Docket Nos. 21931 21932.
Prentice Wilson, Esq., for the petitioners. Joseph P. Crowe, Esq., for the respondent.
Held, under the facts, that co-owner of two oil leases was not entitled to deduct in taxable years 1944 and 1945 sums paid by him in those years for his portion of his share of drilling expenses incurred in 1941, which he was unable to pay in that year and which were then paid in his behalf by another co-owner. Prentice Wilson, Esq., for the petitioners. Joseph P. Crowe, Esq., for the respondent.
The respondent determined the following deficiencies in the income tax of petitioners:
+------------------------------------------+ ¦Docket No.¦Petitioner ¦Year ¦Deficiency¦ +----------+-------------+------+----------¦ ¦ ¦ ¦( 1944¦$1,612.58 ¦ +----------+-------------+------+----------¦ ¦21931 ¦Hazel McAdams¦( 1945¦245.00 ¦ +----------+-------------+------+----------¦ ¦ ¦ ¦( 1944¦1,331.11 ¦ +----------+-------------+------+----------¦ ¦21932 ¦J. B. McAdams¦( 1945¦234.00 ¦ +------------------------------------------+
The sole question is whether the petitioners are entitled to deductions of $21,500 in 1944 and $2,225.59 in 1945 for amounts expended in those years to reimburse a co-owner of oil leases for expenditures made by him in 1941 in connection with the drilling and development of oil wells.
FINDINGS OF FACT.
Petitioners, J. B. McAdams and Hazel McAdams, are, and were during the years in controversy, husband and wife, and the leases involved herein were community property.
During the taxable years 1940 to 1945, inclusive, petitioners operated their business and made income tax returns on a cash basis. Their returns for the taxable years were filed with the collector of internal revenue for the second district of Texas.
W. P. Luse is a brother-in-law of petitioner J. B. McAdams, hereinafter referred to as petitioner, having married petitioner's sister.
Prior to the year 1933, and during the year 1946 and thereafter petitioner had office space with W. P. Luse. The books of the petitioner are under the supervision of Frankie Frensley, bookkeeper and secretary for W. P. Luse, and Miss Frensley has prepared the income tax returns of the petitioner from approximately 1940 forward. Petitioner and W. P. Luse were jointly interested in leases other than those included in these proceedings.
On and prior to August 23, 1940, W. P. Luse, H. T. Luse, and petitioner were co-owners of an oil and gas lease covering 119 acres of land in Liberty County, Texas, the said W. P. Luse owning an undivided one-half interest in said lease, H. T. Luse an undivided 1/20, and petitioner an undivided 45/100 interest. The lease will hereinafter be referred to as the Hlavaty lease. Petitioner had acquired this lease before transferring interests therein to W. P. Luse and H. T. Luse.
On August 28, 1940, W. P. Luse executed a drilling contract with Harry L. Edwards Drilling Co., whereby said drilling company agreed, for the consideration therein provided, to drill one or more wells on the Hlavaty lease.
During the latter part of 1940 and early part of 1941, 5 wells were drilled on the Hlavaty lease. Four of the wells were producing wells, and the fifth well, completed in March 1941, was a gas distillate well and had no commercial value. The drilling and development cost in connection with these 5 wells amounted to $185,073.53, and petitioner's pro rate share thereof amount to 45/100, or $83,283.09.
In order to pay a portion of his pro rata share, petitioner, with the assistance of W. P. Luse, borrowed $52,500 on January 3, 1941, and $17,500 on January 10, 1941, from the Republic National Bank of Dallas, Texas, giving as security to the bank a deed of trust and assignment of petitioner's runs in the Hlavaty lease.
From the proceeds of the above loans, petitioner, in the same year, paid $7,918.88 to the Harry L. Edwards Drilling Co., and $13,620.28 to the Houston Oil Field Material Co., leaving a balance of $61,743.93 due by petitioner on his share of the drilling and development cost of the 5 wells on the Hlavaty lease. The latter amount was paid by W. P. Luse in 1941.
Petitioner paid W. P. Luse $40,259.36 of the $61,743.93 in the year 1941 from the proceeds of the bank loans, but having sustained a business loss in this year he was unable to pay the balance of $21,484.57.
Petitioner deducted as drilling and development cost the $40,259.36 which he had borrowed from the bank and paid to W. P. Luse in 1941, in computing his Federal income tax return for that year.
Petitioner had no taxable income for the years 1941 or 1943.
Petitioner paid W. P. Luse the sum of $19,259.98 in 1944 and the sum of $2,225.59 in 1945, thereby completing the payment of his share of the total amount of the drilling and development cost of the 5 wells on the Hlavaty lease which had been paid by Luse.
The $21,484.57 paid to W. P. Luse by petitioner in 1944 and 1945 in connection with the Hlavaty lease pertained to the drilling of the fifth well on that lease.
On October 10, 1940, petitioner and W. P. Luse were also co-owners of an oil and gas lease covering land located in St. Charles Parish, Louisiana, and known to the parties as the Peyregne Heirs lease. W. P. Luse had a two-thirds interest in said lease and petitioner a one-third interest. Petitioner had acquired this lease prior to transferring an interest to W. P. Luse.
On October 10, 1940, W. P. Luse and petitioner executed a drilling contract with the Dixie Drilling Co. to drill a test well on the Peyregne lease. Thereafter, the Dixie Drilling Co. began drilling operations which were completed in 1941 and resulted in the drilling of a dry hole. The total cost of this well was $27,870.72, of which $9,290.24 represented petitioner's pro rata share. In 1941 W. P. Luse paid the drilling contractor the entire amount due under the contract, including petitioner's share of $9,290.24.
In 1941 petitioner paid W. P. Luse $7,049.22 of his share of the drilling and development cost under the contract with the Dixie Drilling Co., and paid the remaining balance of $2,241.02 in 1944.
W. P. Luse kept an account in his ledger under the tabulation ‘Accounts Receivable.‘ To this account was posted the petitioner's share of the expenses at the end of 1941, in the amount of $21,484.57, on account of the drilling and development operations on the Hlavaty and Peyregne leases, which was paid by W. P. Luse. The balance of petitioner's share of the expenses at the end of 1941, in the amount of $21,484.57, on account of the drilling and development operations on the Hlavaty lease, and the balance of petitioner's share of the expenses at the end of 1941, in the amount of $2,241.02, on account of the drilling of the dry hole on the Peyregne lease, are included in the $23,811.37 shown as the debit balance of this account as of December 31, 1941.
Statements were rendered periodically to petitioner by W. P. Luse, showing the balance due W. P. Luse as a result of Luse paying petitioner's pro rate share of the drilling and development cost on the Hlavaty and Peyregne leases. The amounts shown on these statements were taken from petitioner's account in the accounts receivable section of the books of W. P. Luse, and it was expected that these amounts would be paid by petitioner.
While petitioner was not a party to the drilling contract with the Edwards Drilling Co. for the drilling of wells on the Hlavaty lease, he knew about it, felt he was drilling on this lease and on the Peyregne lease along with Luse, and that he was obligated to pay his share of the drilling and development expenses whether the drilling resulted in oil production or in a dry well. He had no previous arrangement with Luse that the latter would finance him or loan him money, and Luse did not ask him when he was going to pay his share of the drilling expenses.
The respondent contends that payment of $21,500 in 1944 and of $2,225.59 in 1945 by petitioner to Luse were repayments of loans made by Luse to petitioner in 1941, which loans were used to pay drilling and development costs incurred by petitioner in 1941, and, as such, these amounts were deductible by petitioner in computing his Federal income tax for the year 1941, and not in 1944 and 1945.
The petitioner points to the provisions of section 43 of the Internal Revenue Code, providing that deductions must be taken for the taxable year in which ‘paid or accrued‘, or ‘paid or incurred‘, depending upon the method of accounting used by the taxpayer, and contends that inasmuch as he is on the cash basis and did not pay Luse for the portion of the drilling and development expenditures here involved in 1944 and 1945, he is entitled to take deductions in those years.
The petitioner cites and relies upon Eckert v. Burnet, 283 U.S. 140; Helvering v. Price, 309 U.S. 409; Max Gross, 36 B.T.A. 759, and E. L. Connelly, 46 B.T.A. 222. The cited cases hold that taxpayers on the cash basis may not take a deduction for a loss sustained until they have made an outlay of cash or its equivalent, and that the giving of a note does not constitute such an outlay. These cases are not helpful to the petitioner who is here claiming deductions for expenses in 1944 and 1945 which were paid in 1941. Petitioner testified that in 1941 he was legally obligated to pay his share of the drilling and development expenses on both the Hlavaty and Peyregne leases and that he intended to do so whether the drilling produced oil or a dry well. In 1941 he paid, with the proceeds of bank loans, approximately $60,000 of his $83,283.09 share of the drilling expense on the Hlavaty lease, and $7,049.22 of his $9,290.24 share of the Peyregne lease expense. The remainder of his share of the expense incurred in 1941 in connection with both of these leases was paid in that year by Luse in petitioner's behalf. When Luse advanced money to discharge petitioner's pro rata share of the drilling and development expenses in 1941, he in effect loaned petitioner the funds with which to make payment and petitioner used them for this purpose. The fact that Luse paid the amounts in question without the funds going through the hands of petitioner does not affect the status of these payments as loans. Consolidated Marble Co., 15 B.T.A. 193; E. Gordon Perry, 28 B.T.A. 497. Expenses paid with borrowed funds are deductible by a taxpayer on the cash basis in the year in which they are actually paid, and the deduction thereof can not be deferred until a later year when repayment of the borrowed funds is made by the taxpayer. Robert B. Keenan, 20 B.T.A. 498; Ida Wolf Schick, 22 B.T.A. 1067; Crain v. Commissioner, 75 Fed.(2d) 962. Our conclusion is, therefore, that petitioner should have deducted the expenses here involved in 1941 when they were paid by Luse in his behalf, and not in 1944 and 1945, when he repaid Luse for his advances.
While the conclusion reached effectively disposes of the issue before us, it may not be amiss to point out that the evidence in these proceedings strongly indicates that Luse and the petitioner were operating the leases as a mining partnership, sometimes referred to as a joint adventure. Although the petitioner testified he never felt that he was a partner of Luse, he also testified that he considered that he was drilling these leases along with Luse; that he knew about the drilling operations and expected to pay his part; and that he and Luse jointly pursued the drilling on the 2 leases, each of them paying expenses at various times from their own bank accounts, although Luse made the greater number of payments. Under the law of Texas such a partnership or joint adventure ‘may be created by express contract and it may also be created as a matter of law, without an express contract, by the joint ownership and joint operation of the enterprise.‘ Smith v. Rampy (Tex. Civ. App. 1946 , 198 S.W.(2d) 592. Expenses of a partnership or joint venture paid in 1941 would not be a proper deduction in the individual return for 1944 or 1945 of one of its members. Estate of L. O. Koen, 14 T.C. 1406.
Reviewed by the Court.
Decisions will be entered for the respondent.