Opinion
Docket Nos. 107896 108082-108084 109031-109034.
1943-07-9
JAMES LEWIS CALDWELL MCFADDIN, PETITIONER, ET AL.,1 v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Percy W. Phillips, Esq., for the petitioners. Stanley B. Anderson, Esq., for the respondent.
1. Under an oil and gas lease, lessees were to pay a stated sum annually, called ‘rental,‘ and to retain the royalties produced and be reimbursed therefrom each year, the excess to be paid to lessor. Held, such payments were in the nature of advance royalty, and subject to depletion by lessor.
2. A trust received, by way of gift, certain real estate, a portion of which it subdivided into lots for sale at the suggestion of a licensed real estate broker, who was given the exclusive agency with a stated commission on all sales. The broker assumed advertising expense and made collections to the amount of his commissions, the balance being collected by the trust. Held, the lots were held by the trust primarily for sale to customers in the ordinary course of business, and the profits therefrom are taxable as ordinary gains.
3. Recoveries of bad debts claimed and allowed as deductions in a prior year, which resulted in no tax benefit in such year, held not includible in gross income in the year of recovery, under section 22(b). Revenue Acts of 1936 and 1938, as amended by section 116, Revenue Act of 1942.
4. Property was conveyed to trustees for the uses and purposes set forth in a trust instrument of even date, subject to existing indebtedness of grantors and a sum payable to grantor's wife solely out of trust income or corpus each year during the life of the wife or existence of the trust, whichever was shortest in period of time, neither the trustees nor any beneficiary assuming personal liability therefor. Held, under the facts, and Texas law, the transfers were gifts and the beneficiaries' interests in trust corpus their separate property. Held, further, there was not such commingling of separate and community interests as to require either the original acquisition or property subsequently purchased to be treated as community property. Held, further, the beneficiaries' distributive shares of gains from the sale of portions of the corpus, including proceeds of oil royalties, are taxable as their separate income. Held, further, in the absence of evidence as to what constituted general expenses of the trust, or the amount attributable to separate income, respondent's action in not allocating any part thereof to petitioners' separate income is approved.
5. Three of the petitioners paid attorney fees for the recovery of overpayments of income tax in a prior year and interest thereon. Held, such fees should be apportioned pro rata between amounts received as refunds of tax and amounts received as interest and deduction allowed as to portion allocable to recovery of interest only. Percy W. Phillips, Esq., for the petitioners. Stanley B. Anderson, Esq., for the respondent.
These consolidated cases involve deficiencies in income tax asserted against the petitioners, as follows:
+--------------------------------------------------------+ ¦Docket No.¦Petitioner ¦Year¦Deficiency¦ +----------+-----------------------------+----+----------¦ ¦107896 ¦James Lewis Caldwell McFaddin¦1938¦$648.98 ¦ +----------+-----------------------------+----+----------¦ ¦109032 ¦James Lewis Caldwell McFaddin¦1939¦167.41 ¦ +----------+-----------------------------+----+----------¦ ¦108082 ¦W. P. H. McFaddin, Jr ¦1938¦672.00 ¦ +----------+-----------------------------+----+----------¦ ¦109034 ¦W. P. H. McFaddin, Jr ¦1939¦242.96 ¦ +----------+-----------------------------+----+----------¦ ¦108083 ¦Mamie McFaddin Ward ¦1938¦687.15 ¦ +----------+-----------------------------+----+----------¦ ¦109033 ¦Mamie McFaddin Ward ¦1939¦314.73 ¦ +----------+-----------------------------+----+----------¦ ¦108084 ¦W. V. McFaddin ¦1938¦150.51 ¦ +----------+-----------------------------+----+----------¦ ¦109031 ¦W. V. McFaddin ¦1939¦57.81 ¦ +--------------------------------------------------------+
The petitioners are individuals, residing in Beaumont, Texas. During the years 1938 and 1939 each of the petitioners was married and living with his or her husband or wife and was a resident of Texas. Each petitioner and his or her spouse filed separate returns for the taxable years 1938 and 1939, on a community property basis, with the collector of internal revenue for the first district of Texas, located at Austin, Texas.
Certain adjustments resulting in the deficiencies here involved are not contested. These will be taken care of under Rule 50. One allegation of error to the effect that section 820 of the Revenue Act of 1938 should have been applied apparently has been abandoned.
FINDINGS OF FACT.
Petitioners James Lewis Caldwell McFaddin, W. P. H. McFaddin, Jr., and Mamie McFaddin Ward are beneficiaries of a trust known as the McFaddin trust, and each is entitled to receive 21 2/3 percent of the net income thereof. W. V. McFaddin is likewise a beneficiary and is entitled to 11 2/3 percent of the net income.
The trust keeps its accounts and makes its income tax returns upon the basis of a fiscal year ending February 28. The petitioners keep their accounts and make their income tax returns on a calendar year basis. With respect to petitioners' income tax liability for the calendar years 1938 and 1939, with which we are here concerned, the taxable years of the trust which are involved are its fiscal years ending February 28, 1938, and February 28, 1939.
The trust was created by a declaration of trust executed March 1, 1927, by W. P. H. McFaddin, W. P. H. McFaddin, Jr., and J. L. C. McFaddin, as trustees. It was to continue for a period of ten years at which time it was to terminate, unless continued for an additional period of not exceeding ten years at the election of two-thirds in interest and number of the beneficiaries. The beneficiaries have elected that the trust continue.
On the same day that the trust was created W. P. H. McFaddin, petitioners' father, and his wife, Ida Caldwell McFaddin, conveyed considerable land holdings in Jefferson, Knox, King and Fort Bend Counties, Texas, to W. P. H. McFaddin, W. P. H. McFaddin, Jr., and J. L. C. McFaddin, as trustees of the McFaddin trust, in consideration of $10 and the uses, purposes, and trusts set forth in the trust instrument. These properties comprised the original corpus of the trust.
The deeds and declaration of trust were submitted in evidence. We incorporate them herein by reference as part of our findings of fact. Stated briefly, the pertinent provisions of the trust instrument are as follows:
In the preamble, the trust estate is described as all of the property then conveyed, ‘together with any property that may from time to time be added to or become a part of this Trust.‘ Section 1 gives the trustees full power and authority over the trust estate, to invest and reinvest it, to conduct any business, to borrow money, to subdivide any real property constituting a part of the estate, to lease any part thereof for oil, gas, or other minerals, to appoint agents, and, generally, to deal with the estate to the same extent that an owner could. Section 4 refers to certain liens and charges to which certain portions of the trust estate are subject, a schedule of which is attached to the trust instrument, and authorizes the trustees ‘to renew, extend or refund said charges and liens or any portion thereof, or to pay or discharge the same or any portion thereof and to use for said purposes either the principal or income of said trust estate.‘ Section 5 directs the trustees to pay Ida Caldwell McFaddin $30,000 per year out of the income of the trust estate or, if insufficient, out of corpus, such payments to continue until the termination of the trust or until her death, whichever occurred first. Section 6 authorizes the trustees from time to time to set apart from the trust income ‘such amounts as they deem necessary for the purpose of accumulating a reserve with which to discharge in whole or in part the charges or liens mentioned in section four‘; and for accumulating a reserve on account of depreciation, obsolescence, and depletion in such amount ‘as the Trustees deem necessary to maintain and preserve the principal of the trust estate. Any funds so reserved may be invested and reinvested in like manner as other funds in the trust estate and the income arising therefrom shall be subject to all provisions of this agreement with reference to income from the trust estate. The principal of any such reserve funds may be used from time to time by the Trustees in the same manner as any other funds of said trust estate without reference to the source of such funds.‘ Section 8 directs the trustees to distribute the net income of the trust estate periodically among the beneficiaries. Net income is defined as the income derived from the trust estate after deducting therefrom all expenses of operation and maintenance, any amount set up as a reserve under section 6, the amount paid to Ida Caldwell McFaddin, amounts applied to pay or discharge charges or liens mentioned in section 4, and any renewals thereof, and charitable donations. The trustees ‘may determine the mode in which any expenses are to be borne as between capital and income and may determine what moneys or property are to be treated as capital or income, which said determination * * * shall be conclusive and binding upon all persons.‘ Upon direction in writing of a majority in number of the beneficiaries, the trustees shall retain all or any portion of the net income and hold, invest, and reinvest it for the benefit and in the interest of the beneficiaries, with all the powers granted as to the trust estate, ‘provided, however, that the portion of said net income so retained shall not be intermingled with the general trust estate but shall be held separate and distinct.‘ Section 11 provides that no assignment by any beneficiary of income or principal shall be valid, and that no part of the principal or income of the estate or the interests of the beneficiaries therein shall be subject to the payment of any debts of any beneficiary. Section 14 absolves the trustees and beneficiaries of any and all personal obligation or liability for obligations or debts of the trustees and provides that any person dealing with the trustees shall look solely to the trust estate.
On December 1, 1933. W. P. H. McFaddin, individually, and the McFaddin trust, referred to in the lease as lessor, in consideration of $100 and other valuable considerations in hand paid and the royalties therein provided and the agreements to be performed by the lessee, entered into an oil, gas, and mineral lease (hereinafter referred to as the Humble lease) with Humble Oil & Refining Co. and Shell Petroleum Corporation, referred to in the lease as lessee, covering 86,905.98 acres of land, more or less, in Jefferson County, Texas, ‘for the purpose of investigating, exploring, prospecting, drilling and mining for and producing oil, gas and all other minerals.‘ Royalties of one-eighth of the oil and gas produced and saved from the premises, one-tenth of minerals, other than sulphur, and $1 per long ton on sulphur were provided for.
Other provisions of the lease material here are as follows:
4. Lessee agrees on or before January 31, 1934, to pay or tender to Lessor * * * the sum of Twenty-five Thousand Dollars ($25,000.00) (herein called rental). In like manner, Lessee shall pay or tender annually thereafter the sum of Twenty-five Thousand Dollars ($25,000.00) during the primary term; provided, however, that Lessee at Lessee's option shall have the right at the end of five years and two months from date hereof to terminate this lease by failing to pay the rental for the next ensuing year upon giving Lessor sixty (60) days notice of its intention not to pay such rental. * * * Should Lessee not elect to terminate this lease at the end of five years and two months from the date hereof as above provided, then and in that event, Lessee shall maintain this lease in force and effect and make such rental payments herein provided for annually during the remainder of the ten years and two months primary term of the lease subject, however, to the further provisions thereof.
It is expressly provided, however, that should Lessee during the primary term discover oil, gas or other mineral upon the leased premises, Lessee shall have the right to retain and own all of the royalties on production from said premises accruing or to accrue during each year until such royalties during such year amount in value to the equivalent of the rental paid hereunder for that year.
6. Without reference to the commencement, prosecution, or cessation at any time of drilling or other development operations and/or to the discovery, development or cessation at any time of production of oil, gas or other minerals, subject only to the obligation of reasonable development as hereinafter provided, and without further payments than the rentals and royalties over and above the equivalent of such rentals as herein provided, this lease shall be for the primary term of ten years and two months from date hereof, subject to the right of Lessee to terminate the same at the end of five years and two months from date hereof as above provided, and as long thereafter as oil, gas, sulphur or other mineral is produced from said land hereunder, or operations are conducted on the leased premises as provided below.
Soon after the trust was created, a part of the property was laid out in a subdivision known as Central Gardens. An arrangement for the sale of lots in Central Gardens was made with a licensed real estate broker, A. A. Dunn, who had approached the trustees in regard to the development. Dunn had the exclusive agency and he received a 25 percent commission on all sales. He assumed all of the advertising expense. The trust, in addition to furnishing the land, paid the expense of grading and paving streets, surveying, and marking off the lots. Most sales were made by Dunn. In a few cases, sales were made through the office of the trust, but Dunn received his commission on these sales as well as on those made by him. After Dunn had made collections equal to his 25 percent commission, he would turn over the contract to the office of the trust and further payments were made to that office. The development was started in 1936. Eighty-five lots were sold in 1937, the first year in which sales were made, seventy-nine in 1938, and seventy-seven in 1939. Dunn died in 1940. Seventy-eight lots were sold in 1940, fifteen in 1941, and twenty in 1942.
It was stipulated at the hearing that the trust reported in its income tax returns for the fiscal years ended February 28, 1938, and February 28, 1939, the respective amounts of $3,333.33 and $716.67 representing recoveries of portions of a bad debt which had been claimed and allowed as a deduction in its return for 1933, and the trust derived no tax benefit from the deduction allowed in 1933.
At the time of the conveyances in trust the following indebtedness of settlors was outstanding, all of which is included in the ‘SCHEDULE OF LIENS AND CHARGES‘ attached to the trust instrument:
+-----------------------------------------------------------------------------+ ¦Guardian Trust Co., deed of trust on portion of lands ¦$150,000.00¦ +-----------------------------------------------------------------+-----------¦ ¦San Jacinto Trust Co., deed of trust on portion of lands ¦200,000.00 ¦ +-----------------------------------------------------------------+-----------¦ ¦Commerce Farm Credit Co. of Dallas, Texas, deed of trust on ¦78,000.00 ¦ ¦portion of lands ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦State of Texas, balance purchase price on 19,756.8 acres ¦20,779.50 ¦ +-----------------------------------------------------------------+-----------¦ ¦New York Life Insurance Co., promissory note ¦5,670.00 ¦ +-----------------------------------------------------------------+-----------¦ ¦Prudential Insurance Co. of America, promissory note ¦28,499.62 ¦ +-----------------------------------------------------------------+-----------¦ ¦Great Southern Life Insurance Co., promissory note ¦5,284.90 ¦ +-----------------------------------------------------------------+-----------¦ ¦Total ¦488,234.02 ¦ +-----------------------------------------------------------------------------+
The conveyances were made to the trustees subject to the above indebtedness, but in neither the deeds of conveyance nor the trust instrument did the trust or beneficiaries expressly assume or agree to pay the same. All of the indebtedness, however, was repaid prior to the taxable years except approximately $16,000 to the State of Texas.
The trustees borrowed money in 1930, 1931, and 1932 from various banks and from the Yount-Lee Oil Co. to help defray operating expenses. In the years 1932 through 1934, and possibly 1935, the trust operated at a loss.
Since the inception of the trust and prior to the taxable years the trustees purchased various properties, some for cash and some partially on credit. Most of the obligations assumed on such properties were paid off. A part of the income for the taxable years was derived from these properties.
Included in the property originally conveyed in trust were two cattle ranches. The Jefferson County ranch was approximately 10 miles by 25 miles in size and covered approximately 84,000 acres. The Knox County ranch covered about 16,000 acres. The normal number of cattle on these ranches combined was approximately 7,500. These ranches were operated by the trust. The larger ranch in Jefferson County was also leased for rat-trapping operations. In the trust's earlier years trapping operations were conducted by the trust itself. The Jefferson County ranch was included in the Humble lease, which interferes very slightly in the ranching and trapping operations. Some of the property conveyed to the trustees was used for farming operations. The trustees also received many properties which were rented. The land which was subdivided as Central Gardens was also a part of the original conveyance. There were no outstanding debts on the Central Gardens property.
The trust has one principal bank account in a Beaumont, Texas, bank. At times other small bank accounts were maintained for convenience. Transfers of funds were sometimes made between bank accounts. Income from all sources was deposited in the principal account, as well as borrowed funds. All expenses and payments to beneficiaries were paid out of that account. In the taxable years 1938 and 1939 the only bank account maintained by the trust was in the Beaumont bank. In those years all receipts and disbursements, for whatever purpose, went through this bank account. The trust has books of account for these years, including a ledger summarizing receipts from each source.
In Docket Nos. 107896, 108082, and 108084 petitioners James Lewis Caldwell McFaddin, W. P. H. McFaddin, Jr., and W. V. McFaddin in 1938 paid attorney fees for services rendered in litigation involving claims filed by them for refunds of income taxes relative to their distributive shares of income from the trust for a previous year. The matter was settled in 1938 and the claimants received refunds together with interest. The details are given in the following table:
+-----------------------------------------------------------+ ¦Petitioner ¦Interest ¦Fee paid ¦ +---------------------------------------+---------+---------¦ ¦James Lewis Caldwell McFaddin¦$5,691.42¦$1,567.99¦$1,031.47¦ +-----------------------------+---------+---------+---------¦ ¦W. P. H. McFaddin, Jr ¦5,692.89 ¦1,569.46 ¦1,023.80 ¦ +-----------------------------+---------+---------+---------¦ ¦W. V. McFaddin ¦2,031.38 ¦557.69 ¦365.35 ¦ +-----------------------------------------------------------+
In its return for the fiscal year ended February 28, 1938, the trust reported bonuses and royalties and claimed deductions as follows:
+-----------------------------------------------------+ ¦Oil and mineral lease bonuses: ¦ ¦ ¦ +--------------------------------+----------+---------¦ ¦Fidelity Oil Royalty Co ¦ ¦$802.20 ¦ +--------------------------------+----------+---------¦ ¦Sinclair Prairie Co ¦ ¦205.92 ¦ +--------------------------------+----------+---------¦ ¦B. E. Quinn ¦ ¦240.00 ¦ +--------------------------------+----------+---------¦ ¦Magnolia Petroleum Co ¦ ¦539.00 ¦ +--------------------------------+----------+---------¦ ¦Humble Oil & Refining Co ¦ ¦25,000.00¦ +--------------------------------+----------+---------¦ ¦Magnolia Land Co ¦ ¦15.00 ¦ +--------------------------------+----------+---------¦ ¦ ¦ ¦26,802.12¦ +--------------------------------+----------+---------¦ ¦Oil royalties: ¦ ¦ ¦ +--------------------------------+----------+---------¦ ¦Stanolind Oil & Gas Co ¦$20,048.08¦ ¦ +--------------------------------+----------+---------¦ ¦Gulf Oil Corporation (Unity) ¦2,188.74 ¦ ¦ +--------------------------------+----------+---------¦ ¦Gulf Oil Corporation (Stella) ¦140.88 ¦ ¦ +--------------------------------+----------+---------¦ ¦Gulf Oil Corporation (Baker) ¦216.59 ¦ ¦ +--------------------------------+----------+---------¦ ¦ ¦ ¦22,594.29¦ +--------------------------------+----------+---------¦ ¦Natural gas royalties ¦ ¦56.06 ¦ +--------------------------------+----------+---------¦ ¦ ¦ ¦49,452.47¦ +--------------------------------+----------+---------¦ ¦Deductions: ¦ ¦ ¦ +--------------------------------+----------+---------¦ ¦Depletion on bonuses: ¦ ¦ ¦ +--------------------------------+----------+---------¦ ¦27 1/2% on $26,802.12 ¦$7,370.58 ¦ ¦ +--------------------------------+----------+---------¦ ¦Depletion on oil royalties: ¦ ¦ ¦ +--------------------------------+----------+---------¦ ¦27 1/2% on $22,594.29 ¦6,213.43 ¦ ¦ +--------------------------------+----------+---------¦ ¦Depletion on gas royalties: ¦ ¦ ¦ +--------------------------------+----------+---------¦ ¦27 1/2% on $56.06 ¦15.42 ¦ ¦ +--------------------------------+----------+---------¦ ¦ ¦ ¦13,599.43¦ +--------------------------------+----------+---------¦ ¦Net royalties ¦ ¦35,853.04¦ +-----------------------------------------------------+
It also reported profits on sales of assets as follows:
+-------------------------------------------------------------------------+ ¦Asset: ¦ ¦ +--------------------------------------------------------------+----------¦ ¦Rice mill property ($47,526.20 at 30%) ¦$14,257.86¦ +--------------------------------------------------------------+----------¦ ¦Oil royalty sold (1/64th royalty under 4,000 acres, $50,000 at¦ ¦ +--------------------------------------------------------------+----------¦ ¦30%) ¦15,000.00 ¦ +--------------------------------------------------------------+----------¦ ¦Central Gardens lots ($10,013.26 at 30%) ¦3,003.98 ¦ +--------------------------------------------------------------+----------¦ ¦Miscellaneous acreage ($1,752.22 at 30%) ¦525.67 ¦ +--------------------------------------------------------------+----------¦ ¦Total ¦32,787.51 ¦ +-------------------------------------------------------------------------+
The assets sold were a portion of the property conveyed to the trust on March 1, 1927.
In its return for the fiscal year ended February 28, 1939, the trust reported royalties and claimed deductions as follows:
+--------------------------------------------------------------------------+ ¦Gross income: ¦ ¦ ¦ +-----------------------------------------------------+----------+---------¦ ¦Natural gas royalties ¦ ¦$24.77 ¦ +-----------------------------------------------------+----------+---------¦ ¦Lease, Fidelity Oil & Royalty Co ¦ ¦802.20 ¦ +-----------------------------------------------------+----------+---------¦ ¦Lease, B. E. Quinn ¦ ¦160.00 ¦ +-----------------------------------------------------+----------+---------¦ ¦Lease, Magnolia Petroleum Co ¦ ¦539.00 ¦ +-----------------------------------------------------+----------+---------¦ ¦Lease, Shell Petroleum Co ¦$25,000.00¦ ¦ +-----------------------------------------------------+----------+---------¦ ¦Less share to St. Germain, et al ¦593.61 ¦ ¦ +-----------------------------------------------------+----------+---------¦ ¦ ¦ ¦24,406.39¦ +-----------------------------------------------------+----------+---------¦ ¦Oil royalties, Gulf Co. Unity lease ¦ ¦2,116.38 ¦ +-----------------------------------------------------+----------+---------¦ ¦Oil royalties, Gulf Co. Stella lease ¦ ¦118.69 ¦ +-----------------------------------------------------+----------+---------¦ ¦Oil royalties, Gulf Co. Baker lease ¦ ¦127.79 ¦ +-----------------------------------------------------+----------+---------¦ ¦Oil royalties, Stanolind Oil & Gas Co ¦ ¦18,809.31¦ +-----------------------------------------------------+----------+---------¦ ¦ ¦ ¦47,104.53¦ +-----------------------------------------------------+----------+---------¦ ¦Deductions: ¦ ¦ ¦ +-----------------------------------------------------+----------+---------¦ ¦Depletion on above, 27 1/2% of $47,104.53--$12,953.75¦ ¦12,953.75¦ +-----------------------------------------------------+----------+---------¦ ¦Net royalties ¦ ¦34,150.78¦ +--------------------------------------------------------------------------+
It also reported profits on sale of assets as follows: Central Gardens lots ($7,574.99 at 50%), $3,787.50.
OPINION.
ARNOLD, Judge:
Respondent determined (1) that petitioners' respective shares of the income of the trust should be increased, due to (a) his disallowance of depletion claimed on payments under the Humble lease in excess of royalties retained by the lessee, (b) his treatment of profits on the sale of Central Gardens lots as ordinary rather than as capital gain; (2) that such portions of petitioners' distributive shares of the income of the trust as were attributable to royalties and to sales of trust property were separate and not community income; and (3) that with respect to petitioners James Lewis Caldwell McFaddin, W. P. H. McFaddin, Jr., and W. V. McFaddin no deduction was allowable for attorney fees incurred in 1938 for the recovery of an overpayment of Federal income tax.
The petitioners allege error in regard to each of these determinations. They also allege error in that the respondent failed to exclude from gross income of the trust the amounts received by it and reported in its returns for the fiscal years ended February 28, 1938, and February 28, 1939, as payments upon the indebtedness charged off in a previous year as a bad debt. It is also alleged that, in determining the income of the trust for its fiscal years involved, respondent erred in allocating no part of the general expense of the trust to the amounts which he had determined to be distributable as separate income.
The issues to be considered first are those relating to the amount of the trust's income for the fiscal years in question. These pertain to the allowance of depletion upon payments under the Humble lease, the treatment of profits upon the sales of Central Gardens lots, and the treatment of bad debt recoveries. They will be taken up in the order listed.
The respondent disallowed the depletion claimed by the trust upon the annual payments under the Humble lease to the extent that such payments exceeded royalties retained by the lessee pursuant to section 4 of the lease. The royalties so retained amounted to $4,301.64 in 1938 and $4,059.49 in 1939. Respondent contends that the portion of the annual payment in excess of the retained royalties for each year was rental on which no depletion was allowable, and cites as authority Commissioner v. Wilson (C.C.A., 5th Cir., 1935) 76 Fed.(2d) 766; and Continental Oil Co., 36 B.T.A. 693. He also attempts to distinguish or decision in Alice G. K. Kleberg, 43 B.T.A. 277.
In the Wilson and Continental Oil Co. cases, supra, under substantially different facts, it was held that the amounts paid under oil leases for the purpose of obtaining delays in production were delay rentals and not royalties. Continental Oil Co. held that an amount which was clearly a delay rental was not subject to depletion. The Wilson case did not concern itself with depletion.
In Alice G. K. Kleberg, supra, we had the question of whether an amount described in an oil lease as ‘rental‘ was to be treated as a delay rental, not subject to depletion, or as an advance royalty, upon which depletion was allowable. We there held, under facts quite similar to those here involved, that the payment, although called a ‘rental,‘ was really an advance royalty and as such subject to depletion.
The characteristics of delay rentals have been fully considered in previous cases and need not be repeated here. (See Houston Farms Development Co. v. United States (C.C.A., 5th Cir., 1942), 131 Fed.(2d) 577; Commissioner v. Wilson, supra; Alice G. K. Kleberg, supra; Continental Oil Co., supra; J. T. Sneed, Jr., 33 B.T.A. 478.)
We think here as in the Kleberg case the payments in 1938 and 1939 were in the nature of advance royalties. The primary purpose of the lease was the exploration and development of the premises for the production of oil and gas and other minerals therefrom, in which lessor would profit from the royalties obtained from the oil and gas produced. The payments were not for delay in development of the premises for oil, gas, and other minerals, as the lessee was bound to make them regardless of exploration and development of the premises. The lessee had ‘the right to retain and own all of the royalties on production from said premises accruing or to accrue during each year until such royalties during each year amount in value to the equivalent of the rental paid hereunder for that year.‘ The royalties belonged to the lessor and instead of being paid direct they were to be withheld to reimburse lessee to the extent of the payments. The payments were, therefore, in the nature of guaranteed minimum royalties and not delay rentals. If the payments had been made and accepted for delay in exploring and developing the premises, the lessee would have no right to reimbursement out of the royalties produced. The fact that the premises did not produce sufficient royalties during the years in question to completely reimburse lessee for the amounts paid, in our opinion, does not justify us in treating a portion of the moneys paid as delay rentals and a portion as royalties, as respondent contends. We think such construction would do violence to the terms of the lease and the intention of the parties in entering therein.
The fact that the lease refers to the payments here in question as rentals is not controlling in determining the right to depletion thereon. Alice G. K. Kleberg, supra. Royalties and bonuses under oil, gas, and mineral leases have some resemblance to rentals. See Burnet v. Harmel, 287 U.S. 103; Von Baumbach v. Sargent Land Co., 242 U.S. 503; Commissioner v. Laird (C.C.A., 5th Cir., 1937), 91 Fed.(2d) 498. Nevertheless they are entitled to depletion deduction, Murphy Oil Co. v. Burnet, 287 U.S. 299, and without regard to whether there was actual production during the year in which paid, Herring v. Commissioner, 293 U.S. 322.
It is our opinion that the annual payments were not delay rentals, but in the nature of advance royalties and as such subject to depletion, and we so hold.
The next question, relating to the income of the trust for its fiscal years ended February 28, 1938, and February 28, 1939, is whether the profits realized upon the sale of Central Gardens lots are taxable as capital gains as contended by petitioners, or as ordinary gains as determined by respondent.
Section 117(b) of the Revenue Act of 1936 and section 117(a) of the Revenue Act of 1938 both provide that the term ‘capital asset‘ does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.
The petitioners contend that Central Gardens was not held by the trust primarily for sale to its customers in the ordinary course of its trade or business. The proposition, as stated in petitioners' reply brief, is ‘that the sale of real estate in lots through a broker is no more than an investment operation by the trustees, and that they did not hold the property 'primarily for sale to customers in the ordinary course of (their) trade or business'. The business was that of the brokers.‘ Higgins v. Commissioner, 312 U.S. 212 (1941), is cited by petitioners as having given a restricted definition of ‘trade or business‘ and they claim that under the authority of that decision and under the statute, the trust was not engaged in a trade or business in connection with the sale of Central Gardens lots.
Whether or not a particular activity in which a taxpayer engages constitutes a trade or business must depend upon the facts in the case. Higgins v. Commissioner, supra. The Central Gardens development was for the purpose of profit from the sale of lots to customers. Such sales were frequent and continuous, and not isolated or casual. The sale of these lots was a trade or business, R. J. Richards, 30 B.T.A. 1131; affd. (C.C.A., 9th Cir., 1936), 81 Fed.(2d) 369; Willard Pope, 28 B.T.A. 1255; Ehrman v. Commissioner (C.C.A., 9th Cir., 1941), 120 Fed.(2d) 607; certiorari denied, 314 U.S. 668.
It is an elementary rule of agency that the act of an agent, within the scope of his authority, is the act of his principal. The relationship here between the trust and Dunn was no more than that of principal and agent. Dunn, a licensed real estate broker, had undertaken to sell lots in Central Gardens as agent for the trust. The trust retained title to the property and made deeds when the lots were sold. Section 1 of the trust instrument authorizes the trustees to engage in the business of subdividing real estate and to engage agents. The fact that, to a large extent, the trustees confided the management of the sales to their agent does not make the business any the less that of the trust. The business is that of the seller and not the agent. Commissioner v. Boeing (C.C.A., 9th Cir., 1939), 106 Fed.(2d) 305; certiorari denied, 308 U.S. 619 (1939); Welch v. Solomon (C.C.A., 9th Cir., 1938), 99 Fed.(2d) 41; R. J. Richards, supra; Willard Pope, supra. The purchasers of the lots dealt with the trust as well as with Dunn. They were customers of the trust.
On this issue we sustain respondent's determination.
The final issue relating to the amount of the income of the trust for the fiscal years involved is whether certain amounts which had been charged off and taken as a bad debt deduction in a previous year, resulting in no tax benefit, are includible as taxable income in the years of recovery.
The petitioners rely upon section 116 of the Revenue Act of 1942 and contend that the amounts referred to should be excluded from the income of the trust for the years involved.
Section 116 of the Revenue Act of 1942 added to section 22(b) of the Internal Revenue Code and to the corresponding provisions of the Revenue Act of 1938 and prior revenue acts a new subsection providing for the exclusion from gross income of certain recoveries of bad debts, prior taxes, and delinquency amounts. This new subsection was made effective retroactively under the Code with respect to taxable years beginning after December 31, 1938, and under prior revenue acts as if it were a part thereof on their respective enactment dates.
As amended, sections 22(b) of the Revenue Acts of 1936 and 1938, applicable to the fiscal years of the trust here involved, exclude from gross income:
(12) RECOVERY OF BAD DEBTS, PRIOR TAXES, AND DELINQUENCY AMOUNTS.— Income attributable to the recovery during the taxable year of a bad debt, * * * to the extent of the amount of the recovery exclusion with respect to such debt * * * . For the purposes of this paragraph:
(A) DEFINITION OF BAD DEPT.— The term ‘bad debt‘ means a debt on account of worthlessness or partial worthlessness of which a deduction was allowed for a prior taxable year.
(D) DEFINITION OF RECOVERY EXCLUSION.— The term ‘recovery exclusion‘, with respect to a bad debt, * * * means the amount, determined in accordance with regulations prescribed by the Commissioner with the approval of the Secretary, of the deductions or credits allowed, on account of such bad debt, * * * which did not result in a reduction of the taxpayer's tax under this chapter * * * or corresponding provisions of prior revenue laws, reduced by the amount excludible in previous taxable years with respect to such debt, tax, or amount under this paragraph.
As the parties have stipulated that the trust derived no tax benefit from the deduction allowed in 1933, we hold that the amounts of $3,333.33 and $716.67 were erroneously included in the returns of the trust for its fiscal years ended February 28, 1938, and February 28, 1939, respectively.
As to the community property issue, the petitioners contend that from the inception of the trust their respective interests in the trust estate were community property and the income therefrom was community income as to each. The basis for this contention is that, as there was an outstanding indebtedness of the settlors of approximately $488,000 when the trust was created and the trust instrument provided for the payment of $30,000 annually to Mrs. Ida Caldwell McFaddin, the trust estate was acquired not by gift but upon credit and for an onerous consideration during coverture equivalent to a purchase, which, they contend, under Texas law makes the trust estate community property of the trust beneficiaries and the income therefrom community income. The petitioners also contend that even if some, or all, of the trust estate was separate property at the inception of the trust, there was such later commingling of separate and community property and income by the trustees that all of the original trust estate had become community property before the taxable years here involved. Property subsequently purchased by the trustees, petitioners say, was also community property because some of it was acquired upon credit and because the money paid therefor was derived from commingled separate and community funds, and if any part of the income therefrom is separate income respondent erred in not allocating a part of the general expenses of the trust to such separate income.
The record discloses that petitioners were married during the taxable years, but their marital status on March 1, 1927, when the deeds were made and the trust created, is not shown, with the possible exception of Mamie McFaddin Ward, and as to her only by inference in that she was named a beneficiary under her present name.
Under Texas law property, and the increase of all lands, acquired before marriage, and by gift, devise or descent after marriage, is separate property, Arts. 4613, 4614, Vernon's Annotated Revised Civil Statutes of Texas (1925).
In the absence of evidence that the property comprising the trust was acquired subsequent to the marriage of petitioners, we can not hold that their respective interests in the trust were the community and not the separate property of each of them. However, we need not base our conclusion solely on petitioners' failure to show the marital status of petitioners at the time the deeds and trust instrument were executed.
Art. 4613. All property of the husband, both real and personal, owned or claimed by him before marriage, and that acquired afterwards by gift, devise, or descent, as also the increase of all lands thus acquired, shall be his separate property. * * *Art. 4614. All property of the wife, both real and personal, owned or claimed by her before marriage, and that acquired afterward by gift, devise, or descent, as also the increase of all lands thus acquired, shall be the separate property of the wife. * * *
The first argument is that the property comprising the trust estate is community property because acquired during coverture for credit and upon an onerous consideration. The onerous consideration, it is said, was the credit extended in connection with the outstanding indebtedness of the grantors when the property was conveyed, and the amount payable to Ida Caldwell McFaddin.
Although property acquired by either the husband or wife during marriage, except that which is the separate property of either, shall be deemed the community property of the husband and wife, art. 4619, Vernon's Annotated Revised Civil Statutes of Texas (1925), such presumption is not alone sufficient to support the burden cast upon the petitioner to overcome the presumption of correctness of the Commissioner's determination of deficiency. W. D. Johnson, 1 T.C. 1041. Also, such presumption may be rebutted by the evidence. W. W. Clyde & Co. v. Dyess (C.C.A., 10th Cir., 1942), 126 Fed.(2d) 719; Stephens v. Stephens (Tex. Civ. App., 1927), 292 S.W. 290.
Under Texas law the character of property as to its separate or community status is fixed by the facts of acquisition. Woodrome v. Burton (Tex. Civ. App., 1941), 154 S.W(2d) 665; Skinner v. Vaughan (Tex. Civ. App., 1941), 150 S.W.(2d) 260; MacRae v. MacRae (Tex. Civ. App., 1940), 144 S.W.(2d) 320; Myers v. Crenshaw (Tex. Civ. App., 1938), 116 S.W.(2d) 1125; Janes v. Gulf Production Co. (Tex. Civ. App., 1929), 15 S.W.(2d) 1102; McClintic v. Midland Grocery & Dry Goods Co. (Tex., 1913), 154 S.W. 1157.
We do not think the conveyances in trust were purchases of the trust corpus on credit or upon onerous consideration. The debts of approximately $488,000 were debts of the grantors and it does not appear that the grantors were relieved of their obligations with respect thereto or that the trust, the trustees, or the beneficiaries, were substituted as principal obligors, or that they assumed or agreed to pay the debts. Their action with respect to these obligations was discretionary and not obligatory and confined solely to trust income or corpus. In fact, the trust agreement specifically negatives any intent to impose any obligation whatever on the beneficiaries in the nature of a purchase consideration.
In John Hancock Mutual Life Insurance Co. v. Bennett (Tex. Com. App., 1939), 128 S.W.(2d) 791, a father conveyed property by separate deeds to each of his seven children, with a proviso in each deed for the payment to him by each grantee of $200 annually. It was held, in the light of the facts there present, that the conveyances constituted gifts rather than sales for an onerous consideration, as the intention of the grantor was to divide his property equitably among his children during his lifetime. The facts in the case before us are even stronger for holding that the annual payment to Ida Caldwell McFaddin was not an onerous consideration equivalent to a purchase consideration than were the facts in the John Hancock case, in that there the obligation to make the payment was personal. Here the payments were to be made only for the duration of the trust, or until her death, whichever first occurred, and only out of trust income or corpus. ‘Gift‘ and ‘onerous consideration‘ are exact antitheses. The idea of their coexistence involves a paradox. Kearse v. Kearse (Tex. Com. App., 1925), 276 S.W. 690, 693.
The trust beneficiaries were the children of settlor W. P. H. McFaddin and the natural objects of his bounty. He was naturally interested in their welfare and transferred to the trust whatever interest grantors had therein for the children's benefit, taking care in so doing to impose no obligation on them beyond the property transferred. Under these circumstances it can not be said that the indebtedness of the settlors or the amount payable to Ida Caldwell McFaddin constituted consideration for the transfers to the trust to the extent of making what would otherwise be a gift a purchase by the trust for a valuable consideration.
Gifts in trust are gifts to the beneficiaries of beneficial interests in the trust corpus, the distributable income from which is taxable to the beneficiaries, Irwin v. Gavit, 268 U.S. 161, and such interests are separate property under Texas law, Commissioner v. Wilson, supra; Commissioner v. Terry, 69 Fed.(2d) 969.
We do not agree that this interest, although separate originally, became community property because of the alleged commingling by the trustees of separate and community property and income. We are not convinced by the evidence that there was such a hopeless commingling of separate and community interests as to require that the entire interest be treated as community under Texas law, cf. W. D. Johnson, supra; John Hancock Mutual Life Insurance Co. v. Bennett (Tex. Civ. App., 1942), 159 S.W.(2d) 892; Taylor v. Suloch Oil Co. (Tex. Civ. App., 1940), 141 S.W.(2d) 657.
Furthermore, in Texas separate property retains its status as such so long as it can be traced, Scofield v. Weiss (C.C.A., 5th Cir., 1942), 131 Fed.(2d) 631; W. D. Johnson, supra; Stephens v. Stephens, supra; irrespective of enhancement in value; otherwise a specific piece of property would be constantly in the process of shifting from separate to community, and its status would be in constant confusion. Cf. Scofield v. Weiss, supra; Beals v. Fontenot (C.C.A., 5th Cir., 1940), 111 Fed.(2d) 956. Also, we are unable to say that any of the funds utilized by the trustees to pay off indebtedness outstanding against the original trust estate, which payment, it is contended, gave rise to a commingling of separate and community funds, were to any extent community property. Under the terms of the trust instrument gross income was treated as corpus and the rights of the beneficiaries therein did not attach to gross income but only to the distributable ‘net income‘ as defined therein, which is gross income less all operating expenses and additions to the corpus. Therefore, gross income so used was not community income and petitioners' contention that community income was used to pay off trust indebtedness and to acquire additional corpus is without merit.
Paragraph 6 of the trust instrument authorizes the trustees to set aside out of the income of the trust such amounts as they deem necessary for the purpose of accumulating reserves to pay off trust indebtedness, depreciation, obsolescence, and depletion. These funds may be used from time to time by the trustees in the same manner as any other funds of the trust estate without reference to the source of such funds. The income arising therefrom is to be treated as any other trust income. The intention is apparent from the provision that any portion of the trust income so set aside and utilized shall be considered to be part of the corpus. The corpus is effectively protected from being diluted with community income by the last part of paragraph 8 of the instrument, which, although permitting a retention by the trustees of some of the distributive net income, upon election of the beneficiaries, requires that the fund so established and the property purchased therewith be kept separate from the trust estate, and the income from such special fund distributed separately.
The petitioners also argue that property subsequently purchased by the trustees became community property because some of it was acquired upon credit and because the money paid therefor was derived from commingled separate and community funds. The latter portion of this argument we have disposed of previously in holding that none of the funds utilized by the trustees were community property of any of the beneficiaries. The first part of the argument is invalid also, because under the Texas law if the down payment is from separate funds and the intention is clear to bind only the separate estate for future payments, the property so acquired is separate property, Welsh v. Pottorff (Tex. Civ. App., 1935), 87 S.W.(2d) 287; Baxter v. Baxter (Tex. Civ. App., 1920), 225 S.W. 204. This rule clearly applies to the situation presented here. The down payment for property subsequently acquired by the trustees upon credit was from funds which we have held to be separate property; the credit pledged was that of the trust estate,
in which petitioners' interests were also their separate property. The properties so purchased are therefore separate property.
See section 14 of the declaration of trust.
Our conclusion is that the interests of petitioners in the entire trust estate which gave rise to the income here in controversy were their separate property.
The question remains whether the portions of petitioners' respective distributive shares of the ‘net income‘ of the trust which were attributable to royalties and to the sale of trust assets were properly treated by the Commissioner as separate income.
It is well settled in Texas that the proceeds of the sale of separate property are separate income, Commissioner v. Skaggs (C.C.A., 5th Cir., 1941), 122 Fed.(2d) 721; certiorari denied, 315 U.S. 811; Stephens v. Stephens, supra. In Texas oil and mineral royalties are considered to be proceeds of the sale of realty, and if derived from separate property they are separate income, Commissioner v. Wilson, supra; Chesson v. Commissioner (C.C.A., 5th Cir., 1932), 57 Fed.(2d) 141; W. D. Johnson, supra; Dolores Crabb, 47 B.T.A. 916; Mellie Esperson Stewart, 35 B.T.A. 406; Stephens v. Stephens, supra.
No evidence was submitted by the petitioners to show what were the general expenses or what portions thereof were attributable to the production of either community income or separate income or to the production of gross income not distributable under the trust instrument. We, therefore, approve the Commissioner's determination in the community property issue involved.
Petitioners in Docket Nos. 107896, 108082, and 1808084 contend that the attorney fees paid for the recovery of overpayments of their income tax were ordinary and necessary business expenses, deductible under section 23(a)(1) of the Revenue Act of 1938, or ordinary and necessary expenses paid for the production or collection of income deductible under section 23(a)(2) of the Revenue Act of 1938, as amended by section 121 of the Revenue Act of 1942.
As amended, section 23(a)(2) of the Revenue Act of 1938 permits the deduction of nontrade or nonbusiness expenses, as follows:‘In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.‘Treasury Decision 5196, approved December 8, 1942. C. B. 1942-2, p. 96, provides:‘ * * * Expenditures incurred * * * for the purpose of recovering taxes (other than recoveries required to be included in income), or for the purpose of resisting a proposed additional assessment of taxes (other than taxes on property held for the production of income) are not deductible expenses under this section, except that part thereof which the taxpayer clearly shows to be properly allocable to the recovery of interest required to be included in income.‘
In Commissioner v. Burnett (C.C.A., 5th Cir., 1941), 118 Fed.(2d) 659, it was held that attorney fees paid by a taxpayer for services in connection with obtaining a refund of personal income taxes arising out of an adjustment of distributable income of an estate of which she was a beneficiary, and to the trustees of which she acted as consultant, were personal expenses and not deductible as ordinary and necessary business expenses. The same is true in regard to the attorney fees here involved.
The overpayments were not income to petitioners when received. The fees paid for the recovery of the overpayments in tax were therefore not ordinary and necessary expenses paid or incurred during the taxable years for the production or collection of income, nor were they expenditures made by the petitioners for the management, conservation, or maintenance of property held for the production of income, as the trustees were the custodians of the property and such obligation did not rest on petitioners. The interest, however, was income to petitioners when received. To the extent therefore that these attorney fees were paid or incurred for the collection of the interest, they were paid or incurred for the production or collection of income and are deductible under section 23(a)(2) as nontrade or nonbusiness expenses. Regulations 103, sec. 19.23(a)-15, as amended. (See C. B. 1942-2, p. 96.) In our findings of fact, we have set forth the amount of refunds including interest received by each of the three petitioners involved in this issue and the amount of interest received and the fee paid by each. The attorney fees paid by each of these petitioners should be apportioned pro rata between the amount received by each as overpayments of the tax and the amounts received as interest thereon.
Decisions will be entered under Rule 50.