Opinion ID: 528418
Heading Depth: 1
Heading Rank: 2

Heading: Valuation of Taxpayer's Overriding Royalty Interests

Text: 31 The second issue in this case is whether the Tax Court properly upheld the Commissioner's valuation of taxpayer's overriding royalty interests. Under Section 83(a) of the Internal Revenue Code and the applicable regulations, 10 the fair market value of the taxpayer's overriding interests is to be included in his gross income. The fair market value is a question of fact reviewable under the clearly erroneous standard, and the Commissioner's determination of value is presumptively correct. Therefore the taxpayer has the burden of proving otherwise. See, e.g., Hamm v. Commissioner, 325 F.2d 934, 937, 938 (8th Cir.1963), certiorari denied, 377 U.S. 993, 84 S.Ct. 1920, 12 L.Ed.2d 1046. 32 The Commissioner's valuation of the overriding royalty interests was explained in testimony of Frank Boyd, a petroleum engineer for the Internal Revenue Service, whose credentials include a degree in petroleum engineering, special courses in oil and gas valuation, and continuing education in the area. The witness had previously worked for 10 years for the U.S. Geological Survey, where his responsibilities included valuing mineral interests. Boyd's 68-page report valuing taxpayer's interests was received in evidence without objection at the commencement of the trial before the Tax Court (Exh. BQ). Another engineer, Claude Skaukins, assisted Boyd in valuing these royalty interests. In preparing his report, Boyd used all documents contained in the stipulation of facts that was introduced at the beginning of the trial, as well as work papers prepared by an Internal Revenue Service auditing agent. 33
34 The government expert valued the overriding interests in wells that were not yet producing at the time they were assigned to taxpayer by using the price at which the Wilmar corporations were selling working interests to the public and then valuing the overriding royalty interests by twice that amount. He justified this method of calculating the fair market value of such interests because the override pays no drilling or operating expense and receives his interest free of all costs. (Boyd report (Exh. BQ) at 3). He added that an overriding royalty is worth twice what a working interest is worth because [t]he overriding interest is not burden[ed] by any operational development expanse [sic]. Whereas the working interest is. So that all the income you get on the overriding interest is net, whereas a working interest is burden[ed] by operational expense, of course the development expense and the subsequent expense incurred. (Tr. 22). He elaborated on this approach in further testimony. (Tr. 16-20). 35 Taxpayer introduced no expert testimony to the contrary. However, he told the Tax Court that he thought the valuation of a royalty interest should be one and one-half times what a working interest is worth (Tr. 116). His briefs do not contain any convincing argument with respect to the valuation of the overriding royalty interests in the then non-producing wells, nor do they seriously fault Mr. Boyd's choice of the multiplier of two rather than one and one-half. 36 As to such wells, the Tax Court accepted Mr. Boyd's multiplier, adding that it had been applied to the prices of the working interests as set forth in petitioner's [SEC] Schedules (App. A14). 11 The judge concluded that this was the only evidence of the fair market value of these interests that can be given any weight (ibid.). Taxpayer has failed to show that this presumptively correct conclusion was clearly erroneous. Therefore Mr. Boyd's valuation of these interests may not be disturbed. 37
38 In valuing taxpayer's overriding royalty interests in wells that were already producing when the interests were granted to taxpayer in 1975 and 1976, Mr. Boyd used reserve reports prepared by Mr. Zuhone's engineer in 1978. He then added the amount of oil and gas produced from the time of the assignments to taxpayer to the dates of the reserve reports and discounted the resulting income projections to value as of the date of the assignments, using a discount rate of 15% per annum (Tr. 21, 23-24; Exh. BQ at 3, 6, 28-32). Although the Commissioner's method was supported by the applicable regulation, 26 C.F.R. Sec. 1.611-2(e)(1), as the taxpayer argues and the government concedes the use of the reserve reports prepared in 1978 was not allowed under the regulations pertaining to valuation of mineral interests, since only those conditions and circumstances known at the time the interests were acquired may be taken into consideration. The taxpayer apparently argues that the use of the 1978 reserve reports to determine the deficiency by the government in contravention of the tax regulations renders the deficiency arbitrary and excessive within the meaning of Helvering v. Taylor, 293 U.S. 507, 514-15, 55 S.Ct. 287, 290-91, 79 L.Ed. 623, eviscerating the presumption of correctness ordinarily ascribed to deficiency notices and placing the burden of proof on the government. 39 If the taxpayer establishes that the Commissioner's determination is arbitrary, courts generally shift the burden of production to the Commissioner. Clapp v. Commissioner, 875 F.2d 1396, 1403 (9th Cir.1989). However, the taxpayer's argument, which presumes that the failure of the government to adhere to its promulgated procedures in calculating a tax deficiency necessarily results in an arbitrary and excessive deficiency notice, seriously misconstrues the inquiry required under the arbitrary and excessive doctrine. The arbitrary and excessive doctrine is a challenge to the deficiency assessment itself on the basis that it bears no factual relationship to the taxpayer's liability, not a challenge to any proof offered by the Commissioner at trial before the Tax Court or district court. Courts have consistently held that in determining whether a deficiency notice is arbitrary and excessive, they should routinely refuse to examine the evidence used or the propriety of the commissioner's motives or administrative policy or procedure in making the determination.... '[T]he Commissioner's determination may often rest upon hearsay or other inadmissible evidence, and we know of no rule of law calling for a review of the materials that were before the Commissioner in order to ascertain whether he relied upon improper evidence.'  Jackson v. Commissioner, 73 T.C. 394, 400 (1979) (citations omitted); Clapp, supra; Scar v. Commissioner, 814 F.2d 1363 (9th Cir.1987); Riland v. Commissioner, 79 T.C. 185, 201 (1982). The government meets its initial burden of proof in an action to collect tax merely by introducing its deficiency determination. Anastasato v. Commissioner, 794 F.2d 884, 887 (3rd Cir.1986). As Judge Cudahy explained in a decision of this Court, 40 In general, courts will not look behind an assessment to evaluate the procedure and evidence used in making the assessment.... Rather, courts conduct a de novo review of the correctness of the assessment, imposing the risk of nonpersuasion on the taxpayer. In certain quite limited circumstances, however, courts recognize that an assessment should not be accorded even a rebuttable presumption of correctness. For example, when the assessment is shown to be without rational foundation or arbitrary and erroneous, the presumption should not be recognized.... As long as the procedures used and the evidence relied upon by the government to determine the assessment had a rational foundation, the inquiry focuses on the merits of the tax liability, not on IRS procedures. 41 Ruth v. United States, 823 F.2d 1091, 1094 (7th Cir.1987); See also Pfluger v. Commissioner, 840 F.2d 1379, 1382-1383 (7th Cir.1988), certiorari denied, --- U.S. ----, 108 S.Ct. 2906, 101 L.Ed.2d 938. 42 Courts have occasionally declined to accord a presumption of correctness to the deficiency notice and examined the procedures employed by the Commissioner in the context of unreported illegal income where the government simply relies on the presumption of correctness without introducing substantive evidence to link the taxpayer to the income-generating activity in question. See, e.g., United States v. Janis, 428 U.S. 433, 441, 96 S.Ct. 3021, 3026, 49 L.Ed.2d 1046, where a  'naked' assessment ... may be one 'without rational foundation and excessive,' and not properly subject to the usual rule with respect to the burden of proof in tax cases; Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir.1979), Jackson, supra, Llorente v. Commissioner, 649 F.2d 152 (2d Cir.1981), Dellacroce v. Commissioner, 83 T.C. 269 (1984). 43 The presumption of correctness attached to the Commissioner's determination virtually regardless of the information, procedures or policies used recognizes the structural inequality of information in the possession of the Commissioner relative to the taxpayer as well as the de novo nature of the refund/deficiency challenge suit in which the trial court will not inquire into the administrative record behind the determination. The Ninth Circuit explained further the rationale behind the presumption of correctness, in spite of the methodology or procedure followed, in Clapp, 875 F.2d at 1402-1403: 44 Appellants' argument for greater substantive review of the Commissioner's 'determination' mistakes the nature of the notice of deficiency. The notice of deficiency does not result in final liability on the part of taxpayer. If the taxpayer files a petition in the Tax Court, liability will be adjudicated prior to payment. 26 U.S.C. Sec. 6213. The notice of deficiency merely hails the taxpayer into court. The Tax Court has as its purpose the redetermination of deficiencies, through a trial on the merits, following a taxpayer petition.... Issuing a notice of deficiency is in many ways analogous to filing a civil complaint.... [I]f the taxpayer establishes that the Commissioner's determination is arbitrary, courts generally shift the burden onto the Commissioner, putting the commissioner in the same position as a civil plaintiff. 45 If the taxpayer is successful in showing that the assessment is arbitrary and excessive or without factual foundation, the presumption drops from the case. There is, however, a conflict among the circuits as to whether the burden of persuasion is shifted to the Commissioner as well as the burden of production, as noted but not resolved by the Supreme Court in United States v. Janis, 428 U.S. 433, 442, 96 S.Ct. 3021, 3026, 49 L.Ed.2d 1046. Some courts have imposed a lesser burden of proof on the taxpayer in situations where imposing the ultimate burden of persuasion on the taxpayer would require the taxpayer to prove a negative proposition such as the non-existence of allegedly unreported income. See, e.g., Llorente, 649 F.2d 152 (2d Cir.1981); Weir v. Commissioner, 283 F.2d 675, 679 (6th Cir.1960); Cohen v. Commissioner, 266 F.2d 5 (9th Cir.1959); see also Rockwell v. Commissioner, 512 F.2d 882, 886 (9th Cir.1975), certiorari denied, 423 U.S. 1015, 96 S.Ct. 448, 46 L.Ed.2d 386; Baird v. Commissioner, 438 F.2d 490, 494-95 (Biggs, J., dissenting) (3rd Cir.1971). We need not resolve this question since taxpayer has failed to demonstrate that the assessment was arbitrary and excessive or without factual foundation to remove the presumption of correctness from the Commissioner's assessment. Taxpayer does not contend that the assessment was arbitrary in the sense that he is unrelated to the tax-generating activity as in the cases involving unreported illegal income. Most importantly, taxpayer does not assert, much less offer evidence, that the fair market value determined by the use of the 1978 reserve reports was excessive. Taxpayer cannot assert that the mere use of a method of calculation not provided for in the regulations renders the assessment arbitrary and excessive. As noted above, an inquiry into the procedure used to calculate the deficiency to determine whether the assessment is arbitrary and excessive has been regularly rejected by the courts with the exception of the naked assessment scenario. The commissioner may use any reasonable method of calculation where, as in this case, the taxpayer fails to produce or maintain adequate records from which actual income may be ascertained. Goodmon v. Commissioner, 761 F.2d 1522, 1524 (11th Cir.1985); Cummings v. Commissioner, 410 F.2d 675, 678 (5th Cir.1969). The trial court is concerned with determining whether the assessment contains the correct amount of the deficiency, rather than examining the administrative procedure employed in determining the deficiency absent allegations of a constitutional deprivation. Indeed, some courts have stated: If the assessment is right on any theory it must be sustained. Blansett v. United States, 283 F.2d 474, 478 (8th Cir.1960); Cummings, 410 F.2d at 679; Bernstein v. Commissioner, 267 F.2d 879, 881 (5th Cir.1959). 46 Neither is the failure of the government to follow its own regulations otherwise unfair or inequitable 12 unless the taxpayer demonstrates that the deviation from procedure resulted in an excessive deficiency or an assessment without any factual foundation. The use of information collected by the government subsequent to the taxable years in question, although not provided for in the regulations, was certainly a rational method of calculating the fair market value of the mineral interests, possibly even producing a more accurate valuation than available in the taxable years at issue. Indeed the 1978 reserve reports may have indicated that the wells would produce less oil in the future than had been expected at the time the interests were transferred, thus resulting in a market value lower than would have been calculated based on the information available at the time the interests were acquired. 13 47 The accuracy of the Commissioner's method, of course, is irrelevant if the value ascertained by using the 1978 reserve reports is higher than would have resulted using solely that information available in the two taxable years in question. But taxpayer has not presented a single piece of concurrent evidence, such as reserve reports from the taxable years in question, offers to purchase taxpayer's mineral interests, purchase prices of comparable mineral interests during the taxable years, or electric log analyses, to indicate that the value would be lower if the 1978 reserve reports were not used. The presumption of correctness, therefore, does not require a showing of the correct value of the interest under a calculation method prescribed by the regulations. Rather, the taxpayer must simply show that the value is excessive. He has not done so. 48 Having determined that the assessment was not arbitrary or excessive, therefore the presumption of correctness applies, it must be determined whether taxpayer has carried his burden of producing sufficient evidence to shift the burden of production to the Commissioner. Taxpayer bears both the burden of production and burden of persuasion where the deficiency notice is not found to be arbitrary or without rational basis. Ruth, 823 F.2d at 1093. As stated by the Supreme Court in Taylor: [f]requently, if not quite generally, evidence adequate to overthrow the commissioner's finding is also sufficient to show the correct amount, if any that is due. Taylor, 293 U.S. at 515, 55 S.Ct. at 291. Here taxpayer failed to present any evidence to rebut the Commissioner's prima facie case of a deficiency other than attacking the procedure underlying the notice of deficiency, an inquiry in which this Court will not engage absent exceptional circumstances not present here. Taxpayer, who presumably has superior access to information concerning the value of the mineral interests at the time of acquisition, has utterly failed to produce any independent evidence to demonstrate that the market value of the overriding royalties was less than the amount contained in the deficiency. Instead, taxpayer relied solely on his own non-expert testimony and the cross-examination of the government's expert to sustain his burden of proof. Such evidence completely fails to undermine the value employed by the Commissioner. Taxpayer has therefore failed to rebut the presumption of correctness to shift the burden of proof, much less carry the burden of persuasion. Although we hold that use of after-the-fact data does not necessarily remove the presumption of correctness under these particular facts, this procedure violates regulations as well as fundamental valuation principles and is hardly to be encouraged. 49 The decision of the Tax Court is affirmed.