ESTATE OF ARNETT v. COMMISSIONER

Docket No. 58343.

31 T.C. 320 (1958)

THE ESTATE OF THOMAS E. ARNETT, DECEASED, THOMAS H. CRAWFORD, JR., ADMINISTRATOR C. T. A. AND ESTATE OF CLARA BELLE ARNETT, DECEASED, THOMAS H. CRAWFORD, JR., ADMINISTRATOR DBN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

United States Tax Court.

Filed October 31, 1958.


Attorney(s) appearing for the Case

Edwin M. Slote, Esq., for the petitioners.

Robert O. Rogers, Esq., for the respondent.


On March 9, 1955, respondent mailed a statutory notice of deficiency addressed to Mr. Thomas E. Arnett and Mrs. Clara Belle Arnett (husband and wife) at an address in Jacksonville, Florida, in which he determined a deficiency of $2,031.34 in their income tax liability for the year ended December 31, 1951, arising by reason of his disallowance of a deduction claimed by the named taxpayers on account of a loss from the operation of a farm and held by respondent to constitute a personal loss not deductible for income tax purposes. A petition was filed herein on June 8, 1955, in which the petitioners named were "The Estate of Thomas E. Arnett, Deceased, Thomas H. Crawford, Jr., Administrator C. T. A. and Estate of Clara Belle Arnett, Deceased, Thomas H. Crawford, Jr., Administrator dbn." The petition alleged inter alia as follows:

The said Thomas E. Arnett died on or about the 21st day of August, 1954; and the said Thomas H. Crawford Jr., is the duly qualified and acting Administrator C. T. A. of the estate of said decedent. The said Clara Belle Arnett died on or about the 25th day of February 1953; and the said Thomas H. Crawford, Jr., is the duly qualified and acting Administrator D. B. N. of the estate of the said decedent.

The petition alleged that the determination of tax set forth in respondent's notice of deficiency was based upon error in that respondent erred in his determination that the loss from the operation of the farm constituted a personal loss not deductible for tax purposes, and prayed that this Court "determine that there is no deficiency and personal income tax due from the respective estates of the said decedents for the calendar year 1951." The petition was signed by Thomas H. Crawford, Jr. (an attorney admitted to practice before this Court), "as Administrator C. T. A. of the estate of Thomas E. Arnett, deceased and as Administrator dbn of the estate of Clara Belle Arnett, deceased." Omitting the jurat before a notary public of the State of Florida, the verification of the petition reads as follows:

STATE OF FLORIDA COUNTY OF DUVAL

Thomas H. Crawford, Jr., being duly sworn, says that he is the duly appointed, qualified and acting Administrator C. T. A. of the estate of Thomas E. Arnett, deceased and the duly appointed qualified and acting Administrator D. B. N. of the estate of Clara Belle Arnett, deceased; that he has read the foregoing petition, or has had the same read to him and is familiar with the statements contained therein and that the statements contained therein are true except those stated to be upon information and belief, and those he believes to be true.

(Signed) Thomas H. Crawford, Jr.

On August 1, 1955, the respondent filed an answer herein in which he admitted the allegations in the petition relating to the deaths of Thomas and Clara Belle, the fiduciary status of Thomas H. Crawford, Jr., and the notice of deficiency, and denied other allegations in the petition. On December 14, 1955, A. F. Barone entered his appearance "for the Petitioners in the above entitled proceeding." By notice dated November 15, 1956, this case was set for trial at Jacksonville, Florida, on February 4, 1957, which notice was mailed to Thomas H. Crawford, Jr. On January 15, 1957, pursuant to motion granted on that date, respondent filed an amended answer which reiterated the allegations in the original answer and, in addition, affirmatively alleged as follows:

(a) Decedents are not entitled to the allowance for depletion in the amount of $84,691.35 as claimed on their joint Federal income tax return for the taxable year ended December 31, 1951. (b) In the alternative, decedents are not entitled to the deduction for legal fees in the amount of $185,162.11 as claimed on their joint Federal income tax return for the taxable year ended December 31, 1951. (c) In the alternative, the amount claimed by the decedents on their joint Federal income tax return for the taxable year ended December 31, 1951 as an allowance for depletion should be reduced in an amount of not less than $38,111.11. (d) In the alternative, the amount claimed by the decedents on their joint Federal income tax return for the taxable year ended December 31, 1951 as an allowance for depletion should be reduced in an amount of not less than $9,280.97.

In the prayer of the amended answer respondent claimed an increased deficiency for the year 1951 under the provisions of section 272 (e) of the Internal Revenue Code of 1939 in alternative amounts of $64,694.94, $152,773.32, $27,653.02, and $6,776.46.

On February 4, 1957, A. F. Barone withdrew as counsel for petitioners and Edwin M. Slote, having entered his appearance for petitioners, filed herein a motion for continuance based upon the filing of the amended answer, which was granted. On February 28, 1957, petitioners, through their attorney Edwin M. Slote, filed herein a reply to the amended answer which prayed "that the Court determine that there is no deficiency and personal income tax due from the respective estates of the said decedents for the calendar year 1951."

On October 29, 1957, notice was served on Edwin M. Slote, attorney for the petitioners, that this case was set for trial in Jacksonville, Florida, on February 3, 1958, and on that latter date this Court, on the call of the calendar in Jacksonville, fixed a time certain for the trial of this case, to wit: February 7, 1958, at 10 a. m. When this case was called for trial at that time counsel for petitioners filed a "Motion to Dismiss Proceedings under Rule 7 (a) (2) and Rule 21." This motion contains allegations outlining the history of the pleadings herein, and also an allegation to the effect that on January 29, 1957, Edwin M. Slote, attorney for the petitioners, "was retained by the petitioners under an order of the County Judge's Court, in and for Duval County, Florida, * * * in the Estate of Thomas E. Arnett, deceased, to appear on behalf of the petitioners in the within Tax Court proceeding." The motion then alleges as follows:

That under Tax Court Rule 7 (D), it is provided as follows:

"Verifications by fiduciaries shall contain a statement that the fiduciaries signing and verifying have authority to act for the taxpayer. (Italic added.)"

That the verification of the petition herein contains no such statement by Thomas H. Crawford, Jr., who verified the petition herein.

Upon information and belief, the said Thomas H. Crawford, Jr., had no authority from the said County Judge's Court to institute the within proceeding and/or verify the petition herein, in either or both said Estates in which Thomas H. Crawford, Jr., is acting or administrator as therein stated. (Certified copies of the docket shall be offered in evidence in support thereof.)

That by reason of the foregoing, the within proceeding is void ab initio and should be dismissed forthwith on the grounds that this Court did not at the time the petition was filed on June 8, 1955, and therefore now does not have any jurisdiction over the parties and this proceeding for the reasons aforesaid:

A) In failing to comply with Rule 7 (D) of the Tax Court; B) That the amended Answer was not properly authorized; C) That there are, therefore, no pleadings properly before this Court which raise any triable issues for determination.

In support of said motion petitioners introduced into evidence photostatic copies of the probate dockets in the estates of Thomas and Clara Belle and a certified copy of an order signed by the county judge, reading as follows:

IN THE COUNTY JUDGE'S COURT IN AND FOR DUVAL COUNTY, FLORIDA IN PROBATE. File Number 21734-D IN RE: THE ESTATE OF THOMAS E. ARNETT, Deceased.

ORDER AUTHORIZING TAKING OF ACTION

The petition of THOMAS H. CRAWFORD, JR., as Administrator C. T. A. of the Estate of Thomas E. Arnett, Deceased, for an order authorizing him to take certain action in the prosecution of the case under Docket Number 58343, now pending before the Tax Court of the United States, coming on this day to be heard; and after full discussion in open Court and it appearing to the Court that an order should be entered authorizing such action, and the Court being fully advised;

IT IS ORDERED AND ADJUDGED that the said THOMAS H. CRAWFORD, JR., as Administrator C. T. A. is authorized to enter into the following procedures and actions in connection with the case now pending before the Tax Court of the United States either directly or through his attorney:

1) To move to dismiss the proceedings now pending in the Tax Court (file #58343), in which he is Petitioner by reason of the following: (a) That there were no orders entered by the County Judges Court in either or both the Estates above mentioned authorizing the Administrator to file the said Petition on June 8th, 1955. (b) That the motion for leave to serve an amended answer was filed by the respondent in said Tax Court proceedings on January 14, 1957 but said motion was not served upon the Administrator until January 16, 1957, after said order was already granted by the Tax Court, January 15, 1957. (c) That the said Petition did not contain the verification required by rule 7 (d) of the rules of the Tax Court in that it did not contain a statement that the Administrator as fiduciary in both estates had authority to act for said tax payers. In the event said motion to dismiss is denied by the Court, the Administrator or his attorney are authorized to move: 2) For leave to withdraw the Petition dated June 7, 1955 wherein the Administrator made application to the Tax Court of the United States for a determination that there is no deficiency or personal income tax due from both the decedents herein for the calendar year 1951; 3) To consent in open Court to the entry of a deficiency assessment against the estates of said decedents in the sum of $2,031.34 for the calendar year 1951; and in the event the above applications in whole or in part are denied by the Court and the trial is directed to proceed, the attorney for the Administrator is further authorized; 4) To enter into a stipulation of facts with Regional Counsel in the action now pending in the Tax Court of the United States, in the form which bears the approval of the Administrator. This order entered in Jacksonville, Florida, February 7th, 1958. McKenney J. Davis (SEAL) County Judge

After hearing argument of counsel, the Court denied petitioners' said motion to dismiss.

Upon brief petitioners contend that the Court should reconsider this ruling and should dismiss this proceeding for lack of jurisdiction.

Petitioners presented no evidence relating to the deficiency as originally determined by respondent.

Thus the issues presented for decision in this case are: First, whether the Court has jurisdiction over this proceeding; second, whether the decedents were entitled to a percentage depletion deduction as set out in sections 23 (m) and 114 (b) of the Internal Revenue Code of 1939 with regard to amounts recovered from trespassers on the mineral interest owned by decedent Thomas in land located in Kentucky and from conservators of the interest appointed by a Federal district court during the pendency of litigation brought by Thomas asserting ownership thereof and asking an accounting from the alleged trespassers with regard to the oil and gas extracted therefrom by them; third, whether the depletion deduction of the decedents, if allowed, should be computed upon the gross receipts of the trespassers from the mineral interest, or only upon the net recovery from the trespassers who were allowed a setoff for their expenses of extraction because of the innocent nature of their trespass; fourth, whether the legal expenses of decedents incident to the litigation were deductible by the decedents under section 23 of the 1939 Code; and, fifth, whether the interest upon the judgment against the trespassers should be included in income from the mineral property in computing the depletion deduction, and whether discounts earned by the trespassers and the conservators should be so included.

FINDINGS OF FACT.

Those facts stipulated and the exhibits attached thereto are made a part of our findings by this reference. We also incorporate herein by this reference the facts and matters recited above which relate to the petitioners' motion to dismiss and to our jurisdiction over this proceeding.

During 1951, the taxable year in issue, Thomas E. and Clara Belle Arnett, hereinafter sometimes referred to as "decedents," were husband and wife, and had their principal place of residence at 5931 Atlantic Boulevard, Jacksonville, Florida. They filed their joint Federal income tax return for the calendar year 1951, using the cash basis of accounting, with the collector of internal revenue for the district of Florida.

Thomas E. Arnett died on August 21, 1954; his wife had died on February 25, 1953. Thomas H. Crawford, Jr., is the duly qualified and acting administrator, c. t. a., of the Estate of Thomas E. Arnett and is also the duly qualified and acting administrator, d. b. n., of the Estate of Clara Belle Arnett. In those capacities and acting on behalf of said decedents and their estates he filed the petition herein.

On January 7, 1915, Thomas E. Arnett obtained a fee simple to a certain tract of land in Henderson County, Kentucky, amounting to 47 acres. The next day, Thomas E. Arnett, joined by his then wife, executed a mortgage on this tract to T. J. Arnett which read in part: "It being understood and agreed that the coal and mining rights under this land is [sic] not mortgaged or effected [sic] hereby but are reserved together with the free and uninterrupted right of way, underneath the surface." In 1916 a suit was instituted in the Henderson County Circuit Court to foreclose this mortgage. Judgment was entered, the foreclosure accomplished, and the appropriate officer was directed to sell the tract in order to satisfy the indebtedness secured by the property. This judgment and order of sale contained this provision: "The coal and other mining rights in and under said 47 acres have heretofore been conveyed and are not to be sold under this decree."

On January 12, 1918, T. J. Arnett, who purchased the tract at the foreclosure sale, received a deed from the court's officer which read in part: "The coal and other mining rights in and under the 47 acres have heretofore been conveyed." There then commenced a chain of title in the tract of land which ran from T. J. Arnett to Walter H. Lockett and his wife to W. W. Brackett and his wife. Each conveyance in this chain contained an exception of the coal and mining or mineral rights similar to those quoted above. Brackett and his wife, in turn, on September 8, 1942, entered into an oil and gas lease covering this property with J. L. Woodruff named as lessee whereby they reserved a one-eighth royalty interest. The same day Woodruff and his wife conveyed their interest in the lease to Sinclair Prairie Oil Company. On May 14, 1947, Sinclair Prairie assigned this lease subject to a two-eighths overriding royalty to Delta Drilling Company and W. F. Lacy. The latter in his turn assigned parts to A. W. Wesselman and A. V. Martens. Delta Drilling Company, hereinafter referred to as "Delta," Lacy, Wesselman, and Martens commenced exploratory operations on the tract on May 24, 1947. Five wells were brought in; the dates of their first production extend from June to October 1947. Delta was the developer and operator of the mineral property until November 22, 1948.

In September 1947 Thomas E. Arnett, hereinafter sometimes referred to as Arnett, filed suit in the United States District Court for the Western District of Kentucky against the holders of interests in the tract under the chain commenced by T. J. Arnett, claiming ownership of the mineral estate and requesting an accounting for all oil, gas, and other petroleum products removed therefrom. The defendants answered that the deed of the officer of court on January 12, 1918, to T. J. Arnett served only to reserve coal and other elements that were mined.

On November 22, 1948, an interlocutory decree was entered in the litigation which stated:

That the plaintiff, Thomas E. Arnett, is now and has been since January 7, 1915, the owner and is entitled to possession of the oil and gas and the oil and gas minerals and rights in and under the 47 acres * * *

Arnett was awarded an accounting for all oil, gas, and petroleum products removed from the mineral estate by the defendants. The court, however, gave the defendants an opportunity to introduce evidence that they were innocent trespassers. It also awarded all the oil and gas wells and associated equipment on the tract to Arnett.

A final judgment decree was rendered by the court on September 22, 1949, holding that the defendants were entitled to set off a reasonable allowance for their expenditures. The United States Court of Appeals for the Sixth Circuit affirmed the decision of the District Court and the Supreme Court denied certiorari on March 26, 1951. The Supreme Court also denied a petition for rehearing. Arnett v. Sinclair Prairie Oil Co., 88 F.Supp. 343 (W. D. Ky. 1948), affirmed sub nom. Delta Drilling Co. v. Arnett, 186 F.2d 481 (C. A. 6, 1950), certiorari denied 340 U.S. 954, rehearing denied 341 U.S. 917.

The amount of the accounting award in the litigation was determined by the oil operations on the tract of land. The income and operating expenses for the period June 12, 1947, through November 22, 1948, the date of the interlocutory decree, hereinafter called the "first period," were as follows:


Gross oil production --------------------------------------------   $407,179.28
Less: Severance taxes -------------------------------------------      6,107.68
                                                                     __________
                                                                     401,071.60
Cost of operation:
 Drilling operations -------------------------------   $61,352.61
 Overhead and supervision --------------------------     2,917.78     64,270.39
                                                                     __________
                                                                     336,801.21

The amount of the setoff allowed defendants in the litigation was $94,827.17, which amount was the total of the expenses of $64,270.39 and the cost of the equipment on the tract, $30,556.78. The total amount of the accounting award was $306,568.55—a figure which was reached by the following computation:

Gross oil production --------------------------------------   $407,179.28
 Less: Severance taxes ------------------------------------      6,107.68
                                                              ___________
                                                               401,071.60
 Less: Expenditures awarded defendants --------------------     94,827.17
                                                               __________
                                                               306,244.43
 Add: Discount earned -------------------------------------        324.12
                                                               __________
                                                               306,568.55

In addition, the final judgment and decree ordered the defendants in the litigation to pay interest on the amount of the award at the rate of 6 per cent per annum from the date the judgment was entered, September 22, 1949. The defendants in the litigation paid to the clerk of the court the sum of $335,753.33—a total of the amount of the award, $306,568.55, and interest in the amount of $29,184.78 for the period September 22, 1949, through May 10, 1951.

All of the costs of operation during the first period were originally paid by Delta and the equipment on the tract was paid for by Delta. Delta retained none of the profits of operation. On their joint Federal income tax return for the calendar year 1951 decedents included in their gross income and then deducted the cost of oil operations in the amount of $61,352.61 paid for by Delta and "repaid" to Delta by the mechanics of the setoff. The cost of wells and equipment, $30,556.78, was not deducted by decedents as an expense on their income tax return for 1951, with the exception of an amount for depreciation for the first period in the amount of $12,222.71.

By its order dated November 22, 1948, the District Court appointed two conservators to operate the oil and gas estate until the judgment of the court became final. They operated the property during the period November 22, 1948, through May 10, 1951, hereinafter called the "second period."

The income and operating expenses of the property for the second period were as follows:

Gross oil production -------------------------------------------   $256,897.21
 Less: Severance taxes -----------------------------------------      3,855.28
                                                                   ___________
                                                                    253,041.93
Costs of operation:
 Drilling operations ------------------------------   $17,906.35
 Disposal well ------------------------------------    22,032.89
 Overhead, supervision, and conservator's fee -----    10,840.46
                                                      __________     50,779.70
                                                                    __________
                                                                    202,262.23

In addition, during this period the conservators earned discounts in the amount of $190.20.

By an order of May 21, 1951, the court ordered the conservators to pay the sum of $202,900.07 to the clerk of the court. This amount was based on the profit earned during the second period and is reconciled with that profit by the following adjustment:

Net profit per court order --------------------------------------   $202,900.07
 Less: Expenses attributable to operations during period but not
  reported until after order was issued -------------------------        508.30
 Add: Unexpired premium on insurance reported as expense --------         60.66
                                                                     __________
     Actual net profit ------------------------------------------    202,452.43

All of the costs of operation during the second period, i. e., $50,779.70, were paid by conservators, and the severance taxes for the period were paid by them.

Prior to the institution of the litigation decedents entered into a contingent fee agreement with Thomas E. Sandidge, an attorney. By the terms of this agreement Sandidge was to receive a two-eighths interest in whatever oil and gas rights were recovered in the litigation. At the same time Arnett agreed to give a three-eighths part of whatever he might recover to Lucy Arnett, his niece, as compensation for managing and financing the litigation. At some time during the pendency of the suit Arnett entered into another contingent fee agreement with Edwin M. Slote, an attorney, whereby Slote was to assist in representing him in the litigation.

The clerk of the court held the amount of $538,653.40 in cash, such amount being the total of the sums of $202,900.07 and $335,753.33. By order of the court dated May 21, 1951, entered pursuant to stipulation, the clerk disbursed this sum as follows:

Thomas E. Sandidge ---------------------------------------------------   $134,663.35
Edwin Slote ----------------------------------------------------------     50,498.76
Thomas E. Arnett -----------------------------------------------------    151,496.27
Retained pending final determination of Lucy's three-eighths claim ---    201,995.02
                                                                          __________
                                                                          538,653.40

These amounts, when ordered to be paid and not retained, were paid during the year 1951.

On their joint Federal income tax return for the year 1951 decedents deducted $185,162.11, the total of amounts paid to the attorneys, Slote and Sandidge. On this return they reported the amount of $481,817.61 as gross income from oil operations, computed as follows:

Gross income from production -------------------------------------   $664,076.49
 Less: Severance taxes -------------------------------------------      9,962.96
                                                                      __________
                                                                      654,113.53
Other income:
 Discounts earned ------------------------------------------------        514,32
 Interest on judgment --------------------------------------------     29,184.78
                                                                      __________
                                                                      683,812.63
 Less: Amount held by clerk of court pending outcome of litigation
  involving impounded three-eighths interest ---------------------    201,995.02
                                                                      __________
 Reported gross income from oil operations -----------------------    481,817.61

And they reported the amount of $169,382.70 as net income from oil operations, computed as follows:

Gross income from oil operations ---------------------------------   $481,817.61
  Less: Cost of operations paid by Delta ------------   $64,270.39
   Depreciation on equipment purchased by Delta -----    12,222.71
   Cost of operations paid by the conservators ------    50,779.70
   Attorney's fees ----------------------------------   185,162.11
                                                        __________    312,434.91
                                                                      __________
                                                                      169,382.70

They then deducted depletion, equivalent to one-half the net income from oil operations so reported,1 in the amount of $84,691.35. The net profit from oil operations reported by the decedents of $169,382.70 is also the total of the following: Cash received by Arnett—$151,496.27; original cost of the equipment—$30,556.78; and unexpired insurance—$60.66; less accumulated depreciation of $12,222.71 and voucher payable of $508.30.

As the District Court held in its decree of November 22, 1948, Arnett was at that time and at all times prior thereto since January 7, 1915, the holder of legal title of the oil and gas under the tract of land in Henderson County, Kentucky; he was holder of such title, and entitled to possession thereof at all times relevant to these proceedings from January 7, 1915, through the calendar year 1951.

One-half of the attorneys' fees was properly allocable to the collection of income and one-half was allocable to the quieting of title.

OPINION.

KERN, Judge:

The jurisdictional question raised by the motion to dismiss made by petitioners' counsel on the day when this case was finally and definitely set for trial has been pressed by petitioners again on brief. It may be disposed of without extended discussion. To paraphrase the language used in Edwin W. Eisendrath et al., Executors, 28 B. T. A. 744, 755, 756, since the party who filed the petition herein on behalf of the estate of Thomas E. Arnett and the estate of Clara Belle Arnett was the duly appointed, qualified, and acting administrator of those estates, we conclude that we have jurisdiction of the proceeding brought by him. As administrator he stands in the place of the deceased taxpayers and in that capacity is authorized by section 272 of the Internal Revenue Code of 1939 to file a petition with this Court. The order of the State court which we have quoted in full very carefully refrains from deciding that the administrator was without authority to file the petition herein. It merely recites "[t]hat there were no orders entered * * * in * * * the Estates * * * authorizing the Administrator to file the said Petition." It is our opinion that his authority was derived from his status as administrator and from the cited section of the Internal Revenue Code, and did not depend for its existence upon any specific order of the State court instructing him, as administrator, to file this particular petition. Therefore, the statement in the verification to the effect that the person signing the petition is the duly appointed, qualified, and acting administrator of the estates of the deceased taxpayers is by clear implication a statement that he has the authority to file the petition and satisfies Rule 7 of our Rules of Practice. Even if it were technically deficient (which it is not), in the state of the pleadings existing when the motion herein considered was made, it would not be a defect which would affect our jurisdiction. Gibson Amusement Co., 22 B. T. A. 1212. The case of Soren S. Hoj, 26 T.C. 1074, which deals with another part of Rule 7 relating to a verification of a petition by an agent when the petitioner is outside the United States, is not in point.

We therefore reaffirm our action at the trial of this case in denying petitioners' motion to dismiss.

It is obvious that the petitioners had no unrestricted right of dismissal after the filing of respondent's amended answer. Perkins-Barnes Construction Co., 9 T.C. 388.

Petitioners have introduced no evidence relating to the issue which has to do with the deficiency originally determined by respondent. Since they have the burden of proof on this issue we decide it against them.

The other issues arise from new matter pleaded in respondent's amended answer. Under Rule 32 of our Rules of Practice, the burden of proof as to these issues is on respondent.

In general, those issues derive from a lawsuit instituted by Arnett in the United States District Court for the Western District of Kentucky. It is important to know the nature of that action. The pleadings and entire record therein are not in evidence. It is stipulated that it was a suit "asserting ownership of * * * [a] tract of land and requesting an accounting for all oil, gas and other petroleum products removed from the land by the persons claiming under the lease executed by W. W. and Anna Brackett." There is in evidence an "Interlocutory Order and Judgment" of the District Court dated November 22, 1948, in which it is adjudged and decreed inter alia "[t]hat the plaintiff, Thomas E. Arnett, is now and has been since January 7, 1915, the owner and is entitled to possession of the oil and gas * * * in" the tract of land involved in the litigation; that the claims of the defendants in that suit were invalid and were thereby canceled and removed as a cloud on the plaintiff's title; and that the defendants therein make "a full and complete accounting * * * of all oil, gas, and other petroleum products * * * produced, and/or sold by them * * *, showing the fair market value thereof * * *, and the amounts received by them therefor, so that the court can determine therefrom the issue as to the amount of damages, if any, that should be awarded the plaintiff herein." A memorandum of the District Court dated October 8, 1948, and reported in 88 F.Supp. 343, sums up (on page 349) the decision of that court as follows:

The plaintiff is entitled to the quiet possession of the minerals. There should be an accounting made to him of all moneys derived from the sale of minerals to which he would have been entitled had he been left to the proper enjoyment of his estate.

We conclude that Arnett had two purposes in instituting that litigation: (1) To quiet title as to the mineral deposits in a certain tract of land, which mineral deposits he had owned since 1915 and as to which he had record title, and (2) to obtain a money judgment from trespassers representing income derived by them from their exploitation of the mineral deposits owned by him; and that neither purpose was predominant.

The first of these issues is whether Arnett was entitled to the percentage depletion deduction provided for by sections 23 (m) and 114 (b) (3) of the Internal Revenue Code of 19392 in connection with the amounts recovered by him at the time and in the manner outlined in our findings from trespassers upon his mineral property.

In our opinion the general rule is that when the owner of or holder of a capital investment in oil and gas in place (which ownership vested or capital investment was made prior to any litigation) receives as the result of litigation a monetary award against a person wrongfully extracting such oil or gas representing the proceeds from its sale, whether in the form of damages or otherwise, the owner is entitled to the percentage depletion deduction provided by statute calculated upon such receipts. See Thomas W. Blake, Jr., 20 T.C. 721.

The cases of Parr v. Scofield, 89 F.Supp. 98, affd. 185 F.2d 535, and Massey v. Commissioner, 143 F.2d 429, relied upon herein by respondent, present exceptional circumstances which take them outside the general rule. The Massey case involved the availability of percentage depletion to an attorney whose interest was acquired pursuant to a contingent fee contract only upon the successful termination of litigation and at a time when the property to which his interest attached was in the form of money. The Parr case, upon which respondent lays the greater stress, involved a situation where the taxpayer had conveyed his ownership to the gas and oil but succeeded in subsequent litigation against the grantees in establishing an equitable interest in the "net profit" resulting from the operation of the property. Neither of those cases involved the situation here present in which the owner of the oil and gas recovers an award from trespassers representing the proceeds of the oil and gas wrongfully taken and to which he was entitled by reason of an ownership or investment long antedating the litigation in which the award was given.3

The depletion deduction available for oil and gas is for the benefit of "the taxpayer [who] has a capital investment in the oil in place which is necessarily reduced as the oil is extracted." Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 603. Whether it is extracted and sold by his consent or unlawfully by a trespasser is irrelevant provided that he receives the proceeds. We also consider it to be irrelevant that the gross income from the extraction is paid to the taxpayer involuntarily as the result of litigation and in the form of damages after an accounting, rather than voluntarily pursuant to contract. We conclude that Arnett was entitled to a percentage depletion allowance with regard to the gross income received by him and resulting from the operation of oil and gas wells exploiting the mineral rights owned by him and in which he had a capital investment, even though such operation and exploitation were by trespassers and such gross income was received by him in the form of money damages decreed by a court in litigation seeking an accounting from such trespassers. A fortiori, Arnett was entitled to a percentage depletion allowance with regard to gross income received by him and resulting from the operation of the oil and gas wells by the conservators appointed by the District Court. Respondent's argument on this point is to the effect that the gross income of Arnett here in question was in the form of money received upon a judgment award, that the oil from the sale of which the money was derived was no longer in place when the gross income was realized by Arnett, and therefore such gross income cannot be from oil and gas in place within the meaning of section 114 (b) (3). This argument is without merit in principle and is not supported by any pertinent authority.

Having decided the issue stated above in favor of petitioners, it is necessary to consider respondent's alternative contention that the decedents' gross income for depletion purposes for the period of the trespassers' operation should not in any event include development and operating expenses paid by the trespassers. It is stipulated that the gross oil production, less severance taxes, during that period amounted to $401,071.60, that the District Court decided that the defendants in the litigation before it were entitled as innocent trespassers to "a reasonable allowance for their expenditures" in an amount ultimately determined to be $94,827.17, representing cost of wells and equipment, cost of drilling operations, and supervision charges, and that after the subtraction of "expenditures awarded defendants" and the addition of "discount earned," the "net amount of award" was $306,568.55.

Respondent concedes that Arnett's gross income for the purpose of computing percentage depletion under section 114 (b) should include all expenses paid by the conservators during their operation of the property. See Barnhart-Morrow Consolidated, 47 B. T. A. 590, 603-605, affd. 150 F.2d 285. However, respondent contends that even though decedents are entitled to a percentage depletion deduction (as we have held), there should not be included in their gross income for the purpose of computing such a deduction any amounts representing "the expenses incurred and paid by Delta [the trespasser] nor * * * depreciation sustained on the equipment while Delta was controlling operations" since "[t]here is obviously a substantial difference between a situation where an adverse party operates the lease for his own benefit, taking a current deduction therefor,4 and one where a trustee is operating the lease for the benefit of the winning litigant," citing Helvering v. Mountain Producers Corporation, 303 U.S. 376.

The cited case did not involve expenses of production paid by a trespasser and allowed to it as an "innocent trespasser" by a court in a suit for accounting, but involved a situation where the purchaser of oil agreed to develop and operate the oil property at its own expense and to make payments to the owner of the property in amounts calculated by subtracting such expenses. In that case the Court concluded that the owner of the property had agreed by contract that his gross income was to be in amounts reflecting the subtraction of such expenses and that the expenses were paid by the purchaser on its own account and for its own benefit and not for the benefit of the owner.

In the instant case there was no such contract by which Arnett can be said to have agreed that his gross income from the property was to be the amount of the proceeds of the oil extracted minus the expenses of development and operation, and the amount of such expenditures cannot be said to be for the benefit of the trespasser since as trespasser it was not entitled to benefit by its unlawful operations and developments and, as a result of the litigation, it did not so benefit. Its recoupment of costs of development and operation was allowed to it by the court not as a benefit but to prevent its being damaged as a result of expenditures made by it as an "innocent trespasser" which resulted in benefit to Arnett.

In our opinion the expenditures here in question come within the ambit of cases such as Barnhart-Morrow Consolidated, supra, rather than that of Helvering v. Mountain Producers Corporation, supra. They "were made out of production of oil and gas for the benefit of petitioner" (Barnhart-Morrow Consolidated, supra at 605). We conclude that the gross income of decedents upon which percentage depletion was allowable should not be reduced by the amount of such expenditures.

The next alternative issue raised by respondent's amended answer to be considered is whether all or any part of the legal expenses paid by Arnett incident to the litigation which we have characterized heretofore in this opinion is deductible under section 23 (a) (2) of the Internal Revenue Code of 1939.

Legal expenses incident to the quieting of title are not deductible. Legal expenses incident to the collection of income are deductible. In the instant case we have concluded that Arnett had two purposes in instituting the litigation here in question: (1) To quiet title and (2) to collect income; and that neither purpose was predominant. Cf. Midco Oil Corporation, 20 T.C. 587, 591, 592. Under the circumstances here present it is proper to apportion the legal expenses paid by Arnett incident to this litigation by capitalizing the portion allocable to the quieting of title and by allowing as a deduction the portion allocable to the collection of income. Agnes Pyne Coke, 17 T.C. 403, affd. 201 F.2d 742; Daniel S. W. Kelly, 23 T.C. 682, affd. 228 F.2d 512. Upon the facts presented (and we reiterate that respondent has the burden of proof on this issue), it is impossible to determine with exactness what portion of the total fees paid is allocable to the quieting of title and what portion is allocable to the collection of income. Under such circumstances we have held in James Petroleum Corporation, 24 T.C. 509, affirmed on another issue 238 F.2d 678, and in Estate of A. P. Steckel, 26 T.C. 600, that we may approximate the allocation and apportionment under the principle of Cohan v. Commissioner, 39 F.2d 540. Accordingly, we have concluded that one-half of the attorneys' fees is properly deductible by decedents.

Finally we consider the issue involving the question whether interest upon the judgment against the trespassers and discounts earned by the trespassers and conservators should be included in the gross income upon which the percentage depletion deduction is calculated.

As this Court held in Island Creek Coal Co., 30 T.C. 370, with regard to "gross income" upon which the percentage depletion is to be computed, "[w]e think it is clear that `gross income from the property' has reference only to the income attributable to those mining operations defined by the statute."

Miscellaneous items of income from sources or operations or transactions only indirectly related to the direct extraction and sale operations are not includible in the "gross income" or "net income" base upon which the deduction is calculated and limited. Interest upon the amount of the judgment against the innocent trespassers is includible in gross income but not includible in "gross income from the property" for the purpose of the computation of the deduction. The purpose of the deduction as discussed above should make the exclusion of such an item from the base obvious. The amount of the deduction theoretically depends upon the degree to which the wasting asset is depleted. The amount of such depletion and the consequent deduction cannot be made to depend on the time a judgment debtor delays in meeting his obligation. The interest amount is a miscellaneous item of income not "attributable to those mining operations defined by the statute," and not "gross income from the oil and gas." See Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312. The same reasoning would deny the inclusion of the interest on the judgment in the "net income of the taxpayer from the property" for the purpose of fixing the 50 per cent limitation on the deduction.

The item of "Discounts Earned" which was also included in the "gross income" base and "net income" limitation base is also such a miscellaneous item of income. It was isolated from the "Net Yield—Oil Production" entry by an accountant making a statement of operations of the mineral interest and separately stated, along with the interest item, as "Other Income." It is just such other income which should be excluded from the percentage depletion computation.

Decision will be entered under Rule 50.

FootNotes


1. A limitation on the percentage depletion deduction prescribed by the second sentence of section 114 (b) (3), I. R. C. 1939.
2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

In computing net income there shall be allowed as deductions:

* * * * * * *

(m) DEPLETION.—In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. In any case in which it is ascertained as a result of operations or of development work that the recoverable units are greater or less than the prior estimate thereof, then such prior estimate (but not the basis for depletion) shall be revised and the allowance under this subsection for subsequent taxable years shall be based upon such revised estimate. In the case of leases the deductions shall be equitably apportioned between the lessor and lessee. * * *

For percentage depletion allowable under this subsection, see section 114 (b), (3) and (4).

SEC. 114. BASIS FOR DEPRECIATION AND DEPLETION.

(b) BASIS FOR DEPLETION.—

* * * * * * * (3) PERCENTAGE DEPLETION FOR OIL AND GAS WELLS.—In the case of oil and gas wells the allowance for depletion under section 23 (m) shall be 27½ per centum of the gross income from the property during the taxable year, excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance under section 23 (m) be less than it would be if computed without reference to this paragraph.
3. It should be noted that the authority of the Parr case even as to its peculiar facts has been weakened by the addition of section 1305 (b) to the Internal Revenue Code of 1954 (H. Rept. 232, 85th Cong., 1st Sess. (1957), 71 Stat. 413), permitting a depletion deduction to a taxpayer obtaining damages for breach of contract or fiduciary duty insofar as they represent taxpayer's share of income from the operation of property. In S. Rept. No. 836, 85th Cong., 1st Sess. (1957) p. 4, the Finance Committee after noting the Parr case states that section 1305 (b) "is intended to make it clear that for the purpose of computing * * * deductions for depletion * * * the award is to have the same character as the income which would have been received or accrued except for the breach of contract or duty." (Emphasis supplied.) See also H. Rept. No. 870, 85th Cong., 1st Sess. (1957), p. 2.
4. Since respondent has the burden of proof on this issue and there is no evidence that the trespasser took "a current deduction therefor," respondent's statement to this effect on brief cannot be considered as a part of his argument.

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