Opinion ID: 528418
Heading Depth: 1
Heading Rank: 1

Heading: Propriety of Income Tax Treatment of Taxpayer's Royalty Interests

Text: 3 When taxpayer 3 filed his petition in the Tax Court, he resided in Mattoon, Illinois. He was an independent oil producer and the president and sole stockholder (except for directors' qualifying shares) of W. Wilmar Oil, Inc. (Wilmar Oil) and Wilmar Petroleum Company (Wilmar Petroleum). Those corporations were in the business of promoting and selling drilling ventures. 4 In 1972, taxpayer bought for Wilmar Oil an overriding royalty interest 4 in 5,000 acres of land in two Texas counties including the operating mineral leases on that land. Both Wilmar Oil and Wilmar Petroleum promoted and sold drilling ventures consisting of fractional working interests in the oil leases on that property. The two corporations agreed to furnish all labor and supplies and to perform the work required to complete a well and place it in production. Each investor in the Wilmar offerings received a working interest in a well ready to start production. In return the investors paid Wilmar a fractional share of (1) the drilling costs, (2) the cost of readying a producing well for commercial production, and (3) the cost of operating a producing well. 5 The owner of the land subject to the leases retained a royalty interest of 1/8 of production and Wilmar Oil, the owner of the mineral rights lease, retained an overriding royalty of 1/8 of the remaining 7/8 of the mineral production. The remaining 7/8 of 7/8 of the mineral interest was divided into 64 equal parts, 40 of which were offered to the public by Wilmar Oil. The remaining 24 of the 64 parts were to be granted to taxpayer, Wilmar Oil salesmen, or retained by Wilmar Oil. The 40 fractional working interests were to be sold at a price that would yield a profit over Wilmar Oil's lease acquisition and drilling costs even if a dry hole resulted. Taxpayer received overriding royalty interests in various properties by assignment from Wilmar Oil as part of his compensation from the Wilmar companies. In September 1985, the Commissioner sent taxpayer a notice of deficiency for the overriding royalty interests conveyed to taxpayer in the amount of $483,738.95 for 1975 and $3,128.78 for 1976, the only years involved in this appeal. 6 Taxpayer does not contest the general rule that compensation for services is gross income to the service provider. When that compensation is in the form of unrestricted property, the fair market value of the property at the time it is transferred is ordinarily includible in the taxpayer's income. It is the Commissioner's position that Mr. Zuhone received overriding royalty interests as part of his compensation for rendering services to Wilmar Oil and Wilmar Petroleum companies. 7 To avoid taxation upon his receipt of these overriding royalty interests, taxpayer depends entirely upon the pool of capital doctrine first acknowledged by the government in a 1941 memorandum opinion of the then Chief Counsel of the Bureau of Internal Revenue. This lengthy opinion covers the tax implications of many hypothetical oil and gas leasing situations, but taxpayer seemingly relies only on the following excerpt: 5 8 By such arrangements [as involved here], a lessee commonly lessens his own investment and the risks and burdens attending the development by agreements to share the investment obligation and the proceeds of production. The lessee or assignee, like the lessor or assignor who retained a share interest in production having a value equivalent to that of the lessor's prior interest but passed on to the lessee the investment obligations and risks that attend development for a share in production, has parted with no capital interest but has merely in turn given another a right to share in production in consideration of an investment made by such other person. If the driller or equipment dealer is making an investment by which he acquires an economic interest in oil and gas in place, expenditures made by him represent capital expenditures returnable tax-free through the depletion allowance rather than by way of expense deduction, and the oil payment rights acquired do not represent payment in property for services rendered or supplies furnished. Similarly, one who, in return for an oil payment right, furnishes money which the lessee is pledged to use in developing the property would be regarded as making an investment representing an addition to the reservoir of capital investments in oil and gas in place   . 9 GCM 22730, reported in 1941-1 C.B. 214, 221-222. 6 The pool of capital principle allows a taxpayer who contributes development property or services to the pool of capital in establishing an oil or gas well to retain or receive an interest therein without having to pay income tax at the time of receipt. Instead, the proceeds of the interest, subject to depletion, are taxable on receipt. Taxpayer contends that his involvement in development of the wells at issue was such a contribution to capital rather than services performed for the receipt of overriding royalty interests in the wells. 10 Although the pool of capital doctrine has engendered several articles, it has received little treatment by the courts or Commissioner. Prior to its recognition by the Bureau of Internal Revenue, a pool of capital concept was merely alluded to by various courts predominantly under the reasoning that an economic interest in a mineral interest during the exploration and development stage may be too speculative to value at the time of its receipt. In Burnet v. Harmel, 287 U.S. 103, 53 S.Ct. 74, 77 L.Ed. 199, the Court determined that cash bonuses and production royalties received for leases of land for oil and gas exploration constituted ordinary income subject to depletion allowances. The Court referred to the economic interest as an interest that could only be recovered out of production rather than from sale of the property. Also, in Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489, the Court held that the transfer of bonuses and future royalty payments in exchange for oil and gas leases was not a sale, but a subleasing transaction entitling the taxpayer to depletion deductions. In so holding the Court reasoned that the critical issue in determining taxation is whether the taxpayer has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of the oil, to which he must look for a return of his capital. Palmer, 287 U.S. at 557, 53 S.Ct. at 226. See also Transcalifornia Oil Co. v. Commissioner, 37 B.T.A. 119 (1938), and Laster v. Commissioner, 43 B.T.A. 159 (1940), affirmed in part and reversed in part, 128 F.2d 4 (5th Cir.1942), where the Tax Court held that the sale of shares in future recovery of minerals was not a taxable event since the funds received were to be used for drilling. In a series of similar cases, the Fifth Circuit has declined to tax the recipient of an economic interest in future oil payments at the time of receipt due to the uncertainty and contingency of its value. Commissioner v. Edwards Drilling Co., 95 F.2d 719 (5th Cir.1938); Dearing v. Commissioner, 102 F.2d 91 (5th Cir.1939); Lee v. Commissioner, 126 F.2d 825 (5th Cir.1942). 11 Following the issuance of GCM 22730, the Fifth Circuit had an opportunity to readdress the pool of capital doctrine in United States v. Frazell, 335 F.2d 487 (5th Cir.1964), where the taxpayer, a geologist, received a future mineral interest in properties he recommended to be acquired and developed by two investors. Immediately prior to the vesting of the geologist's interests, the properties were transferred to a corporation with the taxpayer receiving a percentage of the stock. The court held that the taxpayer received income when his interests vested in an amount equal to the value of the stock. 12 Later that year the Fifth Circuit decided James A. Lewis Engineering, Inc. v. Commissioner, 339 F.2d 706, 709 (1964), where the petitioner made the same argument as taxpayer here. Chief Judge Tuttle observed that the court would have great difficulty accepting a construction of the Code [in GCM 22730] that would fly in the face of the general provisions of the tax laws to the effect that compensation for services must be returned as a part of gross income. However, the court found it unnecessary to pass upon the validity of GCM 22730 since it determined that the services performed by taxpayer were not development activities related to the acquisition and exploration of the mineral interest but were production activities that could not be capitalized. 339 F.2d at 709-710. The taxpayer there had conceded that the pool of capital doctrine applied only if the services performed were development rather than production activities. 13 Later in Garrett v. Campbell, 360 F.2d 382, 384 n. 3 (1966), the same Circuit avoided applying GCM 22730 because taxpayer Garrett had not raised any question or suggestion as to the application of that ruling. Stock received by Garrett, supposedly in exchange for mineral interests Garrett claimed to have received earlier as compensation for services, was found in a jury trial to be ordinary income within Section 61 of the Code, and the judgment of the district court was affirmed. 14 In regulations to the Tax Reform Act of 1969 the Internal Revenue Service added to the confusion surrounding the pool of capital doctrine in Treas.Reg. Sec. 1.636-1(b) which provides that a production payment carved out in connection with the exploration and development of a mineral interest need not be included in gross income at the time of receipt of the production payment. However, immediately following, the regulation provides: See section 83 and the regulations thereunder, relating to property transferred in connection with the performance of services. 15 Both the majority and dissenting opinions of the full Tax Court in Cline v. Commissioner, 67 T.C. 889, 893, 896 (1977), also avoided application of GCM 22730, mentioning it in passing only. Petitioners had acquired by contract royalty interests in coal leases they had procured for the Wolf Creek Collieries Co. Under the first of two contracts with Wolf Creek the petitioners' royalties were limited to coal processed by Wolf Creek. The majority concluded in dicta that this gave petitioners an economic interest in the coal property, but stated that they had no such interest under a subsequent contract giving them royalties on all coal processed through Wolf Creek, including coal purchased on the open market. To be consistent, the majority concluded that both contracts must be viewed as involving capital assets and held that the royalties received were taxable as capital gains. The four dissenters thought that petitioners' property under the first contract was not a capital asset for income tax purposes and that the royalties under both contracts should be treated as ordinary income representing compensation for services. In a footnote, the dissenters blamed GCM 22730 for fostering a murky history in this field. 67 T.C. at 896 n. 1. 16 The Sixth Circuit did not mention GCM 22730 in reviewing the Tax Court's decision in Cline v. Commissioner, 617 F.2d 192 (1980). However, unlike the Tax Court, the court of appeals held that the essential nature of the payments [to the Clines] was compensation for services, [so that] the Commissioner correctly treated the amounts received by the taxpayers as ordinary income Cline, 617 F.2d at 195. To recapitulate, the federal appellate courts that have considered Mr. Zuhone's argument since GCM 22730 have upheld the Commissioner's determination that the interests received by the James A. Lewis Engineering Co., Garrett and the Clines constituted ordinary income. 7 17 The continued vitality of the pool of capital doctrine was threatened by Rev.Rul. 83-46, 1983-1 Cum.Bull. 78, which examines three hypothetical examples: (1) a corporation which syndicates oil and gas partnerships receives oil and gas overriding royalty interests from a partnership it promoted as compensation for services in locating oil and gas properties; (2) a lawyer performs title searches and drafts leases for a corporation's acquisition of oil and gas properties and receives overriding royalty interests as compensation; (3) an employee of a closely held corporation performs services for the corporation's development of oil and gas properties and is compensated by a salary and overriding royalty interest in each lease acquired by the corporation. The first and third examples closely resemble this taxpayer's situation. The Internal Revenue Service determined in each of the three instances that the fair market value of the overriding royalty interests must be treated as taxable income by the recipient. The ruling relied on Section 83 of the Internal Revenue Code and made no reference to GCM 22730 or whether this 1983 ruling was prospective only. 8 The Background information note to this ruling reveals the Service's motive: 18 In view of the length of time G.C.M. 22730 and Rev.Rul. 77-176 [see n. 7 of this opinion] have been outstanding, it would not be feasible to revoke them. Reference to G.C.M. 22730, Rev.Rul. 77-176, and the pool of capital doctrine, has been intentionally omitted in the proposed revenue ruling in favor of related factual situations, though sufficiently distinct from the G.C.M. 22730 and Rev.Rul. 77-176. It is believed that this approach is the most effective way to accord compensatory arrangements relating to the acquisition and development of oil and gas properties the same tax treatment under sections 61 and 83 of the Code as other compensatory arrangements in which property interests are received.... Because there has been little guidance from the courts on the scope of the doctrine, restrictive interpretations are justified. 19 Background information note to Rev.Rul. 83-46 (Dec. 16, 1982) (available by request pursuant to the Freedom of Information Act, 5 U.S.C. Sec. 552 (1982 & Supp. III 1985), as cited in Schwidetzky, The Pool of Capital Doctrine: A Peace Proposal, 61 Tul.L.Rev. 519 (1987)). In this 1983 revenue ruling, the Service, although not formally rejecting GCM 22730, has indicated its disfavor with the exception therein by severely limiting the application of the pool of capital doctrine. We likewise express doubt as to the wisdom of judicially endorsing this exception to Sections 61 and 83 of the Code for the oil and gas industry in the absence of legislative intent. For the purposes of this appeal, however, it is unnecessary to reject the doctrine under all factual circumstances, since taxpayer does not meet the exception. 20 Presented with the murky history of the 1941 pool of capital exception, taxpayer relies chiefly on an unsigned 1952 article entitled Assignment of an Economic Interest for Personal Services reported in Vol. I, No. 4, Oil and Gas Tax Quarterly (July 1952), as authority for the application of the pool doctrine. There the author, relying on GCM 22730, states that the pool of capital theory will foreclose income taxation if all of the following six factors are present: 21 1. It must be agreed and prearranged between the parties that the services are contributed and that the contributor is to receive a share right in production, marked by the assignment of an economic interest to him, in return for his contribution. 22 2. The services contributed may not effect a substitution of capital, rather they must add to the pool of capital already invested in the oil and gas in place. 23 3. The contribution must perform a function necessary to bringing the property into production or augment the pool of capital already invested in oil and gas in place. 24 4. The contribution must be specific to the property in which the economic interest is acquired. 25 5. The contribution must be definite and determinable. 26 6. The contributor must look only to the economic interest acquired for his possibility of profit. 27 The Tax Court applied without adopting taxpayer's proposed six-factor test, finding that taxpayer was unable to meet even a single factor. We agree with the Tax Court that taxpayer has failed to meet the test he proposes here. These enumerated factors, although helpful in understanding the pool of capital doctrine, are not authoritative even if taxpayer were capable of fulfilling each factor as required by the article. Although the Tax Court addressed each factor seriatim, it is sufficient to determine that taxpayer cannot meet the sixth factor of the test which seems to embody the policy behind the doctrine. Where a contributor contributes services to the pool of capital required for development of a mineral property, however, the pool of capital doctrine creates a presumption that the contributor intends to be compensated solely out of future profits from that mineral property. The various requirements for application of the pool of capital doctrine seem to be designed to assure that this presumption is correct. Parker, Contribution of Services to the Pool of Capital: General Counsel Memorandum 22730 to Revenue Ruling 83-46, 19 Inst. on Oil & Gas L. and Tax'n 315 (1984). The pool of capital doctrine arose partly in recognition that when goods and services are contributed to the exploration and development of mineral wells, the receipt of an economic interest in that well represents a capital investment capable of producing future income, yet accompanied by the risk of a dry well. 1 Oil & Gas Tax., No. 4 at 172 (July 1952). By such arrangements, a lessee commonly lessens his own investment and the risks and burdens attending development to share the investment obligation and the proceeds of production. GCM 22730 at 221. The doctrine reflects the inequity of taxing the recipient on the speculative value of an economic interest in a pre-production mineral investment, deferring taxation until that interest yields income. Palmer, 287 U.S. at 557, 53 S.Ct. at 226-27, Lee, 126 F.2d 825, Dearing, 102 F.2d 91, Edwards Drilling, 95 F.2d 719. This is recognized as the sixth element in the test proposed by the taxpayer in the foregoing 1952 article. The exception to some extent may also reflect a desire to encourage the exploration and development of oil and gas resources prior to the production of oil by postponing any tax consequences until the investment produces cash flow. 28 Here taxpayer did not look solely to the mineral interests for his possibility of profit. The fractional interests were sold by the taxpayer's corporations to the investors at a price sufficient to render a profit even if a dry well resulted. Further, as an employee of the corporation, taxpayer received a salary from the corporation as partial compensation for his services. The overriding royalties received by the taxpayer were unencumbered by the risks and expenses of production which were borne by the investors in the working royalties. Also, the assignment of the royalty interests to taxpayer were not made until many of the wells were at the production stage, enabling taxpayer to avoid the risk of a dry well. Because he received many of the royalties at a time when they were capable of producing cash flow to fund any tax imposed, it is not inequitable to require taxpayer to include these interests in gross income. Even on those royalties received prior to production, taxpayer was able to shift the risk of loss by selling the fractional working interests in that well at a price sufficient to cover his expenses of lease acquisition and drilling costs and yield a profit. Taxpayer insulated himself from any further liability through use of the shell corporations from which he was paid a salary and assigned the interests at issue. 9 The overriding royalties received by taxpayer in return for his services did not represent the pre-development economic interests to which he looked solely for his possibility of profit, the situation that the exception was originally intended to address. 29 The pool of capital doctrine, once acknowledged in GCM 22730, has apparently fallen into disfavor by both the Service and courts. Whatever its original policy justifications, whether to encourage exploration of mineral resources, to avoid immediate taxation of an investment of deferred cash flow, or to delay valuation of a speculative investment until its value is more certain, these arguments are more appropriately addressed to the legislature to justify favored treatment of employees who receive mineral interests as part of compensation in contrast to other employees who receive employer stock as compensation. In any event, taxpayer does not fall within the ambit of the doctrine even as stated in the six-factor test he proposes from the 1952 article since these royalties clearly represent compensation for his services rather than a capital investment. 30