Charles E. Strange; Sherrie R. Strange, Petitioners-appellants v. Commissioner of Internal Revenue, Respondent-appellee, 270 F.3d 786 (9th Cir. 2001)

Charles and Sherrie Strange ("Taxpayers") appeal the Tax Court's assessment of federal income tax deficiencies. The Tax Court found that Taxpayers, in calculating adjusted gross income, had improperly deducted nonresident state income taxes on net oil and gas royalties. We have jurisdiction under Internal Revenue Code ("Code" or "I.R.C.") § 7482, and we affirm.

Taxpayers, residents of Nevada, own income-producing gas and oil interests in nine other states. Each of these states imposes nonresident state income tax on income-producing activity within the state. Accordingly, Taxpayers paid state taxes on the net royalty income earned in each state during tax years 1993 through 1995. In filing their federal income tax returns for these years, Taxpayers deducted their nonresident state income taxes from gross income, yielding adjusted gross income. In addition, Taxpayers took the standard deduction to arrive at taxable income.

Upon an audit of the federal returns for tax years 1993 through 1995, the Commissioner of Internal Revenue ("Commissioner") determined that Taxpayers' nonresident state income taxes were not deductible from gross income under I.R.C. § 62(a) (4). As a result, the Commissioner assessed deficiencies of $3,955, $5,379, and $3,983 against Taxpayers for the respective tax years. Upon Taxpayers' challenge, the Tax Court upheld the deficiencies.

In this case, our task is to interpret I.R.C. § 62(a) (4), providing for deductions from gross income ("above-the-line deductions"). The Tax Court's construction of this statute involves a question of law subject to de novo review. See Sliwa v. Commissioner, 839 F.2d 602, 605 (9th Cir. 1988). Because tax deductions are a matter of legislative grace, statutes providing for them should be narrowly construed against the taxpayer. Deputy v. DuPont, 308 U.S. 488, 493 (1940).

Section 62(a) (4) provides for above-the-line deductions for expenses "attributable to property held for the production of rents or royalties," cross-referencing § 164, which provides for the itemized ("below-the-line") deduction of state income taxes.¹  Taxpayers assert that these two sections, when read together, expressly provide for an above-the-line deduction of nonresident state income taxes on net royalties. We do not agree. Such state income taxes are not "attributable to" royalty-producing property in the way Congress intended under § 62(a) (4).

The goal of statutory construction is to give effect to the intent of Congress. See Arizona Governing Comm. for Tax Deferred Annuity & Deferred Compensation Plans v. Norris, 463 U.S. 1073, 1108 (1983) (O'Connor, J., concurring) ("Our polestar, however, must be the intent of Congress, and the guiding lights are the language, structure, and legislative history of [the applicable statute]").

The language and structure of § 62(a) reveal Congress's intent that state income taxes levied on net royalty income (gross royalty minus production taxes, overhead, operating expenses, and depletion) are not deductible above-the-line. Such income taxes are not expenses incurred in the production of the royalty. See Accountants' Cost Handbook, 1.9 (James Bulloch et al. eds., 3d ed. 1983) (defining expenses as "expired costs . . . used to produce revenue"). Above-the-line deductions must be attributable to "property held for the production of . . . royalties"--not attributable to the royalties derived therefrom. I.R.C. § 62(a) (4) (emphasis added). The language and sentence structure plainly divide the"property" from the derived "royalties."

The legislative history comports with our plain langauge understanding of § 62(a) (4). In passing § 22(n), the precursor to § 62(a) (4),²  Congress indicated the manner in which state taxes paid on royalty income should be reported for federal tax purposes:

The proposed section 22(n) of the Code provides that the term "adjusted gross income" shall mean the gross income computed under section 22 less the sum of the following deductions: (1) Deductions allowed by section 23 of the Code, which are attributable to a trade or business carried on by the taxpayer . . . [and] (4) deductions allowed by section 23 which are attributable to rents and royalties; . . .

The deductions described in clause (1) above are limited to those which fall within the category of expenses directly incurred in the carrying on of a trade or business. The connection contemplated by the statute is a direct one rather than a remote one. For example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas State income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing adjusted gross income. Similarly, with respect to the deductions described in clause (4), the term "attributable" shall be taken in its restricted sense; only such deductions as are, in the accounting sense, deemed to be expenses directly incurred in the rental of property or in the production of royalties. S. Rep. No. 78-885, at 24-25 (1944), 1944 C.B. 858, 877-78. Nonresident state income taxes, imposed on net royalty income, are not expenses "directly incurred . . . in the production of royalties" and thus are not deductible under § 62(a) (4). Id.

AFFIRMED.