Driscoll v. Commissioner of Internal Revenue

147 F.2d 493, 33 A.F.T.R. (P-H) 704, 1945 U.S. App. LEXIS 3552

• Court: Court of Appeals for the Fifth Circuit
• Decided: February 22, 1945
• Docket: 11048
• Status: Published

Opinions

WALLER, Circuit Judge.

After construction of the hotel building of the taxpayer had progressed to the point where a part of the air-conditioning system had been installed, for which fans, motors, and other material had been delivered, taxpayer concluded that some radical changes should be made in the plans and size of the building, and that the air-conditioning system was inadequate. Considerable work had been done and materials used which had to be tom out in making these changes, with the following consequences as aptly stated by the Tax Court: “As a result of, these changes the insulated metal cold air ducts, already installed, were removed. This could only be and was done by a destruction of the material. In addition to the air cooling system the changes necessitated the removal of other materials already installed with a consequent labor cost. In some instances the material so removed could only be disposed of for scrap. In others, material specially fabricated and not yet delivered by the manufacturer was retained by him and an allowance was made on the bill for such material. Some materials were returned to the manufacturer and a cancellation charge made by the latter. The total cost to petitioner of these changes in construction was approximately $500,-000.”

The cost of the changes in air-conditioning and plumbing, together with additional fees to architect and contractor, which petitioner claims was a loss deductible from her income for the tax year of 1940, was $61,160.70. The disallowance by the Commissioner of Internal Revenue of the deductions was approved by the Tax Court.

In addition to the foregoing contention, the taxpayer also shows that in prior years she had executed certain oil and gas leases on large areas of her land, and, in addition to the retention of one-eighth royalty, she had received a bonus of $5 for each acre embraced in said leases, against which bonus payments taxpayer had, during the year received, deducted depletion allowances of 27%% in making her tax return. In subsequent years substantial portions of the acreage covered by these leases were relinquished and surrendered to the petitioner by her lessees, prior to any production of oil from the leased lands.

Commissioner, .directing the restoration to her 1940 income of that proportion of the depletion allowances theretofore taken which the acreage released from each lease bore to the total acreage in that lease, assessed deficiencies against the taxpayer in the amount of such restoration. This was done on the theory that these amounts represented the proportion of the depletion previously allowed on bonuses received for those portions of leases which had been terminated without having produced any oil for depletion.

We agree with the Tax Court in its conclusion that taxpayer was not entitled to deduct as an expense the items claimed as losses wrought by changes in connection with the construction of the hotel, and that cost of changes in design made before or during construction, whether these changes are necessitated because of mistake or otherwise, are but a part of the cost of the structure as finally completed. Extra expenses due to errors in plan and design are a part of the cost that the building traffic must bear. As the Tax Court well said: “The acceptance of petitioner’s theory would result in a deductible loss in practically every construction project. Common experience tells us that no construction job is carried out with such perfection that some material, because of error, mistake, or even slight change in design, is not removed and therefore does not remain a part of the completed structure. Such expenditures are, we think, clearly a cost of construction.”

The decision of the Tax Court in this respect is approved.

This brings us to a consideration of the second contention relative to the return to income of such portion of the depletion allowed on bonus payments as the acreage released from the oil and gas leases bears to the total acreage embraced in the leases.

As long as the confusing concept is adhered to that a bonus paid for signing a lease is not consideration for the lease but is an advance payment on royalty and subject to depletion, perplexities will continue to arise. The statute (26 U.S.C.A. Int. Rev.Code, § 23 (m) provides for a reasonable allowance for depletion in the case of “mines, oil and gas wells.” Paragraph (b) (3), Sec. 114, Title 26, U.S.C.A. Int.Rev. Code, provides for 27%% depletion “in the case of oil and gas wells”, and no statutory authority has been pointed out for the allowance of depletion except in the case of an oil or gas well, nor as to how there can be depletion in law when there has been none in fact.

However, the decision of the Tax Court sustaining the Commissioner was not based upon the proposition’ that depletion is allowable only in case of oil 'or gas wells and not in case of the sale of a ¿lease to lands merely believed to contain oil and gas, but the question is whether or not taxpayer should now be required to return as income the depletion on those portions of the acreage embraced in the leases which were surrendered to the lessor” during the tax year. Respondent contends that such surrender is a pro tanto expiration, termination, or abandonment of the lease within the terms of the regulation.¹

Depletion of oil and gas should not be measured on the acreage basis, for it is possible for one well on a small fraction of one acre to deplete gas and oil on many surrounding acres. Some states forbid more than one well to each forty acres. Except for the synthetic depletion that occurs upon the acceptance of a bonus in connection with the execution of a lease there can be no depletion except by drilling a well. In actuality it ordinarily requires an activity under a lease to produce oil and cause" depletion. Under the decisions the lessor has the right to anticipate production in taking depletion, and there seems to be no reason the lessor could not continue to anticipate production so long as the lease has not been terminated, abandoned, or fully exploited.

Depletion, synthetic or real, is not measured on an acreage basis, nor can it be said that the grant of mineral rights has expired, terminated, or been abandoned so long as the privilege or lease exists and activity under such grant looking to production may reasonably be expected. The decisions of this Court in Sneed v. Commissioner of Internal Revenue, 5 Cir., 119 F.2d 767; Commissioner of Internal Revenue v. Seeligson, 5 Cir., 141 F.2d 358; and Crabb v. Commissioner of Internal Revenue, 5 Cir., 119 F.2d 772, are contrary to the contentions of the Commissioner and the views of the Tax Court.

The regulation of the Commissioner provides for restoration to income of the depletion taken when there has been no production and the lease has expired, terminated, or been abandoned, and the Commissioner may not stretch his regulation so as to construe it to be applicable when “any part of the lease has expired, terminated, or been abandoned”.

The decision of the Tax Court in reference to the disallowance of deductions for changes in the construction of the building was correct and is affirmed, but its decision requiring the restoration to income of the depletion allowances in the leases terminated only in part is disapproved and reversed.

Affirmed in part and reversed in part.

1 Sec. 19.23(m) 10(c), Reg. 10”, promulgated under Sec. 23 (m), Int.Rev.Code, 26 U.S.C.A.Int.Rev.Code, § 23(m).