Davis v. Commissioner

74 T.C. 881, 1980 U.S. Tax Ct. LEXIS 89

Opinions

OPINION

Fay, Judge:

Respondent determined the following deficiencies in petitioners’ Federal income taxes:

Petitioner(s) Docket No. Year Deficiency

Joe C. Davis 6540-77 1967 $2,562.55

1968 39,926.07

1969 43,827,58

1970 28,660.40

1971 33,501.26

Joe C. Davis 6319-78 1972 398,422.68

1973 63,673.85

1974 65,240.58

1975 59,781.49

Estate of Rascoe B. Davis, deceased, Third National Bank, executor, and Delta C. Davis

6540-77

1967 114.18

1968 1,172.93

1969 1,521.49

1970 1,791.68

1971 2,027.86

These cases have been consolidated for purposes of trial, briefing, and opinion.

Because of concessions, the remaining issues presented are:

(1) Whether all or any part of advanced and earned royalties, paid on coal mining leases by petitioners’ partnership with respect to coal disposed of by sublease under sections 631(c) and 1231,¹ are (a) deductible from ordinary income under section 162 or (b) must be subtracted from coal royalty receipts with the net amount treated as either capital gain or ordinary loss under section 1231;

(2) Whether the tax benefit rule requires petitioner Joe Davis to treat as ordinary income rather than capital gain certain amounts of royalty income allocated to him by his partnership with respect to contributed coal mining leases on which he and his controlled corporation had previously taken ordinary deductions for advanced minimum royalties;

(3) Whether petitioner Joe Davis realized taxable income upon gifts of stock to trusts for the benefit of nephews and nieces where such gifts were conditioned upon the trustee’s agreed payment of the resulting gift taxes.

All of the facts have been stipulated and are found accordingly-

Petitioner Joe Davis resided in Nashville, Tenn., at the times his petitions were filed herein. When their petition was filed in this case, Third National Bank, executor of the Estate of Rascoe Davis, had its principal place of business in Nashville, Tenn., and Delta C. Davis, Rascoe’s widow, resided in Nashville, Tenn. Delta C. Davis is a party herein only because she filed joint returns with her husband Rascoe for the years in issue.

During each of the years in controversy, petitioner Joe Davis, his brother Rascoe Davis, now deceased, and five other individuals were partners in a joint venture initially called Davis Webster County Development, and later, Cumberland Land Co. (hereinafter Cumberland). Cumberland was organized under a joint venture agreement dated January 1, 1966. Joe Davis had a 66%-percent interest in Cumberland’s profits and losses; Rascoe Davis’ interest was 4% percent.² Cumberland and each of its partners were calendar year, cash basis taxpayers.

Cumberland was in the business of leasing coal mining rights from landowners in Kentucky and then subleasing those rights to a mining company called Webster County Coal Corp. (hereinafter Webster Coal). Between 1967 and 1971, the same individuals who were partners in Cumberland owned all of the stock of Webster Coal, with the exception that Joe Davis held some Webster Coal stock through his controlled corporation, Davis Coals, Inc. (hereinafter Davis Coals). On February 22, 1971, an unrelated corporation called Mapco, Inc., acquired Webster Coal by merger.

All of Cumberland’s transactions were carried out in the following manner. Cumberland acquired by lease the rights to mine seams of No. 9 grade coal on or underlying the properties of various landowners. In every case but one, the consideration for the lease was the greater of an advanced yearly minimum amount, paid on acquisition, or earned royalties³ of 10 cents a ton for coal mined under the lease. The yearly minimum royalties were “advanced” in the sense that when coal was later mined, the earned royalties then due were reduced by credits for earlier unearned royalties paid.

Cumberland’s leases were thereafter subleased to the mining operator, Webster Coal. Between 1966 and 1971, 11 subleases were executed in all, which for convenience will be referred to in the order in which they were executed. In some cases, leases were subleased to Webster Coal immediately after Cumberland acquired them.⁴ More frequently, however, a group of leases acquired over time was later subleased to Webster Coal as a unit. For example, the seventh sublease, dated March 30, 1970, transferred to Webster Coal Cumberland’s rights under five separate leases acquired between April 1968 and April 1969. On the other hand, in the 10th sublease, dated November 1, 1970, Cumberland transferred to Webster Coal its rights under 19 leases acquired between August and October of that same year. Whatever the delay between lease and sublease, Cumberland subleased all of the coal mining rights it acquired and never mined coal itself.

Under each sublease, Cumberland was entitled to either earned royalties on the coal extracted or yearly advanced minimum royalties. Earned royalties were the greater of 30 cents per ton or 8y2 percent of the gross sales price. However, Webster Coal paid advanced minimum royalties at the end of each lease year if earned royalties were less than the specified minimum. Thus, although Cumberland’s advanced minimum payments to landowners in a given year could exceed royalty income, for coal actually mined Cumberland was ensured a profit of at least 20 cents per ton. Profits on a particular sublease would be larger either if royalties due the landowner were reduced by credits for earlier advanced royalties or if Cumberland’s royalty income was greater than 30 cents per ton, based on 8y2 percent of Webster Coal’s gross sales price.

Prior to Cumberland’s formation, petitioner Joe Davis owned three coal leases, designated the Palmer Bros., Early, and Trader leases, on which he paid advanced minimum royalties. Like those later acquired by Cumberland, each of the leases gave Joe Davis the right to mine a seam of No. 9 coal and required him to pay earned royalties of 10 cents per ton, but specified advanced minimum amounts in each year whether coal was mined or not. From 1960 through 1963, Joe Davis paid $22,444.84 in advanced minimum royalties on the three leases. In 1964 Davis Coals, then named Davis & Hamilton Coals, Inc., agreed to make the minimum royalty payments on the leases in return for exclusive rights to sell the coal. Under this agreement, Davis Coals paid $47,917.26 on the three leases between 1964 and 1967.⁵ Both Joe Davis and Davis Coals claimed ordinary deductions for the payments on their tax returns for the years involved.

On October 1, 1966, Joe Davis assigned the three leases to Cumberland as a contribution to capital, along with “all rights to advance or prepaid rents and/or royalties and credit therefor under each and all of the leases herein assigned.” The transfers were subject to the following terms of the joint venture agreement:

The leases are unencumbered except for current taxes and a lease royalty payment in the aggregate of a minimum per year as set forth in each lease or $0.10 per ton to the landowner, which ever [sic] amount is greater. The assignment will be made subject to the foregoing and the right to recover all royalty prepaid by Davis on said leases for which the Syndicate [Cumberland] shall receive credit from the landowner.

On October 31, 1966, the Palmer Bros., Early, and Trader leases were subleased to Webster Coal. As under all later subleases, Webster Coal agreed to pay Cumberland earned royalties of 30 cents per ton or 8V2 percent of the gross sales price, or, if greater, specified yearly advanced minimum royalties.

In the years 1967, 1968, 1969, and 1972, Cumberland specially allocated certain amounts of royalty income to Joe Davis pursuant to that part of the joint venture agreement entitling him to recover advanced royalties on the Palmer Bros., Early, and Trader leases for which Cumberland received credits from the landowners. In other words, as coal was mined, Cumberland allocated royalty income to Joe Davis to the extent its payments of earned royalties to landowner-lessors were reduced by credits for prior advanced minimum royalties. Income was specially allocated to Joe Davis and disbursed to him as follows:

Year Allocation Date(s) paid Amount

1967 $5,394.33 Apr. 26, 1968

1968 16,062.27 Mar. 25, 1968

1969 30,000.00 Jan. 15, 1969 $682.20

Feb. 21, 1969 4,639.18

Mar. 24, 1969 4,479.97

Apr. 24, 1969 5,963.27

May 23, 1969 6,905.33

June 25, 1969 2,500.02

July 21, 1969 4,830.03

1972 $19,205.50 Feb. 23, 1972 $300.00

_ Apr. 12, 1972 18,905.50

Total ⁶70,662.10

The above payments were treated in Cumberland’s books as “Joe Davis, Special Capital,” and the allocations were reported on Cumberland’s partnership returns for those years as specially allocated long-term capital gain. The balance of the royalty income Cumberland received in those years was shared between all the partners in proportion to their partnership interests. In the other years before us, all royalties received were allocated among the partners according to their interests.

On its partnership returns filed for the years in controversy, Cumberland reported substantially all of the royalties it received from Webster Coal as long-term capital gain.⁷ Such income was also reported by Cumberland’s partners as long-term capital gain.⁸

Between 1967 and 1971, Cumberland paid both advanced minimum royalties and earned royalties on the coal mining leases it subleased to Webster Coal. Most of the advanced minimum royalties were paid to landowners on leases on which no mining took place in the year of payment. Of these advanced royalties, a significant portion was paid on leases which had not yet been subleased to Webster Coal. After February 1971 when Webster Coal was acquired by Mapco, Inc., Cumberland did not make further advanced minimum payments but continued to pay substantial earned royalties. Table I on page 888 sets forth the types and amounts, by year, of all royalties paid to landowners by Cumberland in the years in issue, together with royalties received from Webster Coal which were reported by Cumberland as long-term capital gain.

All of Cumberland’s landowner royalties and other expenses, such as office and professional fees, were allocated among the

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partners in proportion to their interests. Cumberland and each of its partners treated all expenses as deductions from ordinary-income on their Federal income tax returns for the years in question.⁹ Thus, Cumberland and its partners were consistently reporting all royalty income as capital gain while deducting all royalties paid and other expenses from ordinary income. Cumberland reported no amounts as gain or loss from the sale or exchange of property under section 1231. What each partner actually received was his distributive share of royalty income minus his share of expenses, without regard to tax character.

In December 1972, petitioner Joe Davis made gifts of unencumbered securities to trusts he had established for the benefit of six nephews and nieces. At the time of the gifts, the securities were substantially appreciated, having a value of $3,546,875 and a basis in the hands of Joe Davis of $21,670.

The transfers in trust were expressly conditioned on the common trustee’s payment of all Federal and State gift taxes and other taxes imposed on the donor by virtue of the transfers. Pursuant to those terms in the trust agreements, in 1973 the trustee paid $1,174,381.14 in State and Federal taxes. As authorized by the trust instruments, the trustee borrowed funds on behalf of the trusts for this purpose.

In his statutory notices of deficiency, respondent determined that Cumberland and its partners were not entitled to ordinary deductions for advanced and earned royalties paid on coal leases subleased to Webster Coal. Instead, respondent determined that Cumberland was required to subtract royalties paid from royalties received and to report its net income as long-term capital gain or loss. Respondent now concedes, however, that for 1967 Cumberland and its partners are entitled to report ordinary loss from coal leasing operations under section 1231.¹⁰

In his statutory notice for 1967 through 1971 to Joe Davis, respondent determined that special allocations of coal royalty income to Joe Davis in 1967, 1968, and 1969 constituted ordinary income and not capital gain. By amendment to his answer to the petition, respondent alleged that the 1967 allocation of $5,394.33 should instead have been reported as ordinary income in 1968, the year such income was actually paid over to Joe Davis. Respondent further asserted by amended answer that specially allocated coal royalties in the amount of $19,205.50 for 1972 should likewise have been reported by Joe Davis as ordinary income and not capital gain.

In his statutory notice to Joe Davis covering the year 1972, respondent determined that Joe Davis realized income in that year¹¹ of $1,152,761.33 upon his gifts of appreciated securities to certain trusts on condition that the trustee pay all resulting taxes.

Issues 1 and 2

The first and second issues involve advanced minimum royalties and earned royalties paid to landowners on leases of coal mining rights subleased under section 631(c).

A landowner who receives royalties under a lease granting rights to extract minerals in place is not ordinarily entitled to report such income as capital gain. See Burnet v. Harmel, 287 U.S. 103 (1932). Speaking generally, a transaction will be treated as a lease and not as a “sale or exchange,” a prerequisite to capital gain under section 1222, whenever the owner-lessor retains a continuing nonoperating economic interest in the minerals being mined. See Palmer v. Bender, 287 U.S. 551 (1933); Belknap v. United States, 406 F.2d 737 (6th Cir. 1969); United States v. Witte, 306 F.2d 81 (5th Cir. 1962); Lesher v. Commissioner, 73 T.C. 340 (1979).

However, to provide special relief for the recipients of coal royalties, Congress, in 1951, enacted what is today section 631(c). S. Rept. 781, 82d Cong., 1st Sess. (1951), 1951-2 C.B. 458, 488. Stated simply, section 631(c) transforms the owner-lessor’s otherwise ordinary income into capital gain. The statute is complex.

Section 631(c) provides in part:

(c) Disposal of Coal or Domestic Iron Ore With a Retained Economic Interest. — In the ease of the disposal of coal (including lignite), or iron ore mined in the United States, held for more than 6 months before such disposal, by the owner thereof under any form of contract by virtue of which such owner retains an economic interest in such coal or iron ore, the difference between the amount realized from the disposal of such coal or iron ore and the adjusted depletion basis thereof plus the deductions disallowed for the taxable year under section 272 shall be considered as though it were a gain or loss, as the case may be, on the sale of such coal or iron ore. Such owner shall not be entitled to the allowance for percentage depletion provided in section 613 with respect to such coal or iron ore. This subsection shall not apply to income realized by any owner as a co-adventurer, partner, or principal in the mining of such coal or iron ore, and the word “owner” means any person who owns an economic interest in coal or iron ore in place, including a sublessor. The date of disposal of such coal or iron ore shall be deemed to be the date such coal or iron ore is mined. In determining the gross income, the adjusted gross income, or the taxable income of the lessee the deductions allowable with respect to rents and royalties shall be determined without regard to the provisions of this subsection. * * *

By its terms, section 631(c) applies to the disposal of coal (or iron ore, not applicable here) “by the owner thereof under any form of contract by virtue of which such owner retains an economic interest in such coal.” This language describes a lease of mining rights in return for royalties based on production. S. Rept. 781, supra, 1951-2 C.B. at 488. Under such an arrangement, a lessor of coal rights has “retained an economic interest” in the coal because his royalty income depends on the amount of coal mined. See Palmer v. Bender, supra; sec. 1.611-1(b)(1), Income Tax Regs. See generally J. Coggin III, “Disposition of Coal Interests: Section 631(c),” 29 Tax Law. 95 (1975). See also Paragon Coal Co. v. Commissioner, 380 U.S. 624 (1965); Omer v. United States, 329 F.2d 393 (6th Cir. 1964).

The key statutory language appears toward the end of the first sentence: “the [net] amount realized * * * shall be considered as though it were a gain or loss, as the case may be, on the sale of such coal or iron ore.” In short, section 631(c) treats royalty income or loss under a coal lease as having been realized in a sale or exchange. In addition, section 1231(b)(2)¹² treats section 631(c) coal as “property used in the trade or business.” See sec. 1.1231-l(c)(3), Income Tax Regs. Taken together, the two sections treat the net royalty income of a coal lessor as capital gain.

Section 272 completes this statutory scheme. Section 272 provides:

Where the disposal of coal or iron ore is covered by section 631, no deduction shall be allowed for expenditures attributable to the making and administering of the contract under which such disposition occurs and to the preservation of the economic interest retained under such contract, except that if in any taxable year such expenditures plus the adjusted depletion basis of the coal or iron ore disposed of in such taxable year exceed the amount realized under such contract, such excess, to the extent not availed of as a reduction of gain under section 1231, shall be a loss deductible under section 165(a). This section shall not apply to any taxable year during which there is no income under the contract.

Applying only to taxpayers disposing of coal (or iron ore) under section 631(c), section 272 accomplishes two tasks. First, overhead and administrative costs associated with a coal royalty contract are factored into the section 1231 equation and their deduction otherwise is disallowed. See secs. 1.272-l(a) and 1.631-3(a)(1), Income Tax Regs. In effect, section 272 treats administrative expenses as part of the cost of the coal disposed of under the lease.¹³ Second, if a coal lessor realizes a net loss for the year under section 1231, excess administrative costs and depletion basis are expressly made deductible from ordinary income. Sec. 1.272-l(c), Income Tax Regs.

In summary, coal royalty income or loss in a given year is treated as having been realized from a sale or exchange of property used in the trade or business. The result is that coal lessors are entitled to report under section 1231 either ordinary loss or capital gain, as the case may be.

A coal lessor under section 631(c) is not allowed a depletion deduction. Instead, lessors must reduce their gross royalty income by the adjusted depletion basis of the coal disposed of (plus administrative costs disallowed under section 272).¹⁴ Sec. 1.631-3(a)(l) and (b)(1), Income Tax Regs. In this respect, coal lessors are treated in the same way as other mineral owners entitled to capital gain on a sale or exchange, who must report as gain their amount realized minus adjusted basis under section 1001(a). Under section 631(c), the “adjusted depletion basis” of the coal is the same amount as would have been the allowance for cost depletion under section 612. Sec. 1.631-3(b)(2), Income Tax Regs. The allowance for cost depletion under section 612 is the cost or other adjusted basis of the mineral produced as those terms are defined in sections 1011, 1012, and 1016, generally expressed as a cost per unit extracted. Secs. 1.611-2(a), 1.612-1, Income Tax Regs. Thus, section 631(c) operates only upon the coal lessor’s gross royalty receipts minus the costs of the coal mined, that is, his net royalty income or loss.

The lessee’s position is different. First of all, the lessee engaged in mining and selling coal is not entitled to capital gain under section 631(c). This is partly because section 1221(1) treats sales in the ordinary course of business as ordinary income, partly because a lessee-operator simply does not qualify as a lessor, and partly because section 631(c) expressly excludes mining principals.¹⁵ With regard to the lessee’s costs, section 631(c) provides: “In determining the gross income, the adjusted gross income, or the taxable income of the lessee, the deductions allowable with respect to rents and royalties shall be determined without regard to the provisions of this subsection.” Thus, the lessee reporting ordinary income from the sale of coal is entitled to ordinary deductions for his operating costs, including royalties paid. Sec. 1.631 — 3(b)(3)(i), Income Tax Regs. Furthermore, as the owner of an operating interest, the lessee may, at his option, deduct advanced minimum royalties either in the year paid or accrued or for the year in which the mineral product involved is sold. Sec. 1.612-3(b)(3), Income Tax Regs. (1965) (amended 1977).

A sublessor is both a lessor and a lessee. Section 631(c) provides, “the word ‘owner' means any person who owns an economic interest in coal * * * in place, including a sublessor.” Thus, a sublessor both is considered an “owner” and is treated as having an “economic interest” in the coal it has subleased the rights to mine. The result in this case is that Cumberland and each of its partners may report their royalty income from subleasing under section 631(c).

With respect to royalties paid, the regulations treat a subles-sor like a lessor rather than a lessee. Section 1.631-3(b)(3)(ii)(a), Income Tax Regs., states: “Rents and royalties paid with respect to coal or iron ore disposed of by * * * [a lessee who is also a sublessor] under section 631(c) shall increase the adjusted depletion basis of the coal or iron ore and are not otherwise deductible.” An accompanying example provides that-the effect of this regulation is that a sublessor must treat gross royalty income under the sublease minus royalties paid to lessors (and administrative expenses) on the underlying lease as net royalty income taxable under section 631(c).¹⁶

The first issue in these consolidated cases is whether petitioners may deduct from ordinary income all or any portion of advanced and earned coal royalties paid by their partnership with respect to coal disposed of by sublease under section 631(c).

Between 1967 and 1971, Cumberland paid three categories of royalties to landowner-lessors: (1) Advanced minimum royalties paid on leases prior to their sublease to Webster Coal, (2) advanced minimum royalties paid after subleasing but prior to any mining operations, (3) earned royalties paid to landowners for coal mined by Webster Coal. From 1972 on, Cumberland paid only earned royalties. In all years, the amount of earned royalties due on a particular lease may have been reduced by credits from the landowner for earlier paid advanced minimum royalties.

Petitioners argue they may deduct their shares, of Cumberland’s royalty payments to landowners from ordinary income under section 162. They contend section 631(c) permits lessees ordinary deductions and does not separately treat lessees who are also sublessors. Petitioners realize section 1.631-3(b)(3)(ii) of the regulations is to the contrary, but argue that the regulation is unauthorized and invalid. Petitioners further contend that even if earned royalties are not deductible, advanced minimum royalties paid are deductible where there has been no mining under sublease. Finally, petitioners argue that advance royalties paid on a lease prior to its assignment by sublease are deductible from ordinary income in any case.

Respondent argues that a sublessor must treat all royalties paid as reducing net section 631(c) gain. This is a case of first impression, and respondent relies entirely upon the statute, the regulations, and the settled principle that regulations will ordinarily be sustained unless unreasonable and plainly inconsistent with the statute. E.g., Fulman v. United States, 434 U.S. 528 (1978). However, for purposes of this case respondent has conceded that advanced minimum royalties may be taken into account when paid and has stipulated that advanced royalties paid in a given year may produce ordinary loss under sections 272 and 1231 if such payments exceed section 1231 gains.¹⁷ Because of respondent’s concession we are not asked, in this case, to apply literally or to rule on the validity of section 1.631-3(b)(3)(ii)(a) of the regulations which states that royalties paid by a sublessor are to be added to the adjusted depletion basis of the coal disposed of under sublease. Applied literally, this regulation would deny any deduction for advanced minimum royalties paid by a sublessor until the coal was later mined. But because respondent has here conceded when Cumberland’s partners may take royalties paid into account, we are only asked to decide whether such payments must be applied against section 631(c) royalty income or whether they may be deducted from ordinary income. In effect, respondent has applied the example at section 1.631-3(b)(3)(ii)(6) of the regulations without regard to the different kinds of royalties paid by Cumberland.

For the reasons below, we agree with respondent.

To begin with, it is clear that earned royalties paid by a sublessor of coal mining rights are not deductible from ordinary income. The statute treats sublessors as “owners.” Section 631(c) allows an owner-lessor to treat as capital gain “the difference between the amount realized from the disposal of such coal * * * and the adjusted depletion basis thereof” (and administrative costs disallowed under section 272). (Emphasis added.) We think that a sublessor, if entitled to the benefits of section 631(c), must calculate the amount of his income or loss accordingly. Therefore, a sublessor under section 631(c) must reduce his gross royalty income by the adjusted depletion basis of the coal mined under the sublease plus other expenses disallowed by section 272. For such a sublessor, the adjusted depletion basis or cost per unit of coal extracted must be interpreted to include earned royalties paid. The royalties paid by a sublessor are his cost for the coal subleased.

Thus, our reading of the statute gives us the general rule stated in the regulations: royalties paid by a sublessor reduce royalty income for purposes of sections 631(c) and 1231 and are not otherwise deductible. Sec. 1.631-3(a) and (b)(3)(h), Income Tax Regs. This result is consistent with the overall statutory scheme of sections 272, 631(c), and 1231(b)(2), wherein Congress intended that all of the costs of a lessor or sublessor should be subtracted from gross royalty receipts. See H. Rept. 1337, 83d Cong., 2d Sess. 59 (1954); Staff of the Joint Comm, on Internal Revenue Taxation, Summary of the New Provisions of the Internal Revenue Code of 1954, at 80-81 (Comm. Print 1955).

The language in the statute which provides that the lessee’s deductions are not affected by section 631(c) cannot be read as applying to sublessors. Congress never considered this possibility in 1954 when sublessors were added to the statute. See H. Rept. 1337, supra at 59, A190 (1954); S. Rept. 1622, 83d Cong., 2d Sess. 81, 338 (1954). However, it is reasonably clear that the sentence excluding “the lessee” was added when the statute was enacted only to ensure that those not benefiting from section 631(c) would not be adversely affected either.¹⁸

Permitting coal sublessors to report royalty receipts as capital gain and royalties paid as ordinary deductions would lead to results that could not have been intended by Congress. To take a hypothetical example, assume that in 1975 a sublessor disposes of 100,000 tons of coal for $1.50 per ton and receives royalties of $150,000. If this sublessor owed the landowner-lessor $1 per ton on the underlying lease, he would pay royalties of $100,000. Treating the expense as an ordinary deduction and all of the income as long-term capital gain, this sublessor would reduce his capital gains by $75,000 under section 1202 ($90,000 under present law) in addition to a $100,000 deduction for royalties paid. Although he has a net economic gain of $50,000 from coal royalties, this sublessor has achieved excess deductions of $25,000 ($150,000 - $175,000) capable of sheltering other ordinary income from tax. In effect, petitioner’s interpretation of the statute would permit double deductions from a sublessor’s coal royalty income. But see United States v. Skelly Oil Co., 394 U.S. 678 (1969).

The more reasonable interpretation of the statute is to require the coal sublessor, like the lessor, to report his net royalty income under section 631(c). Applied to the above hypothetical, the sublessor would report his economic gain of $50,000 as capital gain under section 1231.

Most of the foregoing analysis applies equally to the advanced minimum royalties paid on nonoperating leases that had been subleased to Webster Coal. We include in this category those leases subleased on the same day that the lease was acquired. Gregory v. Helvering, 293 U.S. 465 (1935). Advanced royalties paid on leases that had been subleased remain payments by a sublessor. As such, they should not be deductible from ordinary income for the reasons we have already set forth. It bears noting that any advanced minimum royalties Cumberland received from Webster Coal under a sublease were entitled to capital gain treatment, provided the other requirements of the statute were satisfied. See. 1.631-3(c)(l), Income Tax Regs. Since Cumberland was entitled to treat sublease income received prior to mining under section 631(c), we think advance royalties paid to landowners prior to mining must also be taken into account under section 631(c). As discussed above, respondent has here conceded that advanced minimum royalties may be taken into account in the taxable years paid.

We realize section 272 permits the deduction .of administrative costs in years in which no royalty income is realized. The last sentence of section 272 provides, “This section shall not apply to any taxable year during which there is no income under the contract.” However, we do not think advanced minimum royalties fall within the ambit of section 272. Advance royalties are not “expenditures attributable to the making and administering of the contract” (sec. 272), they are part of the cost of the coal itself. The cost of the coal mined and administrative costs are each treated in the same way under section 631(c), but that is not to say they are the same thing. We hold that section 272 authorizes no deduction for advanced minimum royalties paid on inactive leases.

A more difficult issue is presented by the advanced minimum royalties paid by Cumberland on leases prior to their sublease to Webster Coal. In accordance with a general principle of natural resource taxation, the regulations under section 631(c) treat individual lease contracts independently. See sec. 1.631-3(b) and (c), Income Tax Regs. See generally sec. 614(a); secs. 1.272-l(a) and (b)(2), 1.611-l(d)(l)(i), 1.614r-l(a), Income Tax Regs. With respect to those leases that had not yet been subleased to Webster Coal, Cumberland was technically only a lessee. As discussed earlier, section 631(c) does not apply to a lessee who is not a sublessor.

Under section 1.612-3(b)(3), Income Tax Regs. (1965) (amended 1977), a lessee who owns an operating interest in minerals in place may elect to deduct advanced minimum royalties in the year in which they are paid or accrued. This regulation was promulgated after the Commissioner lost a number of early cases which held that yearly minimum royalties were in part a period cost like rent. E.g., Commissioner v. Jamison Coal & Coke Co., 67 F.2d 342 (3d Cir. 1933), affg. in part and revg. in part 24 B.T.A. 554, 568-571 (1931); Burnet v. Hutchinson Coal Co., 64 F.2d 275 (4th Cir. 1933), cert. denied 290 U.S. 652 (1933). However, the regulation specifically excludes a lessee who is a sublessor of coal mining rights under section 631(c). Sec. 1.612-3(b)(3) and (e), Income Tax Regs.

In this particular case, the advanced minimum royalties paid on leases Cumberland had not yet subleased should nevertheless be treated as having been made by a sublessor. The record shows that from the outset Cumberland operated as a sublessor. Cumberland, in every case, subleased to Webster Coal the coal leases it acquired. Cumberland never intended to nor did it ever engage in any mining operations. We therefore find as a fact that, in every case, Cumberland acquired leases and paid advance royalties as a sublessor. Accordingly, these payments, like all other royalties paid by Cumberland, must be taken into account under section 631(c). We reach the same result on the ground that, regardless of the actual time interval, in each instance, lease and subsequent sublease may be viewed as one transaction. See Commissioner v. Court Holding Co., 324 U.S. 331 (1945); Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938); Tube Bar, Inc. v. Commissioner, 15 T.C. 922 (1950). Moreover, in the circumstances here presented we cannot say that Cumberland was at any time the holder of an “operating interest,” as that term is used in section 1.612-3(b), Income Tax Regs. All of Cumberland’s leases were held only for sublease to Webster Coal.

We therefore hold that none of the advanced or earned royalties paid by Cumberland may be deducted from petitioners’ ordinary income. All royalties paid must be taken into account in computing net royalty income or loss under section 631(c).

The second issue in this case is whether petitioner Joe Davis (hereinafter petitioner, since the second and third issues relate solely to him) is required by the tax benefit rule to treat as ordinary income, rather than capital gain, certain amounts of coal royalty income Cumberland allocated to him in the years 1967, 1968, 1969, and 1972.

Petitioner and his controlled corporation, Davis Coals, paid advanced minimum royalties on certain leases later assigned to Cumberland. Both Joe Davis and Davis Coals deducted these amounts from ordinary income in the years paid. Under Cumberland’s joint venture agreement, petitioner was entitled to reimbursement for prepaid royalties on the assigned leases for which Cumberland received credit from the landowner. Since Cumberland could receive credit for advanced royalties only when earned royalties were due, petitioner was reimbursed only as coal was actually mined. Income was allocated to petitioner under the joint venture agreement in 1967, 1968, 1969, and 1972 and, except for the 1967 allocation which he received in 1968, was paid over to him in the years allocated. Petitioner reported all such income in the years allocated as long-term capital gain realized from coal royalties.

Respondent argues these payments constitute ordinary income under the tax benefit rule. Respondent also argues that this income should be taxed to petitioner in the years paid, not in the years allocated. Petitioner argues the payments were section 631(c) capital gains specially allocated to him under the partnership agreement. We believe petitioner has framed the issue correctly.

At the outset, it is interesting to note respondent does not challenge the deductions taken for advanced royalties by petitioner and his controlled corporation. Evidently it is respondent’s “legal position” that these deductions were authorized under section 1.612 — 3(b)(3), Income Tax Regs.¹⁹ See Commissioner v. Jamison Coal & Coke Co., supra; Burnet v. Hutchinson Coal Co., supra. Had the deductions been improper, of course, the tax benefit rule would not apply. Kingsbury v. Commissioner, 65 T.C. 1068 (1976); Canelo v. Commissioner, 53 T.C. 217 (1969), affd. 447 F.2d 484 (9th Cir. 1971); Streckfus Steamers, Inc. v. Commissioner, 19 T.C. 1 (1952). Petitioner has not “shifted his position” herein. Cf. Unvert v. Commissioner, 72 T.C. 807 (1979).

Respondent’s theory applying the tax benefit rule in this case is not without a good deal of superficial appeal. Under the tax benefit rule, an amount properly deducted from gross income in determining one year’s tax liability is includable in gross income when it is recovered in a subsequent year. Alice Phelan Sullivan Corp. v. United States, 180 Ct. Cl. 659, 381 F.2d 399 (1967); Estate of Munter v. Commissioner, 63 T.C. 663 (1975). Section 111 codifies the corollary principle that where a deductible loss did not reduce taxable income, a subsequent recovery is not includable. Dobson v. Commissioner, 320 U.S. 489 (1943), rehearing denied 321 U.S. 231 (1944). Where the earlier deduction reduced ordinary income, the character of the recovery included in income is also ordinary. Merchants National Bank of Mobile v. Commissioner, 199 F.2d 657 (5th Cir. 1952), affg. 14 T.C. 1375 (1950); First National Bank of Lawrence County v. Commissioner, 16 T.C. 147 (1951). See Weyher v. Commissioner, 66 T.C. 825 (1976). Respondent here argues that because the royalty income specially allocated to petitioner under the joint venture agreement constituted reimbursement by Cumberland for expenses previously deducted from gross income, petitioner is not entitled to report such income as capital gain.

However, the tax benefit rule does not apply in this case because there has been no “recovery,” either by Cumberland or by petitioner.²⁰ See generally Nash v. United States, 398 U.S. 1 (1970). Cumberland did pay less for the coal it mined in the years it received credit for advanced royalties paid by petitioner. Such is the case whenever a prepaid item, be it interest or animal fodder, is later used up. Every properly allowed deduction for an advance payment shifts that expense to a year earlier than the year in which the expense is actually incurred. See generally Van Raden v. Commissioner, 71 T.C. 1083 (1979), appeal filed (9th Cir., Sept. 18, 1979). But there is no deemed “recovery” of the earlier expense in the later year any more than there is a matching deemed payment in that year as the prepayment is consumed.

Nor was there any recovery by petitioner. The amounts Cumberland allocated to petitioner were a portion of the earned royalties paid by Webster Coal on coal mined, which were due Cumberland without regard to the timing of royalties paid to landowners. The amounts petitioner received were consistently treated on Cumberland’s books, Cumberland’s partnership returns, and petitioner’s tax returns as specially allocated capital gains from coal royalties. Although the amount of petitioner’s allocation was measured by language in the joint venture agreement under which petitioner reserved “the right to recover all royalty prepaid by Davis on said leases for which [Cumberland] shall receive credit from the landowner,” Cumberland was under no obligation to petitioner unless and until coal was mined. We find that Cumberland’s partners intended these payments to petitioner to be an allocation of profits from earned royalties received, rather than a charge paid by Cumberland for coal mined.²¹ In short, we find that Cumberland did not purchase petitioner’s rights to credits for prepaid royalties.

We therefore think this case is distinguishable from Weyher v. Commissioner, supra. In Weyher, the taxpayer sold a piece of real property encumbered by an installment obligation, the interest on which the taxpayer had prepaid and deducted from his income. We held that a portion of the selling price constituted reimbursement for the unaccrued prepaid interest and that under the tax benefit rule such reimbursement had to be returned to income when received. Here there was no sale of an intangible asset created by a previous deduction. Because 1966 is not before us, we are not asked to decide whether petitioner’s contributing his rights to credits to the partnership in 1966 created income. See generally Nash v. United States, supra; United States v. Davis, 370 U.S. 65 (1962). Nor has either party suggested that Cumberland acquired any basis in these credits at that time. See generally Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), affd. per curiam 582 F.2d 378 (6th Cir. 1978), cert. denied 440 U.S. 909 (1979); sec. 1.612-l(b)(l)(i), Income Tax Regs.

If petitioner had, himself, subleased these leases to a mining operator, his net coal royalty income would be treated as capital gain under section 631(c). The amount of his net coal royalties would be increased to the extent his costs were reduced by credits for advanced minimum royalties. But it is hard to see how the tax benefit rule would apply to that situation, unless petitioner was deemed to have reimbursed himself. Interposing the partnership as the sublessor should not change the result in this case, where petitioner was reimbursed only by way of a special allocation of royalty income.

By treating the income and expenses of a sublessor under sections 272, 631(c), and 1231, Congress has enacted a scheme under which net losses in lean years result in ordinary deductions, and net gains in profitable years result in capital gains. Ordinary deductions for advanced minimum royalties taken under section 612 rather than section 631(c) of the Code should not alter section 631(c) treatment of net profits as capital gains in later years. See also sec. 1.612-l(b)(l)(i), Income Tax Regs. In other words, petitioner’s reporting capital gains on specially allocated coal royalties is not “an event inconsistent with what has been done in the past.” Estate of Block v. Commissioner, 39 B.T.A 338, 341 (1939), affd. sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), cert. denied 311 U.S. 658 (1940).

What respondent is really trying to accomplish in this case, although he cites no authority, is to recharacterize income treated as capital gain under section 1231. Cf. Merchants National Bank of Mobile v. Commissioner, supra; First National Bank of Lawrence County v. Commissioner, supra. See also Arrowsmith v. Commissioner, 344 U.S. 6 (1952). However, in analogous situations, Congress has consistently enacted legislation to override section 1231 where deductions generated by property used in a trade or business are recovered through a sale of the property at capital gains rates. See, e.g., secs. 1245, 1250, 1251, etc. See generally sec. 751(c)(2). With respect to depreciation recaptured under sections 1245 and 1250, we have stated: “Obviously, neither Congress nor the Treasury believed that respondent possessed adequate means to prevent taxpayers from converting ordinary income into capital gain prior to the enactment of this legislation.” Macabe Co. v. Commissioner, 42 T.C. 1105, 1117 (1964). Accord, Fribourg Nav. Co. v. Commissioner, 383 U.S. 272 (1966). Thus far, legislation recharacterizing section 631(c) capital gain has been limited to the recapture of certain mining exploration expenditures under sections 617(d) and 617(f)(3).

For the above reasons, we hold the tax benefit rule does not apply in this case.

Respondent alternatively argues that at least a portion of the royalties in question should be treated as ordinary dividend income to petitioner because a part of the payments were “legally due” Davis Coals, petitioner’s controlled corporation. This assertion is without foundation in the record. Under the terms of the joint venture agreement, Cumberland was obligated only to petitioner. If Davis Coals can be said to have surrendered to petitioner any rights to credit for advanced royalties, it did so in 1966, a year not before the Court, at the time petitioner transferred the leases to Cumberland. We therefore reject this argument as well.

Since we have found that petitioner correctly treated the income in question as specially allocated coal royalties, what follows is straightforward. Section 702(a)(3)²² requires each partner to include in income his distributive share of the partnership’s section 1231 gains and losses. Sections 704(a) and 704(b)²³ provide that specific items of partnership income, gain, loss, deduction, or credit may be allocated among the partners differently from their general partnership shares of income and loss, as long as the partnership agreement so provides and the purpose of the allocation is not merely to avoid taxes. Orrisch v. Commissioner, 55 T.C. 395 (1970), affd. per curiam without published opinion (9th Cir. 1973 31 AFTR 2d 73-1069); Kresser v. Commissioner, 54 T.C. 1621 (1970). Since section 631(c) coal royalties constitiute income taken into account under section 1231, such royalties may be specially allocated within the limitations of section 704(b).

Section 704(b)(1) requires that any special allocation be part of the partnership agreement. Sec. 1.704-l(a), Income Tax Regs. This requirement is satisfied here because we have found that the partnership agreement, both on its face and as applied by the parties, allocated to petitioner a portion of the earned royalties Cumberland received for coal mined under the Palmer Bros., Early, and Trader leases. See Boynton v. Commissioner, 72 T.C. 1147 (1979); Holladay v. Commissioner, 72 T.C. 571 (1979); Kresser v. Commissioner, supra.

Section 704(b)(2), as interpreted by the regulations, requires every special allocation to have “ ‘substantial economic effect,’ that is, * * * the allocation [must] actually affect the dollar amount of the partners’ shares of the total partnership income or loss independently of tax consequences.” Sec. 1.704r-l, Income Tax Regs.²⁴ This limitation is satisfied here because the income allocated to petitioner was in fact paid over to him and the royalties received by Cumberland’s other partners in those years were accordingly reduced. Harris v. Commissioner, 61 T.C. 770, 786 (1974). See Orrisch v. Commissioner, supra; Kresser v. Commissioner, supra.

Respondent’s final argument is that even if the amounts allocated to petitioner represent a division of Cumberland’s profits, petitioner is not entitled to capital gain under section 631(c) because he retained no economic interest in the assigned leases.²⁵ We disagree.

Respondent’s argument misconstrues fundamental principles of partnership taxation. Section 702(b) states:

The character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share under paragraphs (1) through (8) of subsection (a) shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.

This language has been consistently interpreted to mean that the character of partnership income is determined at the partnership level. Sec. 1.702-l(b), Income Tax Regs.; Podell v. Commissioner, 55 T.C. 429 (1970); Grove v. Commissioner, 54 T.C. 799 (1970). See sec. 703(a); United States v. Basye, 410 U.S. 441 (1973); Resnik v. Commissioner, 66 T.C. 74 (1976), affd. per curiam 555 F.2d 634 (7th Cir. 1977). Because Cumberland was the sublessor of the assigned leases, Cumberland’s net income from these leases is taxed under sections 631(c) and 1231. Accordingly, Cumberland’s partners must each report their distributive shares of this income under section 702(a)(3). Sec. 1.702-l(a)(3), Income Tax Regs.

We therefore hold petitioner is entitled to report under sections 631(c) and 1231 those amounts of coal royalty income specially allocated to him under the joint venture agreement. It follows that petitioner properly reported such partnership income in the years it was received by Cumberland. Sec. 706(a).²⁶ See United States v. Basye, supra. Cumberland’s disbursement of petitioner’s 1967 allocation to him in 1968 does not change this result.

We recognize that our disposition of this issue will result in petitioner’s reporting capital gain on net coal royalties in 1967, while Cumberland’s other partners, provided they have no other section 1231 gains, will be entitled to deduct ordinary losses in that year under sections 272, 631(c), and 1231. Coal under sublease actually mined in 1967 produced a profit, part of which profit was allocated to petitioner. Payments made on inactive properties, however, resulted in a net loss for the year with respect to partners other than petitioner.²⁷

No “ceiling” rule, sec. 1.704^1(c)(2)(i), Income Tax Regs.; Rev. Rul. 75-458, 1975-2 C.B. 258 (in effect applying a “ceiling” rule to sec. 704(b) special allocations), has been violated by this result. The “ceiling” rule set forth in section 1.704-l(c)(2)(i), Income Tax Regs., provides generally that gains or losses not actually realized by the partnership with respect to contributed property may not be specially allocated. See also sec. 703(a). However, it is quite clear that income or loss with respect to particular partnership assets may be specially allocated under section 704(a) and (b), as well as section 704(c)(2). Sec 1.704-l(b)(2), examples (l)-(4), Income Tax Regs.; Rev. Rul. 75-458, supra. Such is the case here, and nothing in the record suggests that unrealized gains or losses were allocated under Cumberland’s joint venture agreement.

Issue 3

The final issue for decision is whether petitioner Joe Davis realized income by reason of his gifts of stock in trust where such gifts were conditioned upon the trustee’s agreed payment of the resulting Federal and State gift taxes. The facts and legal question presented herein are indistinguishable from those in Estate of Henry v. Commissioner, 69 T.C. 665 (1978), appeal filed (6th Cir., May 5, 1978). We continue to adhere to our position in Henry and therefore hold that petitioner did not realize taxable income as a result of his gifts in trust because of the trustee’s payment of gift taxes imposed. Bradford v. Commissioner, 70 T.C. 584, appeal filed (6th Cir., Dec. 26, 1978); Hirst v. Commissioner, 63 T.C. 307 (1974), affd. 572 F.2d 427 (4th Cir. 1978); Turner v. Commissioner, 49 T.C. 356 (1968), affd. 410 F.2d 752 (6th Cir. 1969).

To reflect concessions and the foregoing,

Decisions will be entered under Rule 155.

Reviewed by the Court.

1 All section references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue.

2 his interest was held by the Estate of Rascoe Davis for years after 1971, which are not here in issue.

3 The term “earned royalties” is commonly used in commercial practice and the law to distinguish them from advanced royalties. See Briscoe v. United States, 210 Ct. Cl. 158, 536 F.2d 353 (1976) (sand and gravel); Gann v. Commissioner, 31 T.C. 211 (1958) (book royalties); Louis Werner Saw Mill Co. v. Commissioner, 26 B.T.A. 141 (1932) (oil and gas); Omer v. United States, an unreported case (W.D. Ky. 1962, 11 AFTR 2d 383, 63-1 USTC par. 9113) (coal).

4 The second, fifth, and ninth subleases — dated Mar. 26, 1967, Sept. 22, 1969, and Oct. 23, 1970, respectively — each transferred to Webster Coal a lease that Cumberland had executed with the landowner(s) on the same day as the date of sublease.

5 The record does not explain why Davis Coals made two payments in 1967 totaling $9,000 after the leases had been assigned by Joe Davis to Cumberland in October 1966, as discussed below.

6 For reasons unexplained by the record, this amount is $300.02 larger than the sum of the advanced minimum royalties paid by Joe Davis and Davis Coals.

7 Relatively small amounts of royalties in 1969 and 1970 were treated as short-term capital gain and these are not in issue. But see Rev. Rui. 59-416, 1959-2 C.B. 159, 161 (these royalties should have been treated as ordinary income subject to depletion).

8 Petitioners, however, have here conceded that a portion of the royalties Cumberland received in each year from 1967 through 1971 constituted dividends paid by Webster Coal to its shareholders, passed through the partnership.

9 In his notices of deficiency for the years 1967 through 1971, respondent disallowed as deductions from ordinary income Cumberland’s office and professional expenses, and applied them to reduce royalty income treated as capital gains under secs. 631(c) and 1231. See sec. 272; secs. 1.272-l(d) and 1.631-3(a), Income Tax Regs. Petitioners do not challenge this determination.

On the other hand, in the deficiency notice for the years 1972 through 1975, respondent expressly allowed such expenses to Cumberland and petitioner Joe Davis as ordinary deductions. We will not disturb the parties’ inconsistent treatment of these expenses because the issue has not been raised by the parties.

10 This result depends in part upon respondent’s separate treatment of royalty income specially allocated to Joe Davis. In view of our determination of the second issue herein in favor of that petitioner, respondent’s concession will not apply to Joe Davis’ royalty income for 1967 because he realized a net profit from coal royalties for that year.

11 On brief, respondent alternatively suggests this income was realized in 1973, the year in which the gift taxes were paid by the trustee.

12 Sec. 1231(b)(2) provides:

(2) Timber, coal, or domestic iron ore. — Such term [“property used in the trade or business”] includes timber, coal, and iron ore with respect to which section 631 applies.

13 Examples of such administrative expenses include ad valorem taxes, insurance, and professional fees associated with a coal lease. Sec. 1.272-l(d), Income Tax Regs.

14 Sec. 631(c) provides in part:

the difference between the amount realized * * * and the adjusted depletion basis thereof * * * shall be considered as though it were a gain or loss, as the case may be, on the sale of such coal * * * . Such owner shall not be entitled to the allowance for percentage depletion provided in section 613 with respect to such coal or iron ore. [Emphasis added.]

15 Sec. 631(c) provides in part: “This subsection shall not apply to income realized by any owner as a co-adventurer, partner, or principal in the mining of such coal.”

16 Sec. 1.631 — 3(b)(3)(ii)(6), Income Tax Regs., states:

“Example. B is a sublessor of a coal lease; A is the lessor; and C is the sublessee. B pays A a royalty of 50 cents per ton. C pays B a royalty of 60 cents per ton. The amount realized by B under section 631(c) is 60 cents per ton and will be reduced by the adjusted depletion basis of 50 cents per ton, leaving a gain of 10 cents per ton taxable under section 631(c).”

17 On brief, respondent argued:

“With respect to the advanced royalty payments, it is the respondent’s legal position that such payments must be included in the adjusted depletion basis along with earned royalty payments and made a part of the sec. 631(c) computation not in the year of payment, but in the year of disposal of the coal.”

This “legal position” directly contradicts respondent’s stipulation that “Under the theories respondent advances, the respondent concedes that the [net] loss [in 1967] is an ordinary loss.” Moreover, in his notice of deficiency, respondent took all royalties paid to landowners into account when paid. It is obvious from the chart at p. 888 supra, that requiring Cumberland to capitalize advanced minimum royalties would lead to increased deficiencies for the early years of Cumberland’s operations. We conclude that respondent conceded this issue by not asking for increased deficiencies based thereon. We see no point in giving advisory opinions on legal theories respondent argues in vacuo. Fernandez v. Commissioner, 15 B.T.A. 1369 (1929).

¹⁸

S. Rept. 781, 82d Cong., 1st Sess. (1951), 1951-2 C.B. 458, 488, 575:

“It is also made clear that these provisions do not apply to a lessee * * *

“For the purpose of clarification, your committee has also expressly provided that, in determining the gross income, the adjusted gross income, or the net income of the lessee, the deductions allowable with respect to rents and royalties shall be determined without regard to the provisions of section 117(k)(2), as amended by this section.”

19 Compare n. 17 supra.

20 Because we dispose of this issue on the ground there has been no “recovery” herein, we need not discuss the fact that petitioner did not deduct or receive any tax benefit from payments made and deducted by Davis Coals.

21 In terms of partnership taxation, we find that neither sec. 707(a) (payments made to partners other than in their capacity as partners) nor sec. 707(c) (payments made without regard to partnership income) applies in this situation. See Pratt v. Commissioner, 64 T.C. 203 (1975), affd. in part and revd. in part on other grounds 550 F.2d 1023 (5th Cir. 1977); Ragner v. Commissioner, 34 T.C. 111 (1960).

22 SEC. 702. INCOME AND CREDITS OF PARTNER.

(a) General Rule. — In determining his income tax, each partner shall take into account separately his distributive share of the partnership’s—

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(3) gains and losses from sales or exchanges of property described in section 1231 (relating to certain property used in a trade or business and involuntary conversions),

23 SEC. 704. PARTNER’S DISTRIBUTIVE SHARE.

(a) Effect of Partnership Agreement. — A partner’s distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this section, be determined by the partnership agreement.

(b) Distributive Share Determined by Income or Loss Ratio. — A partner’s distributive share of any item of income, gain, loss, deduction, or credit shall be determined in accordance with his distributive share of taxable income or loss of the partnership, as described in section 702(a)(9), for the taxable year, if—

(1) the partnership agreement does not provide as to the partner’s distributive share of such item, or

(2) the principal purpose of any provision in the partnership agreement with respect to the partner’s distributive share of such item is the avoidance or evasion of any tax imposed by this subtitle.

24 The “substantial economic effect” requirement of the regulations is now codified in sec. 704(b)(2). Tax Reform Act of 1976, sec. 213(d), Pub. L. 94-455, 90 Stat. 1520, 1548.

25 See also sec. 1.631-3(b)(4)(ii), example (3) Income Tax Regs, (taxpayer who has an economic interest, but who does not dispose of coal under contract, does not qualify under sec. 631(c)).

26 SEC. 706(a). Year in Which Partnership Income Is Includable. — In computing the taxable income of a partner for a taxable year, the inclusions required by section 702 and section 707(c) with respect to a partnership shall be based on the income, gain, loss, deduction, or credit of the partnership for any taxable year of the partnership ending within or with the taxable year of the partner.

27 This result follows from respondent’s concession in this ease that advanced minimum royalties paid by a sublessor on unmined properties may be taken into account when paid under sec. 1231. See n. 17 supra.