Smith
v.
Comm'r of Internal Revenue

Tax Court of the United States.Jun 27, 1947
8 T.C. 1319 (U.S.T.C. 1947)
8 T.C. 1319T.C.

Docket Nos. 7951-7956.

1947-06-27

CHESTER R. SMITH, PETITIONER, ET AL.,1 v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

R. B. Cannon Esq., and Claude Collard, C.P.A., for the petitioners. Donald P. Chehock, Esq., for the respondent.


A partnership acquired an undivided interest in a producing oil and gas lease, by a contract which also gave it the preference to drill future wells at prevailing contract prices. When the coowner drilled wells by contracts with others, the partnership brought suit for damages for profits lost. It alleged mining partnership, but final judgment, on appeal, was not based on that ground, the partnership obtaining judgment for damages for loss of profits, offset by judgment for the defendant for the partnership's share of development expense. Held, the Commissioner did not err in adding to the partnership income amounts representing the money judgment obtained by the partnership, though offset by judgment for development expenses, and in determining deficiencies against the partners accordingly. R. B. Cannon Esq., and Claude Collard, C.P.A., for the petitioners. Donald P. Chehock, Esq., for the respondent.

These cases, duly consolidated, involve income tax for the calendar year 1941. Deficiencies were determined as follows:

+---------------------+ ¦Docket No.¦Deficiency¦ +----------+----------¦ ¦7951 ¦$790.13 ¦ +----------+----------¦ ¦7952 ¦684.28 ¦ +----------+----------¦ ¦7953 ¦684.28 ¦ +----------+----------¦ ¦7954 ¦790.13 ¦ +----------+----------¦ ¦7955 ¦714.67 ¦ +----------+----------¦ ¦7956 ¦714.67 ¦ +---------------------+

The question presented is whether Buffington & Smith, a partnership, had income in the taxable year by reason of a settlement entered into after certain litigation.

FINDINGS OF FACT.

Buffington & Smith was in the taxable year, and had been since 1936, a partnership composed of petitioners (Chester R. Smith, D. M. Buffington, and J. E. Smith, in equal parts. (The other petitioners are their respective wives.) The partnership had headquarters at Grandfalls, Texas, and was engaged in the business of drilling oil and gas wells for others, well servicing, and, to some extent, producing oil. All of the petitioners reside in Texas. The partnership return was filed with the collector for the second district of Texas. It and the petitioners' individual income tax returns were upon a cash and calendar year basis.

In 1937 the partnership, in consideration of drilling a successful test well, acquired a one-eighth interest in a lease known as the Payton lease, which had not theretofore been a producing lease. Thereafter the partnership drilled four more wells on the lease. About August 1938 all owners except the partnership assigned their interests to British-American Oil Producing Co., hereinafter referred to as British-American. Thereafter, and prior to about August 1939, that company took exclusive charge of operations and drilled twenty wells on the lease.

The contract under which the partnership had drilled the initial well and acquired its interest provided, inter alia, that if the well was a producer the partnership was ‘to have preference of all future drilling operations, at the prevailing contract price‘; also: ‘It is further agreed that in the handling of this as a joint venture that there is to be no expense as overhead charged up on either side.‘ The contract did not otherwise contain any provision as to operation or development of the property, joint or otherwise, in case the first well was a commercial well, or provide in terms for a mining partnership.

British-American let its drilling contracts on the lease to contractors other than the partnership. The partnership therefore brought suit against British-American, alleging, inter alia, the formation of a mining partnership by the contract and the right, under its contract, to have the preference in drilling wells on the lease, exclusive possession of the lease taken by British-American, notice of the contract and breach thereof by British-American in causing others to drill the wells; and money damages by reason of British-American's breach of the provision for preference as to drilling, and that the plaintiff's profit on each well would have been not less than $1,500. It was also alleged that the plaintiffs were responsible for payment of their pro rata part of expense of developing and preserving the leasehold, that the plaintiffs' right under the contract to drill was valuable, over and above the profit it would make on drilling, in the opportunity it would have to study the area and underground structure. Injunction was asked to restrain British-American from interfering with the plaintiffs' preference to drill the wells, and claim was made for $24,000 accrued damages and for damages accruing in the future in at least the amount of $45,000 and for costs. British-American, by answer and cross-action, denied any mining partnership and alleged that the ownership of the lease was by tenancy in common, alleged plaintiffs' liability for one-eighth of the expenses of drilling and operation of the property, and denied liability under or any breach of contract or damage done to the plaintiffs. Liability by the plaintiffs in the amount of $28,530.16 was also alleged, for the plaintiffs' proportionate part of expense up to April 1, 1939, for which cross-judgment and a lien was asked. A stipulation was filed on September 8, 1939, agreeing that the plaintiffs, though not admitting the defendants' right to drill wells contrary to the preference in the contract, were liable for one-eighth of costs of drilling, equipping, and completing wells, payable only out of oil and gas as and when produced, and the plaintiffs in their reply admit the liability for $28,530.16 expenses, less $1,750, as stipulated; but deny liability for overhead charges. The reply pleads as set-off against plaintiffs' liability for expenses, and as counterclaim, the damages suffered by breach of contract, and prays for such damages. Injunction applied for by the petitioners to restrain further drilling was denied by the court. The litigation continued for a considerable period, the proceeds of oil and gas produced in the meantime being withheld from the plaintiffs by Atlantic Refining Co.

On January 1, 1940, the United States District Court for the Western District of Texas rendered judgment, holding that there was mining partnership, that the plaintiffs were entitled to recover damages, measured by the loss of profits they would have made in the drilling of the wells if permitted, in the sum of $25,000, for 20 wells at $1,250 profit, but that British-American have judgment against the plaintiffs on cross-action for the amount stipulated due on account, that is $25,382.46 ($28,530.16 less $1,750, and less $1,397.70 overhead expenses), to be set off against the $25,000, leaving a judgment of $382.46 in favor of British-American.

Upon appeal taken by British-American (and one Dorr also made a defendant because he had made the original contract with the partnership, assigned the leasehold interest to it, and had later sold to British-American) the United States Circuit Court of Appeals for the Fifth Circuit, by opinion reported at 116 Fed.(2d) 363, modified the judgment below. It released Dorr on the ground that he had assigned to British-American and thereafter had no control of drilling, that no further demands were made on him or communication had with him, and that under such facts he should not be held liable for performance of contract by British-American. The court held that there was a profit of $1,250 a well in drilling the wells, but reduced the amount to $1,093.75 a well because of the partnership ownership and liability for one-eighth. In addition, the court limited the damages to 19 wells, therefore reduced the judgment for the partnership from $25,000 to $20,781.25, offset by $25,382.46 recovered by British-American leaving judgment in favor of British-American for $4,601.21, instead of $382.46. Otherwise the judgment below was affirmed.

After denial of rehearing, and denial of certiorari to the Supreme Court of the United States, the parties to the litigation entered into a written settlement on April 25, 1941, giving effect to the judgment and settling the financial matters between them from the beginning of operation by British-American down to March 31, 1941. It was agreed, inter alia, that at March 31, 1941, after allowing all credits agreed upon and as fixed by the Court, the partnership owed British-American $14,974.22; that Atlantic Refining Co. was holding for the partnership approximately $26,452.90 (figures up to March 31, 1941); that Atlantic should release such funds by paying British-American $14,974.22, and the remainder (which is $11,478.68) to the partnership; that the agreement acknowledges satisfaction of the judgment and that a copy of the agreement should be filed in the District Court.

From May 1, 1939, to April 30, 1941, Atlantic Refining Co. impounded $26,962.12 as to Buffington & Smith. This was disbursed as follows: $14,974.22 to British-American, and $11,987.90 to Buffington & Smith and their attorneys. The settlement was calculated as follows: Due British-American, on July 31, 1939, $28,530.16 less $23,928.98 ($20,781.25 ‘U.S. Dist. Court decision re * * * Profit on Drilling 19 wells at $1,093.75 per well,‘ plus $1,750 stipulated as to well No. 6, plus $747.03 general office overhead and $650.70 district lease expense (items held not chargeable to Buffington & Smith)) leaving $4,601.18 due British-American. To this was added $11,945.88 charges from July 31, 1939, to March 31, 1941, making $16,547.06. From this was deducted $1,898.79 for general office overhead and district lease expense from July 31, 1939, to March 31, 1941, and $325.95, being one-half of cost of appeal, leaving $14,974.22.

The total amount due British-American, $40,476.04, less amounts of overhead and district lease expenses, not chargeable, amounting to $3,296.52, is $37,179.52. Adding $325.95 for one-half cost of appeal, agreed upon, gives a total of $37,505.47 due British-American. This exceeds the $14,974.22 paid by Atlantic to British-American by $22,531.25.

The Commissioner determined the deficiencies here involved (so far as here pertinent) by adding to the partnership income $22,531.25, consisting of the $20,781.25 profit on the 19 wells plus $1,750 stipulated profit on well No. 6, as set forth above.

OPINION.

DISNEY, Judge:

Did the Commissioner err in adding $22,531.25 to partnership income for 1941? There is, in effect, no dispute as to the figures, the difference between the parties being as to their significance and proper treatment.

It is the petitioners' view, in substance, that there was a mining partnership between Buffington & Smith and British-American; that, regardless of the form of the litigation, it was, in effect, for an accounting and that, since at the end of the litigation in 1941 the partnership was adjudged to owe British-American $4,601.21, it had no income in 1941. The respondent, as reflected in the deficiency notices, considers as income in the taxable year the damages, the loss of profits on 19 wells according to the court's decision, plus the $1,750 stipulated as to the other well, No. 6, a total of $22,531.25; the theory being that though the net result of the action and cross-action between the litigants was a judgment for British-American in the amount of $4,601.21, nevertheless, the plaintiffs, on a cash basis, did recover and have applied to offset liability to British-American, $22,531.25, with the same effect as if they had been paid that much money and then applied it upon the adjudicated liability to British-American.

Though many cases have been cited by the parties and examined by us, we think it not necessary to discuss them in detail here. It is well settled that the recovery of damages for the loss of profits results in income to one on the cash basis in the year of recovery. Though the petitioner urges that the matter was one of accounting between mining partners and points to the decision of the United States District Court that the relation was such, we not only note that that decision is not binding upon us, not being an adjudication of any state court or constituting res adjudicata, but also that the Circuit Court's opinion does not appear to us to be upon that theory; furthermore, we consider that in fact the relationship was not that of mining partners. The contract between the partnership and Dorr contains no such provision. In sum, it merely provides for the transfer of an interest in a lease in consideration of drilling a producing well. A producing well was drilled and the interest transferred. This transfer alone would, of course, merely create tenancy in common. The only provision of the contract in anywise modifying tenancy in common is that which provides: ‘It is further agreed that in the handling of this as a joint venture, that there is to be no expense as overhead charged up on either side.‘ We think that clearly this language, merely referring to joint venture, is not sufficient to create a mining partnership. Moreover, even if there were mining partnership, in our view, the further provision causing the litigation and prayer for damages was so separate from any mining partnership as to eliminate such relationship from consideration here. The litigation grew up wholly because of a pleaded and proven violation by British-American of the contract provision that the partnership was ‘to have the preference of all future drilling operations, at the prevailing contract price.‘ The mining partnership as such, we think, could enter into such a contract with one of its members.

We can not consider section 19.183-1 of Regulations 103, cited by the petitioner, as applicable here. That provision states, in effect, that payments to a partner for services rendered are not deductible in computing partnership net income, being held to represent a division of partnership profits. The petitioners' view is that the damages recovered by the partnership in 1941 constituted mere payment to a partner for services rendered, and that the provision of the agreement for the preference in drilling to the partnership constituted an agreement with respect to distribution of partnership profits, so that such profits were merely the distributive share of Buffington & Smith for a period prior to July 31, 1939, therefore not includible in income in 1941. The regulation does not assist us on the present question. We have here a contract which might have been made with a stranger, by an alleged mining partnership, under which the stranger would have made profits. We do not think that for our present purpose the profits made by the partnership as a contractor constituted a mere agreement with respect to distribution of partnership profits, so as to cause a suit for damages for breach of contract and loss of profits to be properly regarded as one merely for an accounting, despite its language specifically praying for damages for such loss of profits.

Moreover, the evidence before us, in our opinion, fails to show that there ever was a mining partnership, for nothing indicates that prior to the acquisition of the other seven-eighths by British-American the partnership had ever participated in the operation of the lease. The evidence is merely that the partnership drilled four more wells after the first test well. The action of British-American in its exclusive operation of the lease is clearly inconsistent with mining partnership. Not only must the contract between the parties provide for joint operation of the property, but also that it must be actually jointly operated. 40 C.J. 1145; 18 R.C.L. 1200. This is the law of Texas. Gardner v. Wesner, 55 S.W.(2d) 1104. Reading the decision of the Fifth Circuit in British-American Oil Producing Co. v. Buffington, 116 Fed.(2d) 363, convinces us that that court did not base its conclusions upon the fact of mining partnership, but upon a loss of profits of $1,093.75 per well for nineteen wells.

We do not consider sound the distinction, from the present situation found by the petitioners, in the cases cited by respondent to support the idea of taxing damages recovered for profits lost (including North American Oil Consolidated v. Burnet, 286 U.S. 417; United State v. Safety Car Heating & Lighting Co., 297 U.S. 88). That distinction is that no such case involves a cross-action as here. We see the point as altogether immaterial. The petitioner did recover judgment for damages instead of profits lost. Its opponent recovered a judgment for money (expenses) owed. The two judgments were offset, but that fact can not render less obvious the fact that the petitioner got full benefit, in payment of its debt, of the judgment in its favor, without which it would have had o pay money to its opponent on the cross-judgment. Unless, as petitioners argue and we do not believe, there was mining partnership and mere delay in ascertaining and distributing partnership income, the fact that damages recovered were applied in payment of debt on a cross-action can avail the petitioners nothing. They were on the cash basis. They got full monetary benefit, in 1941, of the damages then recovered by the partnership. There was clearly constructive receipt of income. Congress intended to tax proceeds of claims or choses in action for recovery of lost profits. United States v. Safety Car Heating & Lighting Co., supra; Hilda Kay, 45 B.T.A. 98.

We conclude and hold that the Commissioner did not err in adding $22,531.25 to the partnership income in 1941 and in computing the petitioners' deficiencies on that basis— the assignment of error in each case.

Decision in all docket numbers will be entered for the respondent.