith t he di ct io na ry de fin it io n o f a wo rk in g i nt eres t quo te d s up ra no te 3, we h av e sa id : "Ge ne ral ly, * * * a wo rk in g i nt eres t i n a n o il fie ldis a le as eh ol d i nt eres t g ran te d b y th e fee si m

pl e o wne r of

th e la ndto ex pl or e fo r an d- 33 -

[* 33 ] ex tra ctoi l fr om

th e la nd ." Co ke s v . Comm is si on er, 9 1 T.C. 2 22 , 22 3 (1 98 8)
. Ene rg yte c h adwork in g i nt eres ts inth e Sch uyler an d M il st eadlea se ho ld s, an d i t
as si gn ed7.9 3% i nt eres ts inth os e worki ng in te res ts to th e LLCs. Re sp on de nt arg ue s tha t the ass ig nm en t t o J im as to wlo was n otva li d u nt il reco rd edin20 06 an d th atth e as si gn m en t t o Oi l Co m in g was no t v al idsi nc e n ev er re co rd ed
. Res po nd en t o ve rs tate s the cas e. Ther e were wri tt enass ig nm en ts of p erce nt ag e worki ng in te res ts to th e LLCs, ex ecu te d b y anoff ic er o f Ene rg yte c, whi ch , eve n th ou gh un reco rd ed , were v al id , un de r Tex as law, as be twee n t he LLCs an d Ene rg yte c. See Tex . Bus . & Co m . Cod e Ann . sec . 26 .01 (W es t 2 00 9) ; Tex . Pro p. Co de Ann . sec . 13 .00 1( b) (W es t 2 00 4) . Each LLC was , th us , a co te nant(i.e ., co own er) wi th Ener gytec (a ndot he rs ) of th e res pe ct iv e le as eh ol d. Se e Glo ve r v. Uni onPac. R.R . Co., 1 87 S.W .3d20 1, 2 13 (Tex . App . 20 06 ) ("Own ers of
un di vi de d p orti on s o f oi l an d g as in te res ts are t en an ts inco m m on ."). 6

Res po nd en t al so ag ue s tha t, b ecau se th e as si gn m en ts were n otex ecu te d 6 un ti l 2 00 5, the n, ev enif v al idun de r Tex as law, the y co ul d n otha ve be eneffe ct iv e fo r 20 04 . As no te d s up ra, h owe ve r, each ass ig nm en t s ta te d t ha t i t was "t o b e effe ct iv e" a s o f 20 04 , andev id en ce i n t he reco rdin di cat es th atth e LLCs i nv es te d in th e dril li ng pro gr am s an d a t l eas t Oi l Co m in g b eg anrece iv in g d is tri bu ti on s i n 20 04 . Evid en ce o f 20 04 in ve st m en ts by both J im as to wlo an d Oi l Co m in g i s al so furn is he d b y

Ener gytec's 20 04 return, wh ic h re po rts gro ss rece ip ts of o ve r $1 6 m il li on attrib ut ab le to "Di sp os it io n o f va rio us work in g i nt eres ts ". No a m ou ntis so de no min at edon eithe r it s 2 00 5 o r 20 06 return. We fin d o n t ho se fact s tha t the LLCs ef fect iv el y rece iv edth ei r pe rcen ta ge work in g i nt eres ts in20 04
.- 34 -

[* 34 ] 4. Carry in g Ona Trad e o r Bu si ne ss Co op erat iv el y Mer e co own ers hi p o f pr op erty , eve n i f itis m ai nt ai ne d, k ep t i n re pa ir, and
ren te d o r le as ed , do es no t co ns ti tu te anen ti ty sep arat e fro m th e co own ers fortax pu rp os es . See s ec. 3 01 .77 01 -1 (a)( 2) , Pro ced . & Adm in . Reg s. Nev erthe le ss , as st at edsupr a: "A joi ntve ntur e o r ot he r co nt ractua l arran ge m en t m ay crea te a se pa rat e en ti ty for fed eral tax pu rp os es if the pa rti ci pa nt s carry on a tr ad e, bu si ne ss , fin an ci al op erat io n, o r ve ntur e an d d iv id e th e p ro fit s the refr om ." Id
. (em ph as is ad de d)
. Dur in g t he au di t years, En erg yte c o pe rat edth e wel ls on th e Schuyler an d Mi ls te adlea se ho ld s, an d, wh il e b ot h p ro du ct io n a ndsal es of o il were m in im al , th ere wer e b ot h p ro du ct io n a ndsal es . Ind eed , du rin g t he sec on d t ria l, o ne of
res po nd en t's co un se ls co nc ed edth at , du rin g t he au di t years, the re was a bu si ne ss in ex is te nc e wit h re sp ectto each of t he Sch uyler an d M il st eadlea se ho ld s: a "b us in es s co ns is ti ng of dril li ng foroi l an d s el li ng it ". Co un se l ad de d: "Ene rg yte c own edth e b us in es s o r was co nduc ti ng th e o pe rat io ns of t he bu si ne ss act iv ity ." Co un se l's st at em en ts ab ou t the ex is te nc e o f bu si ne ss es with re sp ectto each le as eh ol d a re co ns is te ntwith o urfin di ng s. Th e b us in es s i n que st io n was ex pl oi ti ng th e ri gh ts co own edby the work in g i nt eres t o wne rs (in cl ud in g t he LLCs) t o e xp lo re fo r an d e xt ractoi l fr om each lea se ho ld . Duri ng th e y ears ,- 35 -

[* 35 ] Ener gytec d idno t i ts el f di rect ly ope rat e th e wel ls on th e Sch uyler an d Mi ls te adlea se ho ld s. Item pl oyed fi rs t Co le Eng in eeri ng an d t he n C omm an ch e to do so . W e h av e fo un d t ha t, dur in g tho se y ears , eachco ll ect edoi l fr om th e wel ls in ta nk s, s ol d t he co ll ect edoi l, o ffs etop erat in g e xp en se s ag ai ns t s al e p ro ceed s, an d ap po rti on edwhatpro ceed s re m ai ne d a m on g t he work in g i nt eres t o wne rs in pr op orti on to th ei r pe rcen ta ge in te res ts . W e h av e fu rth er fo un d tha t n o wo rk in g in te res t o wne r co ul d t ak e inki ndor s el l o n i ts ownit s s ha re o f an y oi l p ro du ct io n. W e h av e n otm ad e th os e fi nd in gs pri m ari ly on the ba si s o f th e ev al ua ti on rep orts
orot he r do cu m en ts inev id en ce, b utwe ha ve m ad e th em pri m ari ly on the ba si s o f te st im on y of r es po nd en t's witne ss , Pau l Will in gh am , who , beg in ni ng inSp rin g 20 05 , was, fi rs t, em

pl oyed b y Ener gytec as co nt ro ll er an d, the n, as vi ce pr es id en t/ co nt ro ll er. He was a cred ib le witne ss , fam il ia r with En erg yte c's op erat in g p ro cedur es . He tes ti fie d t ha t the oi l p ro du cedinco nn ect io n wi th an y on e o f Ene rg yte c's dri ll in g p ro gr am s " wen t i nt o atan k a nditwas s ol d a s a l oa d
an d t he n, o nc e th e rev enue cam e in , itwou ldbe di st rib ut edam on gs t wh oe ve r was th e o wne r ba se d upo n i ts own ers hi p p erce nt ag e." He t es ti fie d t ha t n ei th er LLC
co ul d t ak e it s s ha re o f th e o il inki nd
. Mr. Will in gh am 's d es cri pt io n o f th e dril li ng , sal es , andap po rti on m en t-o fpr oc eed s p ro ces s i s i nd ic at iv e th atEner gytec o pe rat edth e wel ls on th e Sch uyler- 36 -

[* 36 ] an d M il st eadlea se ho ld s o n aco op erat iv e b as is forth e worki ng in te res t
own ers , and , in de ed , we hav e so fou nd . In s o fi nd in g, we re co gn iz e th at , du rin g th e au di t years, n o wri tt enjoi ntop erat in g a gr eem en t g ov ern edop erat io n o f th e well s o n e ithe r th e Sch uyler o r th e Mi ls te adlea se ho ld . ThatEner gytec wo ul d op erat e th e wel ls on a co op erat iv e b as is witho uta writ te n jo in t o pe rat in g ag reem en t was , ho wev er, p refi gu redby the ev al ua ti on rep orts , whi chth e LLCs ha d re cei ve d b efo re re cei vi ng ass ig nm en ts of t he ir p erce nt ag e worki ng in te res ts . The rep orts de sc rib e Ene rg yte c as op erat in g t he well s o n t he lea se ho ld s; th ey st at e th atEner gytec i s o ffer in g t o s el l p ro gr am s co ns is ti ng of 7 .93 % work in g i nt eres ts in th e wel ls , andth ey

pro ject t he m on th ly netreturn t o e achpro gr am . It i s i m pl ic it in th e ev al ua ti on rep orts th atEner gytec wo ul d, d ire ct ly or in di rect ly, op erat e th e well s an d s ha re the ne t p ro ceed s p ro po rti on at el y am on g t he work in g i nt eres t
own ers . Tha t J im as to wlo un de rs to odth atitwas i n aco op erat iv e rel at io ns hi p a s reg ard s the Sch uyler l eas e dril li ng pro gr am was c ert ai nl y

th e und ers ta nd in g o f
an ot he r of

res po nd en t's witne ss es , Ste ve n D. Whit e, pe ti ti on er's pre de ces so r as tax
m at te rs pa rtn er fo r Ji m as to wlo . Whe n a sk edby resp on de nt 's c ou ns el ab ou t h is de ci si on to "i nv es t i n * * * Inc om e Pro gr am 10 5" , Mr. Whi te res po nd ed : "I wou ld
sa y I di dn 't i nv es t. I b ecame partne rs with t he m [Ene rg yte c]." Mr. Whi te furth er- 37 -

[* 37 ] tes ti fie d t ha t h e cam e away from a m eet in g wi th anEner gytec re pr es en ta ti ve with t he un de rs ta nd in g t ha t J im as to wlo wou ldbe pa rti ci pa ti ng ina pa rtn ers hi p i n th atitwou ldbe "o wni ng part o f a wel l tha t o th er p eo pl e wou ldha ve sh ares in
. The oi l wo ul d b e p ro du ced , andI wou ldge t my all ot te d I g ue ss return b ack ." On th e b as is of t he tes ti m on y of M es sr s. Will in gh am

an d Whi te , we th in k t ha t Ene rg yte c m ay

accu rat el y

be de sc rib edas t he co m

m on ag en t o f th e co own ers of each work in g i nt eres t fo r th e p ur po se of e xp lo it in g t he ap pu rte na ntlea se ho ld
. Altho ug h i t i s tru e th at , un ti l M arch 20 06 , th e LLCs r ecei ve d fi xe d pa ym en ts inex ces s o f th ei r sh ares of a ctua l n etrev enue s fr om pro du ct io n, i n M ay 20 06 Ener gytec i ni ti at edth e o rig in al ly int en de d a rran ge m en t b y requi rin g e ach LLC's fu ture s ha re o f actua l n etrev enue fro m pro du ct io n t o o ffs etth e ex ces s po rti onof wh atEner gytec h as be entre at in g a s p rio r advanc e p aym en ts ba se d upo n pr ojec te d n etrev enue . Mor eo ve r, as Mr. Will in gh am tes ti fie d, the co own ers (in cl ud in g t he LLCs) wer e cre di te d wi thth ei r sh ares of wh at ev er n etin co m e th e well s d idpro du ce. J im as to wlo 's n etrev enue fro m it s s ha re o f th e worki ng in te res t in th e Sch uyler l eas eh ol d a s o f Mar ch31 , 20 06 , was m in im al : g ro ss rev enue of $2 ,54 9, ac tu al ex pe ns es of $ 1,5 65 , netrev enue of $ 98 4. Oi l Co m in g fa red
so m ewh atbe tt er as of t ha t d at e fro m it s s ha re o f th e worki ng in te res t i n the Mi ls te adlea se ho ld : g ro ss rev enue of $ 26 ,76 2, ac tu al expe ns es of $ 6,7 62 , andne t- 38 -

[* 38 ] rev enue of $ 20 ,00 0. Aft er Ma rch 20 06 , whenEner gytec ce as edm ak in g pa ym en ts to th e LLCs b as edon pro jecte d n etin co m e, an d t hr ou gh Nov em be r 20 09 , th ere was no ne t re ve nu e fro m pro du ct io n a ss oc ia te d wi th th e Schuyler le as eh ol d wel ls , andJi m as to wlo was c red it edwith n on e. On the ot he r ha nd , th ro ug h t ha t p eri odOil Co m in g was cred it edwith $ 13 ,03 1, i ts pro rat a sh are o f ne t
rev enue fro m

pro du ct io n a ss oc ia te d wi th th e Mi ls te adlea se ho ldwell s. Thus , whi le itis un do ub te dl y

tru e th at , at l eas t i n m ajorpo rti on , th e cas h p aym en ts th at th e LLCs r ecei ve d wer e unr el at edto pro du ct io n, an d wh il e itm ay be tru e (we h av e no ev id en ce) t ha t an equa ll y m ajorpo rti on of t he cla im edex pe ns es was u nr el at ed to op erat io ns , itis no ne th el es s tru e th at , du rin g t he au di t years, ea chof the LLCs
was th e o wne r of

7.9 3% o f a wo rk in g i nt eres t i n o il an d g as well s tha t wer e pr oduc in g a t l eas t m in im al am ou nt s o f oi l i n wh ic h e ach own eda sh are. Mo reo ve r, th e ev id en ce i nd ic at es th atEner gytec i nt en de d t he fix edpa y m en ts to be refl ect iv e o f actua l, an ti ci pa te d wel l p ro du ct io n. As no te d s up ra, h owe ve r, be cau se th e rev enue an d p ro fitpro jecti on s upo n wh ic h t ho se pa ym en ts were b as ed pr ov edto be ov erl y

op ti m is ti c, itwas n eces sa ry to st op pa ym en ts inMarc h 2 00 6
an d a tt em ptto carry

ou t the ori gi na l i nt en t t o h av e th e co own ers rece iv e n o m or e th anth ei r pr o ra tash ares of t he actua l p ro fit s fr om well pro du ct io n.- 39 -

[* 39 ] The LLCs were , th us , bec au se of the ir c oo wne rs hi p o f worki ng in te res ts in th e Sch uyler an d M il st eadlea se ho ld s, an d b y vi rtu e o f th e co m

m on ag en cy

of Ene rg yte c, pa rti ci pant s i n " actua l" oi l dril li ng an d s al es bu si ne ss es . Tho se actua l oi l dril li ng an d s al es bu si ne ss es un do ub te dl y in cu rredex pe ns es an d o th er de du ct ib le it em s, an d, b ecau se , as s ta te d i n t he ev al ua ti on rep orts , each work in g in te res t o wne r's sh are o f dr il li ng pro ceed s was on ly netof i ts sh are o f ex pe ns es , each LLC's s ha re o f pr oc eed s was bu rd en edby its sh are o f th os e ex pe ns es (n ot withs ta nd in g t ha t, atlea stin it ia ll y , di strib ut io ns di d n otrefl ectth os e n et sh ares ). EachLLC cla im edde du ct io ns forwhatitsays is it s s ha re o f th os e it em s, whi chres po nd en t d is al lo wedan d wh ic h a re atis su e in th es e cas es (e.g ., "o il & g as ex pe ns es -IDC" , "o il de pl et io n e xp ", "o il & g as pro du ct io n e xp en se s" , "qua l pr oduc ti on act iv it ie s" ). Res po nd en t's arg um en t, s etforthab ov e, th atth e LLC's "l ack edan y

real eco no m ic co nn ect io n t o a n a ctua l b us in es s en te rp ris e" i s tha t "[t ]he cas h p aym en ts were unr el at edto pro du ct io n, an d t he ex pe ns es cla im edwere un rel at edto op erat io ns ." Tha t ar gu m en t i gn or es th e te st im on y of r es po nd en t's witne ss (Mr. Will in gh am) ab ou t the actua l fu nc ti on in g o f wel l o pe rat io ns . It al so ig no res th e fac t tha t fi xe d p aym en ts st op pe d i n M ay 20 06 infav or

of a"tru in g up"
co ns is te ntwith ach arac te riz at io n o f th e p rio r cas h p aym en ts as a dv an ce p aym en ts ag ai ns t ac tu al rev enue s. In de ed , res po nd en t co nc ed es on bri ef tha t the LLCs- 40 -

[* 40 ] "n om in al ly hel d wo rk in g i nt eres ts ". Mo reo ve r, by the FPAA in Ji m as to wlo 's c as e an d b y th e an swe r in Oil Co m in g's cas e, res po nd en t wo ul d l im it to pa ss iv e lo ss st atus an y lo ss es res ul ti ng fro m

th e LLCs' d educ ti on s n otbe cau se th e lo ss es di d n otres ul t fr om work in g i nt eres ts inanoi l an d g as pro pe rty, but be cau se th e lo ss es di d re su ltfro m work in g i nt eres ts , whi chwere h el d t hr ou gh th e LLCs. See sec . 46 9( c)(3 ). EachLLC was, thu s, a c oo wne r with En erg yte c (an d o th ers ) of a worki ng in te res t i n a n o il an d g as lea se ho ld , whi chwork in g i nt eres t en ti tl edth e co own ers th ereo f to fin d a ndex tra ctoi l an d g as . To ex pl oi t the work in g i nt eres t, the
co own ers ha d t o c oo pe rat e. Duri ng th e au di t years, En erg yte c, act in g a s co m m on ag en t, o pe rat edth e wel ls on a co op erat iv e b as is forth e worki ng in te res t o wne rs . No wo rk in g i nt eres t o wne r co ul d t ak e h is sh are o f pr oduc ti on inki ndor s el l i t in de pe nd en tl y

of t he ot he r own ers . The co own ers were n otm erel y sh ari ng ex pe ns es . They were jo in tl y carry in g o n atra de or b us in es s an d d iv id in g t he pr oc eed s the refr om .

5. Cl as si fic at io n fo r Tax Purp os es Bec au se th e co own ers of t he work in g i nt eres ts ineach of t he Sch uyler an d Mi ls te adlea se ho ld s jo in tl y carr ie d o n atra de or b us in es s, d iv id in g the pro ceed s th eref ro m am on g t he m se lv es , eachtra de or b us in es s co ns ti tu te d fo r Fed eral tax- 41 -

[* 41 ] pu rp os es anen ti ty sep arat e fro m th e co own ers of t he ap pu rte nantwork in g in te res t. See sec . 30 1.7 70 1- 1( a)(2 ), Pro ced . & Adm in . Reg s. Th ere b ei ng no arg um en t tha t the res ul ti ng en ti ty sho ul d b e cl as si fie d a s a t ru st(or ot he rwis e sp eci al ly clas si fie d) , th e en ti ty is wi th in th e m ean in g o f th e reg ul at io ns a bu si ne ss en ti ty, cl as si fie d a s ei th er a p artne rs hi p o r a co rp or at io n. Se e se c. 30 1.7 70 1- 2( a), Pro ced . & Adm in . Reg s. Si nc e itis a do m es ti c b us in es s en ti ty w ith m or e th antwo
m em be rs th atis no t a p er s e co rp or at io n (a ndno t el ect in g t o b e cl as si fie d a s a co rp or at io n) , itis , by de fau lt , cla ss ifi edas apartn ers hi p. Se e se c. 30 1.7 70 1- 3( a)
an d (b )(1 ), Pro ced . & Adm in . Reg s. W e n eedno t atth is ti m e g etin to anex te nd eddi sc us si on of wh ethe r pr om ul ga ti on of t he so -cal le d c he ck -a-b ox reg ul at io ns , sec ti on s 3 01 .77 01 -1 , 30 1.7 70 1- 2, an d 3 01 .77 01 -3 , Pro ced . & Adm in . Reg s., eff ect iv e in 19 97 , canbe
reco nc il edwith the pri orcas el aw de fin in g p artne rs hi ps , si nc e we s ee n o c on fli ctin th es e cas es . Our co nc lu si on th atth e co own ers of e ach work in g i nt eres t wer e joi nt ly carry in g o n atra de or b us in es s an d d iv id in g t he pro ceed s the refr om wou ld be su ffi ci en t t o s at is fy

th e m ul ti fact ortes t fo r de te rm in in g p artne rs hi p cl as si fic at io n t ha t we em

ph as iz edinLun a v . Comm is si on er, 4 2 T.C. 1 06 7, 1 07 7- 10 78 (19 64 ), an d s ub se qu en t ca se s. E.g., Supe rio r Trad in g, LLC v
. Co m m is si on er, T.C. Mem o. 2 01 2- 11 0, 2 01 2 WL 13 19 74 8, at*4 n.9 ("Th e im po rt- 42 -

[* 42 ] of t he se so -cal le d Lu nafact or s h as no t d is si pa te d a ny afterth e p ro m ul ga ti on of sec . 30 1.7 70 1- 3( a), Pro ced . & Adm in . Reg s." ); WB Acqu is it io n, In c. v. Co m m is si on er, T.C. Mem o. 2 01 1- 36 , 20 11 W L 47 76 97 , at * 9; Co m te k Exp os it io ns , Inc . v. Co m

m is si on er, T.C. Mem o. 2 00 3- 13 5, 2 00 3 WL 21 07 81 02 , at *6 , aff'd , 99 Fed . App x. 3 43 (2dCir . 20 04 ); Al ho us e v . Comm is si on er, T.C. Mem o. 1 99 1- 65 2. W e al so no te th atth e que st io n o f whe th er the joi ntex pl oi ta ti on of awork in g in te res t i n a n o il an d g as lea se ho ldcrea te s an en ti ty has a lo ng , con te nt io us hi st ory , cul m in at in g i n aser ie s o f cas es th atco nc lu de th atwork in g i nt eres t o wne rs
an d wel l o pe rat or s cr eat e a p oo l o r joi ntve ntur e fo r op erat io n o f th e wel ls . In Ben te x Oi l Co rp . v. Co m mis si on er, 2 0 T.C. 5 65 (19 53 ), th e ta xp ay er (B en te x) ha d joi ne d wi th two ot he r co own ers of a n o il an d g as lea se ho ldto ex pl oi t i t. The y op erat edun de r anora l ag reem en t p ro vi di ng th ateach co own er wo ul d s ep arat el y ta ke an d s el l h is sh are o f th e le as e p ro du ct io n. Th e o pe rat io n, i de nt ifyin g i ts el f as a joi ntve ntur e, fi le d p artne rs hi p re tu rn s fo r 19 37 th ro ug h 1 93 9, i n wh ic h i t el ect ed to ex pe ns e, rathe r th ancap it al iz e, in ta ng ib le dri ll in g c os ts . Later, b ecau se itwas to it s ad vant ag e, Ben te x a tt em pt edto di savo w th e IDC el ect io n m ad e b y th e or ga ni zat io n, ar gu in g t ha t the org an iz at io n was no t a p artne rs hi p o r a joi ntve ntur e
an d h adno rig htto m ak e th e el ect io n. We su m m ari ly dis pe ns edwith t ha t- 43 -

[* 43 ] arg um en t, s ta ti ng th at , onth e fac ts be fo re u s, " we en te rta in no do ub t" th at th e o rg an iz at io n " was a joi ntve ntur e o r pa rtn ers hi p wi th in th e b ro adde fin it io n o f th atterm in* * * [wh atis no w sec ti on 77 01 (a)( 2) ]". And wh il e itm ay be th atth e un de rlyin g ra ti on al e fo r ou r co nc lu si on was tha t, b ecau se th e o rg an iz at io n fi le d a pa rtn ers hi p re tu rn , th e m em be rs were es to pp edfro m

de nyin g p artne rs hi p s ta tu s, i n Co ke s v . Comm is si on er, 9 1 T.C. at23 0, wi th ou t an y m en ti on of t he pa rtn ers hi p return, we s ai d:

In19 53 , ina un an im ou s C ou rt- rev ie wedop in io n, we h el d t ha t a ta xp ay er wh o h el d aon e-qua rte r in te res t i n a n o il an d g as lea se was a p art ic ip an t i n apa rtn ers hi p o r joi ntve ntur e, an d s o a n e le ct io n t o cu rren tl y de du ctor t o c ap it al iz e certa in expe nd itur es co ul d b e m ad e on ly by th e p artne rs hi p o r joi ntve ntur e, an d c ou ldno t b e m ad e se pa rat el y

by the tax pa y er. Ben te x Oi l Co rp . v. Co m m is si on er, 2 0 T.C. 56 5 (1 95 3)
. InPerry v. Co m

mis si on er, T.C. Mem o. 1 99 4- 21 5, i nv ol vi ng sel f-em pl oym en t t ax , th e ta xp ay er o wne d p erce nt ag e worki ng in te res ts innu m ero us well s und er ag reem en ts pro vi di ng th at , inpro po rti on to th ei r res pe ct iv e p erce nt ag e in te res ts , th e worki ng in te res t o wne rs own edth e o il an d g as pro du cedby the well s an d t he equi pm en t an d t he m at eri al s t o o pe rat e th e wel ls . The t ax pa y er's li ab il ity forsel fem pl oym en t t ax tu rn edon whet he r he was am em be r of a pa rtn ers hi p c arrying on a tra de or b us in es s. Th ere was no pa rtn ers hi p a gr eem en t, al th ou gh th e ta xp ay er's pe rcen ta ge work in g i nt eres ts ineach well were s ub ject t o ast an da rdform- 44 -

[* 44 ] op erat in g a gr eem en t. Rel y in g o n B en te x andCo ke s, we co nc lu de d: "[T]he
worki ng in te res t o wne rs an d wel l o pe rat or s cr eat eda po ol or jo in t v en ture fo r op erat io n o f th e wel ls . Accor di ng ly, pe ti ti on er's in co m e fro m th e worki ng in te res ts was i nc om e fro m a pa rtn ers hi p o f whi chhe was am em be r, un de r th e br oa d d efi ni ti on of 'p artne rs hi p' f ou ndinsec ti on 77 01 (a)( 2) ." The re were he re n o wri tt enpa rtn ers hi p a gr eem en ts am on g the co own ers of th e worki ng in te res ts ineit he r th e Sch uyler o r th e Mi ls te adlea se ho ld , no r ha d t he
co own ers ex ecu te d jo in t o pe rat in g a gr eem en ts . Neverth el es s, dur in g the au di t y ears Ener gytec o pe rat edth e wel ls on bo th lea se ho ld s o n aco op erat iv e b as is for be ne fitof t he work in g i nt eres t o wne rs . The wo rk in g i nt eres t co own ers an d Ene rg yte c (i n i ts rol e as co m m on ag en t fo r th e co own ers ) th ereb y crea te d p oo ls or joi ntve ntur es (witho utdi st in ct io n, jo in t v en tu res ) fo r op erat io n o f th e wel ls th at
wou ld , onth e au th or ity

of c as es pa rti cu la r to th e cl as si fic at io n o f arra ng em en ts for th e ex pl oi ta ti on of wo rk in g i nt eres ts inoi l an d g as pro pe rti es , li ke Ben te x, Co ke s,
an d P erry, be cl as si fie d a s p artne rs hi ps forFed eral tax pu rp os es .

6. Co nc lu si on To s umm ari ze: Ji m as to wlo an d Oi l Co min g wer e p art ia l o wne rs of wo rk in g in te res ts inth e Sch uyler an d M il st eadlea se ho ld s; th e wel l o pe rat io ns (carrie d o ut by Energ yte c o n t ho se lea se ho ld s fo r th e b en efi t o f th e o wne rs of the work in g- 45 -

[* 45 ] in te res ts ) cre at edsep arat e en ti ti es (joi ntve ntur es ) cl as si fie d a s p artne rs hi ps fo r Fed eral tax pu rp os es , and , by vi rtu e o f th ei r sh ares of t he work in g i nt eres ts , th e LLCs wer e m em

be rs of t ho se joi ntve ntur es (i.e ., partn ers inpa rtn ers hi ps ). Res po nd en t m ay

st il l ar gu e th at , forlac k o f eco no m ic subs ta nc e o r on acco un t o f
so m e o th er an ti ab us e d oc tri ne , th e cl as si fic at io n o f th os e joi ntve ntur es as pa rtn ers hi ps m

us t b e d is reg ard ed . W e d o n ot , andm ay no t, u nd er RJ T Inv s. X v
. Co m m is si on er, 4 91 F.3dat 7 37 -7 38 , andPet al um a FX Partn ers , LLC v. Co m m is si on er, 1 31 T.C. 84 , add res s tha t i ss ue inth is pa rtn er-l ev el pro ceed in g. Res po nd en t m

us t m ak e th atarg um en t i n p ro ceed in gs ag ai ns t the two dri ll in g pr og ram pa rtn ers hi ps . B. App li cat io n o f Sec ti on 62 31 (g )(1 ) Sect io n 6 23 1( g) (1 ) pr ov id es init s en ti rety : SEC. 6 23 1( g) . Partne rs hi p R eturn t o b e Det erm in at iv e o f Whe th er Subc hapt er Ap pl ie s.-- (1 ) Dete rm in at io n t ha t s ub ch ap te r ap pl ie s.-- If, o n t he ba si s o f a p artne rs hi p re tu rnfora ta xabl e y ear, the Secr et ary reas on ab ly det erm in es th atth is subc hapt er ap pl ie s t o s uc h pa rtn ers hi p fo r su chy ear b utsu chde te rm in at io n i s erro ne ou s, the n t he pro vi si on s o f th is subc hapt er ar e h ereb y ex te nd edto su chpa rtn ers hi p (andit s i te m s) forsu chtax ab le y ear a ndto pa rtn ers of s uc h p artne rs hi p.- 46 -

[* 46 ] Res po nd en t, ci ti ng th e la ckof a ny referen ce t o o r in di ci um of ajoi ntve ntur e in th e LLCs' a ndEner gytec's returns (an d t he effe ct iv e d en ia l, i n t ho se returns , th at
su chpartn ers hi ps ex is te d) , arg ue s tha t h e "re as on ab ly reli edon th e Fo rm s 1 06 5 fil edby * * * [th e LLCs] inde te rm in in g t ha t the TEFRA partn ers hi p p ro vi si on s ap pl ie d o nl y

at the ir l ev el an d n otto an y all eg edso ur ce p artne rs hi ps ." Res po nd en t's rel ia nc e o n s ect io n 6 23 1( g) (1 ) is mis pl aced
. Sect io n 6 23 1( g) (1 ) was ad de d t o t he TEFRA partn ers hi p p ro vi si on s b y th e Tax pay er Re li ef Actof 1 99 7, Pub. L. No. 1 05 -3 4, s ec. 1 23 2( a), 1 11 Sta t. at10 23
. Bo th th e st atut ory

lan gu ag e an d t he Hou se W ay s an d M ean s C omm it te e Rep ort 7
m ak e cl ear tha t the in te ntof t he pro vi si onwas t o a ll ev ia te th e Co m m is si on er's di ffi cu lt ie s i n d et erm in in g " whe th er t o fo ll ow the TEFRA partn ers hi p p ro cedur es orth e reg ul ar d efi ci en cy

pro cedur es ", a p ro bl em

ge ne ral ly caus edby the in ab il ity to asc ert ai n wi th cert ai nt y whet he r th e p artne rs hi p i n que st io n h ad10 or f ewer pa rtn ers an d, the refo re, was a "s m al l p artne rs hi p" ex em ptfro m th e TEFRA pa rtn ers hi p p ro vi si on s. See H.R. Rep t. No . 10 5- 14 8 (1 99 7) , 19 97 -4 C.B. (Vo l. 1 ) 31 9, 9 09 -9 10 . Thatis no t re sp on de nt 's p ro bl em inth es e co ns ol id at edcas es , as i t is un di sp ut edth atth e TEFRA pa rtn ers hi p p ro vi si on s ap pl y to th e LLCs, i .e., th at
The pro vi si on ori gi na te d i n t he Hou se an d was ad op te d, v erb at im , by th e 7 Sen at e an d t he Hou se -Sen at e co nf eren ce co m

mitte e.- 47 -

[* 47 ] res po nd en t p ro pe rly iss ue d F PAAs t o t he LLCs, wh ic h, p ur su an t t o s ect io n 30 1.7 70 1- 2( c)(1 ), Pro ced . & Adm in . Reg s., are tax ab le as p artne rs hi ps . Res po nd en t's pro bl em

is th atall of t he ad

jus tm en ts inth os e FPAAs rep res en t flo w-th ro ug h i te m s fr om

so ur ce p artne rs hi ps ov er wh ic h we l ackjuri sd ic ti on in wha t wo ul d t he n b e a p artne r-l ev el pro ceed in g. Se e Rawl s Tra di ng , L.P. v. Co m m is si on er, 1 38 T.C. at 2 88 -2 89 ; Se nt e In v. Cl ub P'sh ip of Ut ahv. Co m m is si on er, 9 5 T.C. at24 8. C. Res po nd en t's Autho rit y To Is su e FPAAs to th e Jo in t Ven tures Res po nd en t ar gu es th at , eve n t ho ug h t he os te ns ib le joi ntve ntur es ' fai lu res to fil e p artne rs hi p re turn s p erm itres po nd en t t o a ss es s t ax li ab il it ie s ag ai ns t the ir pa rtn ers (an d, the refo re, t o i ss ue FPAAs t o t he os te ns ib le dri ll in g p ro gr am pa rtn ers hi ps ) "atan y

ti m e", s ee s ec. 6 22 9( c)(3 ), as a pr act ic al m at te r, th e is su an ce of FPAAs t o t he joi ntve ntur es wou ldbe im po ss ib le . In re ach in g t ha t co nc lu si on , res po nd en t p oi nt s t o t he ab se nc e o f (1 ) joi ntve ntur e returns res ul ti ng inth e fai lu re to id en ti fy

a ta x m at te rs pa rtn er, as de fin edinsec ti on 62 31 (a)( 7) , or, i nd eed , any of th e p artne rs , and(2) in fo rm at io n " as to th e n am e, EIN, addres s, o r pr in ci pa l pl ace o f bu si ne ss of e ithe r al le ge d s ou rce p artne rs hi p." Res po nd en t al so po si ts th at , if h e is su es FPAAs t o t he LLCs as pa rtn ers inth e al le ge d s ou rce p artne rs hi ps , th e le gi ti m acy of th os e FPAAs "m or e th anli ke ly * * * wil l b e co nt es te d i n t hi s- 48 -

[* 48 ] Co urt." Res po nd en t al so fear s tha t the is su an ce o f "ad di ti on al FPAAs t o a ny al le ge d s ou rce p artne rs hi ps * * * co ul d e xp os e res po nd en t t o ach arg e th at* * * [th ey ] are * * * arb itrary andcap ric io us an d t hu s i nv al id ", ci ti ng Scarv. Co m m is si on er, 8 14 F.2d13 63 (9t h C ir. 1 98 7) , rev 'g 8 1 T.C. 8 55 (19 83 ). Lik e al l co urts , we are a c ou rt o f li m it edjuri sd ic ti on . As we st at edinRawl s Trad in g, L.P. v . Comm is si on er, 1 38 T.C. at 2 92 , "in de te rm in in g the ou te r li m it s of th e am bi t o f ou r subjec t m at te r juri sd ic ti on , we can no t co ns id er the
co ns eque nc es , ho wso ev er h ars h t he y m ay be , th atour de ci si on in fli ct s upo n o ne of th e p art ie s." Mo reo ve r, as inth atcas e, we be li ev e res po nd en t's co nc ern s ar e ov erb lo wn. The re ar e ex hi bi ts inth e rec or d i de nt ifyin g t he co own ers of b ot h t he Sch uyler an d M il st eadlea se ho ld s an d e no ug h e vi de nc e o f joi ntve ntur es to pr ecl ud e a s uc ces sf

ul arg um en t tha t the FPAAs s ho ul d b e co ns id eredarb itrary and cap ric io us an d, the refo re, i nv al idun de r Scar. W e al so no te th at , pu rs ua ntto
se ct io n 6 23 1( a)(7 ) an d s ect io n 3 01 .62 31 (a)( 7) -1 (p ) an d (q ), Pro ced . & Adm in
. Reg s., res po nd en t m ay

be ab le to sel ectas t he tax m at te rs pa rtn er an y on e o f a
nu m be r of work in g i nt eres t o wne rs , in cl ud in g M r. Pet it o o n b eh al f of eachof t he joi nt -v en tu rer LLCs , forpu rp os es of s erv in g t he FPAAs.- 49 -

[* 49 ] D. App li cat io n o f Sec ti on 62 22 W e h av e al so co ns id ered , onou r ownm ot io n, the po ss ib le ap pl ic at io n o f
se ct io n 6 22 2, wh ic h re qu ire s co ns is te nc y be twee n h ow a p artne r tr eat s a pa rtn ers hi p i te m

on hi s re tu rnan d h ow the partn ers hi p t reat s i t o n i ts return. Se e se c. 62 22 (a). Th e co ns eque nc e o f an y in co ns is te nc y

be twee n h ow a p artne r tr eat s a p artne rs hi p i te m

on hi s re tu rnan d h ow the pa rtn ers hi p t reat s i t o n i ts return i s th at , un le ss th e p artne r no ti fie s the Secr et ary of th e in co ns is te nc y , sec ti on 62 25 , whi chrequi res a pa rtn ers hi p- le ve l p ro ceed in g b efo re as se ss m en t o f a d efi ci en cy , do es no t ap pl y

to co m pu ta ti on al ad

jus tm en ts ne ces sa ry

to bri ng th e p artne r's tre atm en t o f th e p artne rs hi p i te m s o n h is return i nt o c on si st en cy with t he pa rtn ers hi p's tre atm en t o f th e it em s o n i ts returns . See s ecs . 62 22 (c), 6 22 5. Th e LLCs d idno t n ot ify the Secr et ary of an y in co ns is te nc ie s wi thth e joi ntve ntur es , so th atth ere i s atlea stth e p ot en ti al forres po nd en t, o n t he au th or ity of s ect io n 62 22 (c), t o b y

pa ss sec ti on62 25 an d t o i m m ed iate ly ass es s d efi ci en ci es intax
res ul ti ng fro m

co m pu tati on al ad

jus tm en ts ne ces sa ry

to bri ng co ns is te nc y . Res po nd en t's au th or ity

to bypas s p artne rs hi p- le ve l p ro ceed in gs ag ai ns t the joi ntve ntur es an d t o m ak e imm ed ia te ass es sm en ts att rib ut ab le to co m pu ta ti on al ad jus tm en ts at t he LLC (pa rtn er) l ev el is li m it edto th e ci rcu m st an ces de sc rib edin
se ct io n 6 22 2( b) (1 )(A)(i ), i.e., wh ere " th e p artne rs hi p h as fil eda return b utth e- 50 -

[* 50 ] pa rtn er's tre atm en t * * * [of a pa rtn ers hi p i te m ] is * * * i nc on si st en t wi th th e [p artne rs hi p's ] tre atm en t o f th e it em ", an d t he partn er h as fai le d t o n ot ify the Co m m is si on er o f th e in co ns is te nc y . See s ec. 6 22 2( c). As o ne co m m en ta to r ha s su gg es te d, tha t au th or ity

do es no t ex is t i n t he cas e o f a p artne r's fai lu re t o fi le a no ti ce o f in co ns is te nttre atm en t ar is in g (u nd er s ect io n 6 22 2( b) (1 )(A)(i i)) so le ly fro m th e p artne rs hi p's fai lu re t o fi le a return. St ev enR. Mat he r, Aud itPro cedur es fo r Pas s- Thro ug h En ti ti es , 62 4- 2dTax M an ag em en t (B NA) at A-2 9 (" [T]here i s no ap pa ren t co ns eque nc e wit hi n t he sco pe of t he TEFRA pro vi si on s fo r an in co ns is te nc y

ari si ng fro m

th e fai lu re o f th e p artne rs hi p t o fi le a pa rtn ers hi p return." ) 8 W e fi ndsec ti on 62 22 to be in ap pl ic ab le he rei n. III. Co nc lu si on The joi ntve ntur es of wh ic h e achof t he LLCs was a m em be r were pa rtn ers hi ps requi redto fil e p artne rs hi p re tu rn s an d, thu s, s ub ject t o t he TEFRA pa rtn ers hi p p ro vi si on s. Th e subs ta nt iv e is su es all in vo lv e p artne rs hi p i te m s o f th e Sec. 6 22 2( b) cle arl y

co nt em pl at es a pa rtn er's fil in g ano ti ce o f 8 in co ns is te nc y

with re sp ectto an y

pa rtn ers hi p i te m

if the partn ers hi p h as no t fi le d a return. Se e se c. 62 22 (b )(1 )(A)(i i). Si nc e th e p artne rs hi p m ay fil e a d el in qu en t return a fte r th e p artne r ha s fi le d h is return, a p artne r fi li ng a no ti ce o f in co ns is te nc y

wil l i n t ha t ca se be ex cu se d fr om th e co ns is te nc y

requi rem en t pu rs ua ntto sec . 62 22 (b )(1 ), flu sh lan gu ag e ("s ub se ct io n (a ) sh al l n otap pl y to su ch it em ").- 51 -

[* 51 ] joi ntve ntur es . The LLCs were p as s- th rupa rtn ers an d, wi th res pe ctto th em , th e subs ta nt iv e is su es all in vo lv e wha t wo ul d b e co m pu ta ti on al ad

jus tm en ts if the
subs ta nt iv e is su es (pa rtn ers hi p i te m s) were d eci de d a dv ers el y to th e joi ntve ntur es . See s ec. 6 23 1( a)(6 ); R awls Trad in g, L.P. v . Commis si on er, 1 38 T.C. at 2 85 ; Se nt e In v. Cl ub P'sh ip of Ut ahv. Co m m is si on er, 9 5 T.C. at24 8. Th e fac t tha t the joi nt
ve ntur es fai le d t o fi le pa rtn ers hi p re tu rn s an d t ha t the Co m m is si on er h as ne ithe r in it ia te d n orco m

pl et edpartn ers hi p p ro ceed in gs do es no t ch an ge th atan al y si s. See Al ho us e v . Comm is si on er, T.C. Mem o. 1 99 1- 65 2. Th e FPAAs is su edto Ji m as to wlo an d Oi l Co m in g app ear t o re fle cton ly com pu ta ti on al ad

jus tm en ts . If

9 th atis tru e, th e FPAAs are i nv al idan d d o n otco nf er jur is di ct io n o n u s. Rawls Trad in g, L.P. v . Comm is si on er, 1 38 T.C. at 2 89 . W e wil l co nf er wi th th e p art ie s to de te rm in e whe th er the re ar e an y is su es (ot he r th anco m

pu ta ti on al ad

jus tm en ts ) pr op erl y ad dr es se d i n thi s p ro ceed in g. We m us t d is m is s fo r la ckof juris di ct io n in so far a s the in di vi du al FPAAs p ert ai n t o c om pu ta ti on al it em s. To re fle ctth e fo reg oi ng , An ap pr op ria te ord er wi ll be is su ed
. The re ar e o th er i te m s o n s om e o f th e FPAAs res po nd en t i ss ue d wi th res pe ct 9 to th e LLCs. Th os e it em s m ak e n o a dju st m en ts to th e LLCs' r eturns . Thu s, el im in at in g t he ad

jus tm en ts th atap pe ar t o b e co m pu tati on al ad

jus tm en ts , th e FPAAs ap pe ar t o m ak e n o c ha ng es to th e LLCs' r eturns .