Case Name: Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. David FASKEN and Inez G. FASKEN, Appellees0
Court: United States Court of Appeals for the Fifth Circuit
Jurisdiction: United States
Decision Date: 1959-06-12
Citations: 267 F.2d 792
Docket Number: No. 17235
Parties: Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. David FASKEN and Inez G. FASKEN, Appellees0.
Judges: 
Reporter: Federal Reporter 2d Series
Volume: 267
Pages: 792–802

Head Matter:
Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. David FASKEN and Inez G. FASKEN, Appellees0.
No. 17235.
United States Court of Appeals Fifth Circuit.
June 12, 1959.
Rehearing Denied July 20,1959.
John R. Brown, Circuit Judge, dissented.
Marvin W. Weinstein, Melva M. Graney, Joseph F. Goetten, Lee A. Jackson, Attys., Dept, of Justice, Washington, D. C., John C. Ford, Asst. U. S. Atty., Dallas, Tex., Charles K. Rice, Asst. Atty. Gen., Dept, of Justice, Washington, D. C. (Heard L. Floore, United States Attorney, Ft. Worth, Tex., on the brief), for appellant.
Richard S. Brooks, Midland, Tex., Harry C. Weeks, Fort Worth, Tex. (Whitaker & Brooks, Midland, Tex., Weeks, Bird, Cannon & Appleman, Fort Worth, Tex., of counsel), for appellees.
Before TUTTLE, JONES and BROWN, Circuit Judges.

Opinion:
JONES, Circuit Judge.
David Fasken and his mother, Inez G. Fasken, brought suit against the District Director of Internal Revenue claiming a refund of income taxes for the years 1949 and 1950 and interest. Judgment for them was entered by the district court. From that judgment the district director has appealed. The Faskens, mother and son, who will be herein referred to as the taxpayers, owned approximately 165,000 acres in Andrews and adjacent counties in Texas. These lands were held by the taxpayers as partners, with David Fasken owning a 75% interest and Inez G. Fasken holding the remaining 25%. In 1949 the taxpayers entered into two agreements, one being made with Forest Oil Corporation and the other with Stanolind Oil and Gas Company. Two agreements were made by the taxpayers in 1950, one being with Stanolind Oil and Gas Company and another with Anderson-Prichard Oil Corporation. In most respects these agreements were similar.
By each of the agreements the taxpayers agreed to convey to the oil company an undivided 45% interest "in and to the oil, gas and other minerals in and under and that may be produced from" the lands described in the agreement, "down to and including a depth of 5500 feet from the surface, all minerals below such depth being retained by" the taxpayers. Mineral deeds, in the conventional Mid-continent T Form, which described, in the aggregate, the 45% mineral interests in all of the lands covered by the agreement, were executed by the taxpayers and placed in escrow with a bank. The delivery was accompanied by instructions to deliver each deed to the oil company upon the receipt by the bank of an affidavit made by an officer of the oil company showing that an oil well had been commenced on the particular tract and upon the payment by the oil company for the account of the taxpayers of the agreed price for such tract. The Forest agreement fixed the price on the basis of $12,500 for each forty-acre tract; Stanolind's 1949 agreement required it to pay $37,500 for the forty-acre tracts; the price as fixed in each of the 1950 agreements was $25,-000 for each forty acres. Each of the agreements with the exception of the 1949 Stanolind agreement, gave the oil company an option to acquire 45% interest in the minerals upon other lands. The price to be paid for the interests acquired pursuant to exercising an option was, in all cases, the sum of $25,000 for each forty acres. Each agreement provided that the oil company should commence the drilling of a well within 30 days from the date of the agreement and upon the completion of a well on one forty-acre tract, to begin within 30 days, the drilling of another well on a different forty-acre tract. On the completion of each producing well the taxpayers were to pay the oil company the sum of $25,000 which was recited to be in payment of the taxpayers' 55% share of the drilling cost. If a well was not completed as a producing well the taxpayers were to pay the oil company an amount equal to 55% of its cost, but not more than $25,000.
The oil company was given charge of production. If the price of oil was $1.01 per barrel or more the taxpayers paid 20 cents per barrel as its share of operating costs. If the price of oil was under $1.01 per barrel the operating costs were prorated on a 55-45 percentage basis. The net proceeds from equipment salvaged from abandoned wells was to be divided into the same ratio. The oil companies were authorized to market the taxpayers' 55% share of the oil for their account or to purchase it at prevailing field prices. Accounting procedures were stipulated in detail.
In 1949 deeds of the taxpayers were delivered to Forest covering, in the aggregate, eight tracts of forty acres each, covered by the agreement, for $100,000 and five tracts of forty acres each, acquired pursuant to option, for $125,000. In 1950 a deed of the taxpayers was delivered to Forest covering one forty-acre tract for $25,000. In 1949 Forest completed twelve wells and for its share of the drilling costs the taxpayers paid Forest $25,000 per well or $300,000. In 1950 Forest completed one well and the taxpayers contributed $25,000 toward its drilling cost. The pattern of the Forest transactions was, in general, followed in the dealing between the taxpayers and the other two oil companies. Under the first Stanolind contract deeds of the taxpayers for fractional mineral interests in the eight forty-acre tracts covered by the agreement were delivered in 1949 to Stanolind for which the taxpayers received $37,500 for each forty, or a total of $300,000. On each of these eight tracts Stanolind completed a producing well in 1949, and the taxpayers paid $200,000 to Stanolind as their share of the drilling cost. Under the second Stanolind contract deeds of the taxpayers were delivered in 1950 for an aggregate of nine forty-acre tracts for which the taxpayers received $225,000. On these tracts eight wells were completed in 1950 and in that year the taxpayers paid Stanolind $200,000 as their share of the drilling costs. In 1951, a tax year not involved in these proceedings, a ninth well was brought in and in that year the taxpayers paid Stanolind $25,000 as their share of the cost of drilling it. Deeds for fractional mineral interests were delivered by the taxpayers to Anderson-Prichard in 1950 covering thirteen tracts of forty acres each for a total consideration, paid that year, of $325,-000. During that year Anderson-Prichard completed eleven wells. The taxpayers made drilling cost payments on nine of these, in 1950, in the amount of $225,000. In 1951 two other wells were completed. On these, and on two of the 1950 wells, the taxpayers made payments in 1951 of their share of drilling costs in the amount of $100,000.
In their income tax returns the taxpayers reported the amounts received from the oil companies upon the deliveries of deeds as capital gains. They reported the amounts received from their share of the oil production as ordinary income. The taxpayers allocated the amounts paid to the oil companies for their share of drilling costs between intangible drilling and development expense and depreciable tangible equipment costs. They deducted the amounts allocated by them to intangible drilling and development cost, depreciation on their part of tangible equipment, some geological expense which they had incurred, their proportionate share of the cost of operating the wells, and the statutory depletion deduction on their share of production. The oil companies treated the amounts paid upon the deed deliveries as cost of the mineral interests which the deeds purported to convey. The amounts which the companies treated as tangible and intangible drilling costs were reduced by the amounts paid to them by the taxpayers. There was thus a consistency of treatment of the various items of receipts and disbursements by the taxpayers on the one hand and the oil companies on the other.
In the 90-Day Letters to the taxpayers which gave notices of deficiencies in the 1949 taxes, the Commissioner of Internal Kevenue recited a determination, "in substance and effect as distinguished from form and appearance", that the taxpayers transferred to Forest the mineral interests conveyed that year, plus $75,000, in consideration of the drilling and equipping of twelve wells, and that the "exchange" of checks, to the extent of $225,000, would be disregarded. As to the Stanolind transactions in 1949, the Commissioner determined that the taxpayers transferred to Stanolind the mineral interests conveyed for a consideration of $100,000 plus the drilling and equipping of eight wells, and that the "exchange" of checks, to the extent of $200,000, would be disregarded. The amount of $75,000, paid by the taxpayers to Forest in excess of the sums they received from Forest, was apportioned by the Commissioner between depreciable drilling costs and deductible intangible drilling expenses. The Commissioner disallowed the taxpayers' claims as to the remainder of these items as reported. The amount of $100,000, received by the taxpayers from Stanolind in 1949 in excess of the sums they paid to Stanolind, was treated by the Commissioner as capital gains. The Commissioner rejected the rest of the taxpayers' claims for capital gains. The taxpayers paid the deficiencies as determined by the Commissioner and brought suit to recover. Oral findings and conclusions were made by the district court at the end of the trial. Among other things it was said:
" the Court would be derelict in a proper scrutiny to pronounce these contracts between the plaintiffs and Stanolind and Forest as methods for defeating and merely covering up agreements so as to defeat the power of the Government to get its proper tax from the citizen. These contracts that were made with these drilling companies by the plaintiffs were in good faith and actually expressed not only the intention of the parties but the carrying out of each particular contract which followed and accompanied a warranty deed for the drillers."
In appealing from the judgment, the Government urges that the district court gave effect to form and ignored substance, that form should be ignored and effect given to substance and that in so doing the agreements between the taxpayers and the oil companies must be treated as leases rather than as sales.
The Government reminds us that in the field of taxation the realities and substance of written documents are to be regarded rather than their form. This principle is well established. Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 60 S.Ct. 209, 84 L.Ed. 226; Haley v. Commissioner, 5 Cir., 1953, 203 F.2d 815. But, as has been said, "Form alone takes, and holds and preserves substance." The form of the instruments cannot be wholly ignored in seeking to ascertain their realities and substance even though it is not controlling. West v. Commissioner, 5 Cir., 1945, 150 F.2d 723, certiorari denied 326 U.S. 795, 66 S.Ct. 488, 90 L.Ed. 484; rehearing denied 327 U.S. 815, 66 S.Ct. 679, 90 L.Ed. 1039, rehearing denied 328 U.S. 877, 66 S.Ct. 1008, 90 L.Ed. 1646, rehearing denied 328 U.S. 881, 66 S.Ct. 1359, 90 L.Ed. 1648; Albritton v. Commissioner, 5 Cir., 1957, 248 F.2d 49; Umsted v. Commissioner, 8 Cir., 1934, 72 F.2d 328. The transactions between the taxpayers and the oil companies were cast in the form of sales of undivided interests. The taxpayers say to us that the transactions in legal effect, the realities and the substance, have resulted in sales and not in leases, and that the stated payments for the recited transfers were considerations for bona fide sales.
Facts are stubborn things, they are rigid, and the shape of them is not always such that they will snugly fit into the technical contours of legal pigeonholes. But in this case it is not necessary that they do so. The transaction before us partakes of some of the characteristics of both a lease and a sale. Such was the case in West v. Commissioner. In that case the Wests sold land to an oil company, including the underlying oil, gas and other minerals, subject to certain outstanding royalty interests and reserving to themselves certain overriding royalties. The oil company agreed to drill "with reasonable diligence" and to operate four drilling rigs on the lands involved. The Tax Court held that, in legal effect the transaction amounted to a lease of the minerals. 3 T.C. 431. This Court affirmed. West v. Commissioner, supra.
In the West case,
"The purpose of the transaction was the production of oil; and, to that end, the Wests retained the legal title to an undivided interest in the oil in place and contemporaneously stipulated for an income-producing operation 'resembling a manufacturing business carried on by the use of the soil.' " 150 F.2d 726-727.
In the West opinion it was also stated,,
"In other words, the fact that the instruments of transfer passed only a fractional mineral interest, retaining the remaining portion thereof is not controlling in determining the legal relationship created between the parties. It must also be considered that the properties conveyed were in part actual and in part probable producers of oil; that the transferee was engaged in the oil business, and was interested in the properties only for the purpose of developing the minerals; that one of the objects of the transferors was to secure full development of the minerals; that the transferee was contractually obligated to develop ; and that the transferors, though securing to themselves so valuable a covenant, were chargeable with no part of the costs thereof." 150 F.2d 727.
It may be that the clause relating to-the securing of development without cost to the transferor does not apply to all or parts of the transactions before us, but if not, there would be no such significant difference as would prevent the foregoing from being applicable to this, case.
We think the West case is a controlling precedent upon the facts before us. It has been many times cited with approval and the principle it announces is sound. The judgment of the district court must be reversed. We are in agreement with the Commissioner that. the transactions between the parties resulted in leasing' arrangements rather than sales. We do not adopt the Commissioner's contention that the payments to and by the Faskens should be disregarded pro tanto. The Commissioner disallowed the deductions claimed by the taxpayers for their payments to the oil companies merely because, the Commissioner reasoned, the cash payments made by the Faskens should be disregarded to the extent that they could be offset by the payments previously made to them by the companies; this on the theory that, taken as a single transaction, the money payments should cancel each other out rather than treating the funds received by taxpayers as taxable capital gains and the funds paid out by them as drilling and equipment costs. Since we hold, as was held in West v. Commissioner, supra, that the transactions were in the nature of leases, it follows, as was precisely held in the West case, that the initial payments to the Faskens must be treated as lease bonuses or advance royalty payments. As such they are to be taxed as ordinary income subject to depletion allowance. As the initial cash payments to the Faskens are to be treated as income to them as under leases, so should the amounts subsequently paid out by them be given effect by the allowance of appropriate deductions. The Commissioner and the taxpayers have stipulated as to the proper allocation between intangible drilling and development costs and tangible equipment charges. There is no question raised as to the tax treatment to be given to the Faskens' share of the oil produced.
In order that a judgment may be entered giving effect to the conclusions herein expressed, the judgment of the district court is reversed and the cause remanded.
Reversed and remanded.