United States of America, Appellant, v. Murphy J. Foster and Olive R. Foster, Appellees, 324 F.2d 702 (5th Cir. 1963)

Louis F. Oberdorfer, Asst. Atty. Gen., Dept. of Justice, Lee A. Jackson, Melva M. Graney, Michael Mulroney, Attys., Dept. of Justice, Washington, D. C., Louis C. LaCour, U. S. Atty., New Orleans, La., for appellant.

Walter J. Suthon, III, New Orleans, La., Thomas A. Harrell, Shreveport, La., for appellees, Monroe & Lemann, New Orleans, Blanchard, Goldstein, Walker & O'Quin, Shreveport, La., of counsel.

Before RIVES and JONES, Circuit Judges, and DAWKINS, District Judge.

BENJAMIN C. DAWKINS, Jr., District Judge.

This appeal tests the correctness of a judgment by the trial court wherein appellees prevailed in a tax refund suit. The question for decision is whether, in a case involving facts as here presented, proceeds from the sale of an oil payment^*  are to be treated as ordinary income or capital gain. Both the oil payment and a royalty interest were reserved by the taxpayer (See fn. 1) when he executed a mineral lease, but only the oil payment subsequently was sold.

Murphy J. and Olive R. Foster brought this action for refund of income taxes and interest for the year 1955 amounting to $1,517.38.¹  Taxpayer owned an undivided 1/10th interest in Dixie Plantation, containing about 800 acres, in St. Mary Parish, Louisiana. July 1, 1955, he and his co-owners executed an oil, gas and mineral lease upon all but 11.11 acres of the land to Chester Hunter, for a six-months primary term and so long thereafter as oil or gas was produced.

Taxpayer and his co-lessors received a bonus of $5,000, but they retained what was termed a 10/24ths "royalty" interest until $220,000 was paid, and thereafter a 5/24ths royalty.²  On the same day this lease was executed, the lessors sold to other parties what they described as a "royalty," but which was limited to a payment of $110,000 out of 5/24ths of production.³  The transfer was made subject to the Hunter lease. The assignors received $100,882.35 for the oil payment, of which taxpayer's share was $10,088.23.

In his 1955 income tax return taxpayer treated this transaction as the sale of a capital asset held for more than six months. After an audit, the Internal Revenue Service disallowed capital gain treatment and determined that the proceeds were ordinary income subject to depletion allowance.

The District Court, however, in granting plaintiffs' motion for summary judgment (the parties having stipulated the facts), held that there had been a sale of a capital asset.⁴  It reasoned that the true nature of the interest conveyed must be examined in order to determine whether it was property subject to capital gain treatment under the provisions of the Internal Revenue Code.⁵  In a footnote, the Court explained Louisiana's concept as to mineral servitudes. It noted that, although ownership of minerals in place is not recognized in Louisiana, for income tax purposes Louisiana mineral servitudes, leases, royalties, oil payments, and other mineral interests are property rights which may be treated as capital assets if they meet the test of Section 1221 of the 1954 Internal Revenue Code, as interpreted by the Courts.⁶ 

Applying the accepted rule that the substance of the transaction must be determined from its total effect, the Court found that two separate and distinct property interests had been retained by taxpayer: 1) his share of a 5/24th royalty interest and 2) his share of a $110,000 oil payment from another 5/24th of production. These interests ran concurrently, so the Court held, as did the oil payment interests in Witherspoon v. United States,⁷  in which it was held that where two retained oil payments run concurrently, proceeds from the sale of one are subject to capital gain treatment.

The District Court thus reasoned that two separate interests were retained, that they were concurrent interests, each independent of the other, and therefore the oil payment assignment here made was not that of a carved out interest. Therefore, it held, the proceeds of this sale were subject to capital gain treatment.⁸ 

A further basis for the Court's decision was that the ultimate pay-out of an oil payment on nonproducing land, such as here, could not be calculated with the degree of accuracy required by the Supreme Court to classify it as an assignment of future income.⁹  Other considerations mentioned by the Court in this connection were that the lessee was not obligated to drill a well on the land, and the lease would terminate if no well was drilled within four months from the date of the lease agreement. It also would terminate if a second well was not begun within three months after completion or abandonment of the first well. An affidavit given by the lessee indicated that, although he considered "there was a reasonably good possibility the premises would be productive of oil or gas," the formation was known to be faulted and therefore production could not be predicted with certainty. Later developments substantiated in some measure the correctness of his estimate in that the second well drilled was a dry hole. But we must note significantly at this point, and as later discussed in more detail, there were producing wells on adjoining property and the 11.11 acres of Dixie Plantation excluded from the lease already were included in a producing unit established by the Louisiana Commissioner of Conservation.

For the reasons we now present, it is our conclusion, despite the persuasiveness of the District Court's opinion, that it erred in holding the proceeds from taxpayer's assignment of the oil payment to be entitled to capital gain treatment.

In a case decided after Witherspoon — Estate of O. W. Killam, 33 T.C. 345 (1959) — the Tax Court held that proceeds from the sale of a "carved out" oil payment¹⁰  amount to a transfer of anticipated future income, and therefore are taxable as ordinary income. However, in Killam the Court apparently deemed it necessary expressly to distinguish Witherspoon by pointing out that there the interests ran concurrently, whereas in Killam they ran successively.¹¹ 

The significance as to whether an oil payment runs concurrently with another interest lies in the test sometimes used in determining whether an oil payment is a capital asset or not. This concept is to the effect that, if the oil payment is carved out of another, larger and longer mineral interest, and the price received for the sale is not pledged to development, then it is treated as ordinary income.¹² 

The landmark case of Commissioner v. P. G. Lake, Inc., supra, fn. 9, laid down certain broad principles which govern in determining whether proceeds from the sale of an oil payment are subject to capital gain treatment. There the Supreme Court found that the Internal Revenue Code's capital gain provisions are designed to relieve the taxpayer from an excessive tax resulting from conversion of property which has appreciated in value over a period of time.¹³  This treatment is an exception to the general rule of taxing all net income as ordinary income, and, as an exception, it should be narrowly construed.¹⁴  Consideration received upon transfer of mineral interests will be carefully scrutinized to determine whether it was accepted for an increase in value of an income-producing property or merely in place of the right to receive future income.¹⁵ 

No rule was established by Lake requiring all carved out interests to be taxed as ordinary income simply upon a finding that they were carved out and that the price received was not pledged for development. The substance and effect of the whole transaction must be examined; form alone will not control. Nevertheless, the Commissioner, some courts, and legal writers continue to espouse definitions and rules as to ordinary income or capital gain couched in terms of whether an interest is carved out or not.¹⁶  An oil payment is said to be carved out if the owner of any royalty, lease, or other mineral interest, including a larger oil payment, assigns an oil payment but retains an interest in the property from which the oil payment is assigned.¹⁷  We believe a close analysis of Killam and Floyd, supra, fn. 17, will clarify application of this concept in determining whether there has been a sale of a capital asset or assignment of future income.

In Killam, the taxpayer sold his interest in a mineral lease and reserved a $150,000 oil payment, plus 4% interest on the unpaid balance, from 75% of 7/8 ths of the oil produced; and thereafter a $200,000 oil payment, plus 4% interest on the unpaid balance from 80% of 7/8 ths of the oil produced. Subsequently, he sold the $150,000 oil payment. It was held that this was a carving out of an interest extending over less than the life of the entire depletable lease property from which the interest was carved. The two reserved oil payments were treated as one property interest from which the taxpayer carved out and sold one of the oil payments. Quoting from Lake, the Tax Court held that "the substance of what was received was the present value of income which the recipient would otherwise obtain in the future."

Subsequent to decision by the lower court of the present case, this Court affirmed the Tax Court decision in Floyd, supra, fn. 17.¹⁸  The District Court, in a footnote, found a distinction between this case and Floyd because in that case there was an agreement by the assignor of the oil payment to repurchase portions thereof contingent upon production. This, the Court indicated, amounted to less than the complete divestiture required by the Commissioner to avoid ordinary income tax treatment. However, an examination of the assignment in Floyd reveals that the taxpayer sold the oil payment for $75,000 and agreed to repurchase a $7,500 portion for each well less than 21 drilled on the property by a certain date (there being 15 producing wells on the lease at the time of the sale). This agreement did not reduce the transaction to something less than a complete divestiture of ownership of the oil payment. In substance, the taxpayer guaranteed that if 21 wells were not drilled, then at the request of the assignee he would repurchase a certain number of oil payments. The option was vested in the assignee, not in the taxpayer.

In Floyd, just as here, the assignor retained a royalty and an oil payment, and subsequently sold the oil payment but retained the royalty. These interests were to run concurrently until the oil payment was completed. Nevertheless, this Court, in a per curiam opinion affirming the Tax Court, held the proceeds were taxable as ordinary income and stated that the principles involved were indistinguishable from Lake.¹⁹ 

In Floyd and Killam, just as in Lake, there was production from the property at the time of the assignment, and this production could be applied to pay-out the assigned oil payment. Lake clearly implies that reasonable foreseeability of pay-out is an element to be considered in determining whether a capital asset has been sold, or whether there has been merely an assignment of future income.²⁰ 

Obviously, as argued by appellees, any rule deduced from these cases will not long survive possible ingenious or ingenuous devices for creating quasi-oil-payments and sui generis mineral interests in efforts to obtain capital gain tax results. For present purposes, nevertheless, the following precept, which we adopt and apply, seems correctly to identify proceeds from the sale of carved out oil payments which are not entitled to capital gain treatment: the assignment of an oil payment (not pledged for development), which extends over a period less than the life of the depletable property interest from which it is carved, results in ordinary income if the pay-out of the oil payment can be predicted with reasonable accuracy at the time of the sale.²¹  Pay-out of an oil payment carved from producing property can be predicted with reasonable accuracy if it is not unreasonable to conclude that total reserves and the amount of production dedicated to pay-out are adequate for that purpose.²²  For undeveloped property, however, an additional determination is necessary, i. e., that adequate pay-out production reasonably can be expected from the property.

In applying our understanding of a proper application of the law to this case, two major questions arise: 1) was the oil payment carved out of a depletable property interest? and 2) could pay-out of the oil payment be predicted with reasonable accuracy at the time it was sold?

We believe the oil payment sold here was carved out of a depletable property interest. Considering the total effect of the transaction and not its mere form, it is reasonable to conclude that taxpayer (and his co-lessors) retained a 5/24 royalty interest and a $110,000 oil payment payable out of another 5/24 royalty. But, in finding that the assigned oil payment was carved out of taxpayer's depletable property interest, all the mineral interests which taxpayer retained underlying this one tract of land and subject to a single lease, under tax law principles, are to be considered as one interest.²³  Prior to execution of the lease, taxpayer and his co-lessors had full, perfect ownership of the land. By leasing it, they created another property interest for the benefit of the lessee, but the interest they retained continued as one interest. A landowner conceivably might purport to retain a thousand separate interests, although in reality what he has held back is but one reserved interest with various types of divisions or units. This analysis is implicit in Killam and Floyd.

Here, looking at substance rather than form, we must find that pay-out of the oil payment could have been, and must have been, predicted with reasonable accuracy at the time it was sold. There was oil production on adjoining property; indeed, part of Dixie Plantation was included in a previously created production unit; the lessee, an experienced operator, thought there was a good possibility that the property would be productive of oil or gas; taxpayer and his co-owners were willing to accept a bonus of only $5,000 for a mineral lease on some 788 acres of obviously valuable property, or about $6.50 per acre, when it is well known that ordinarily the bonus for a lease similarly located would be at least $100, $200, $300 per acre, or more; the arrangement to sell the oil payment clearly had been completed before the lease was executed, as was conceded by appellee's counsel in oral argument; and the purchasers of the $110,000 oil production payment paid $100,882.35 for it, a discount of less than 10 per cent.²⁴ 

The analogy to a tree and its fruit has been widely adopted by legal writers in analyzing tax situations such as this.²⁵  If an assignor conveys, for a lump sum payment, a terminable interest which extends for a period less than the life of the property interest retained, this is referred to as a sale of the fruit. Such a sale results in depletable ordinary income. Where, however, the interest sold constitutes the entire interest of the assignor, or a fractional interest extending over the entire life of the lease, then this is a sale of the tree, or part of it. Such sales would be subject to capital gain treatment.

Here we hold that there was a sale of "fruit," not "tree," or a part of it.

We thus conclude that the proceeds received by taxpayer from the oil payment assignment in question fall within the rule subjecting them to tax treatment as ordinary income. We emphasize, however, that the tests we have made are merely tools used in analyzing the true nature of the transaction. Under the facts here present, we find that their application correctly establishes that taxpayer did not sell a capital asset, but merely assigned anticipated future income. The District Court's judgment is

Reversed.