The Beal Foundation, Plaintiff-appellant, v. United States of America, Defendant-appellee, 559 F.2d 359 (5th Cir. 1977)

The question for decision in this case is whether the district court erred in granting the government's motion for summary judgment in taxpayer's suit for tax refund. The facts are not disputed. The legal issue presented, however, is the validity of an IRS regulation requiring that a cost basis be used in determining the depletion deduction allowed a charitable organization for computation of net investment income. Because the regulation is entirely consistent with the statute it interprets, we affirm.

The following facts are gleaned from the record and are not in dispute. Taxpayer is a Texas non-profit charitable institution exempt from income tax pursuant to § 501(c) (3),¹  Internal Revenue Code of 1954. Additionally, taxpayer is a "private foundation" as defined by § 509(a)²  of the Code. A substantial portion of taxpayer's income is generated by overriding royalty interests in oil and gas acquired by taxpayer in 1963 as gifts. At the time of donation, the donor's adjusted bases in the royalty interests were zero. In 1970, these royalty interests generated $67,875 in gross income for taxpayer.

In its tax return for 1970, taxpayer reported $64,379 net investment income generated by the royalty interests. Pursuant to § 4940³  of the Code, taxpayer paid 4% excise tax on its net investment income in the amount of $2,575. In 1972, however, taxpayer claimed a refund of $1,047 and interest generated by a previously unclaimed depletion deduction of $26,175 to its 1970 gross income. After waiving notice of claim disallowance, taxpayer filed this action for the partial refund of the excise tax paid in 1970.

Taxpayer premised its recovery on the ground that a Treasury regulation interpreting § 4940 erroneously required a cost basis for depletion rather than fair market value as of December 31, 1969. Taxpayer asserted that the regulation was inconsistent with the plain meaning of the underlying statute and was unreasonable. There being no dispute as to the underlying facts, the district court entertained cross motions for summary judgment. The district court then held that the regulation was valid and denied the refund, occasioning taxpayer's appeal.

This is a case of first impression. The legal issue presented is the validity of Treasury regulation § 53.4940-1(e) (2)iii⁴  prescribing a "cost" or "substituted basis" to be used in calculating the depletion deduction available in determining a charitable organization's net investment income. Taxpayer claims that the regulation conflicts with § 4940(c) (4) (B) prescribing a fair market basis for the determination of gain on the disposition of property held by a charitable organization.

In order to successfully challenge the validity of a regulation the taxpayer bears the burden of overcoming the presumption that the regulation is valid. The Supreme Court has declared that ". . . Treasury regulations must be sustained unless unreasonable and plainly inconsistent with the revenue statutes and that they constitute contemporaneous constructions by those charged with the administration of these statutes which should not be overruled except for weighty reasons." Commissioner of Internal Revenue v. South Texas Lumber Co., 333 U.S. 496, 501, 68 S. Ct. 695, 698, 92 L. Ed. 831 (1948). See also Fawcus Machine Co. v. United States, 282 U.S. 375, 378, 51 S. Ct. 144, 75 L. Ed. 397 (1930).

Because the conflicting claims of taxpayer and the government are complex and depend upon the framework of the Code, it is necessary to examine the statutes that give rise to the conflict.

Section 4940 requires tax-exempt charitable foundations to pay 4% excise tax on their net investment income. The purpose of the excise tax is to defray the administrative expense of enforcing the tax laws concerning charitable organizations. Section 4940(c) (1) defines net investment income as follows:

(1) In general. For purposes of subsection (a), the net investment income is the amount by which (A) the sum of the gross investment income and the capital gain net exceeds (B) the deductions allowed by paragraph (3). Except to the extent inconsistent with the provisions of this section, net investment income shall be determined under the principles of subtitle A. (Emphasis added.)

Thus, from the plain language of the statute, in order to determine what constitutes net investment income, the provisions of subtitle A are to be used. If the use of subtitle A in any of its specifics conflicts with a result required under another provision of § 4940, however, then the provision of § 4940 should control.

Permitted deductions to gross investment income are specified in § 4940(c) (3). For purposes of determining net investment income, the provision recognizes deductions which are normally permitted for those engaged in the production of income. Section 4940(c) (3) (B) contains two limitations, however, to the use of "usual" deductions. First, depreciation deductions pursuant to § 167 are limited to those arising under the straight line method. Second, and more germane to the instant case, a depletion deduction is permitted pursuant to § 611.⁵  But the deduction shall not be determined with regard to § 613 (percentage depletion).

The prohibition of the use of § 613 provides an illuminating example of the framework of § 4940. According to the methodology of § 4940(c) (1) if a charitable foundation wished to avail itself of a depletion deduction, it would be permitted under § 4940(c) (3) (B) (ii). Under the normal scheme of subtitle A, the depletion allowance under § 611 could not be less than that specified by § 613.⁶  Because such a use of § 613 conflicts with § 4940(c) (3) (B) (ii), however, § 4940(c) (1) requires that § 4940(c) (3) (B) (ii) control, and the depletion deduction is calculated only with regard to § 611. Subtitle A then takes over and requires that the basis available for depletion is to be determined according to § 612.

At this point in the labyrinths of the Code, the paths and positions of taxpayer and government diverge. According to § 53.4940-1, the basis available to the foundation is the adjusted basis determined in accordance with § 1011, as provided by § 612.⁷  Inexorably proceeding, § 1011 requires, in the instant case, application of § 1015⁸  to determine the basis of property acquired by gift. Section 1015 provides that the basis of the property shall be the adjusted basis of the property in the hands of donor prior to the transfer. Application of this "substitute basis" rule results in taxpayer having a zero basis available for depletion because the property had been fully cost-depleted by the donor. Because taxpayer's basis is zero, application of § 612 and § 611 results in a zero depletion deduction. Therefore, according to the regulation, the depletion deduction is permitted to the charitable foundation but only to the extent of cost,⁹  if the property were purchased, or the basis of the donor, if the property was acquired by gift.

Taxpayer claims that the regulation is in irreconcilable conflict with the provisions of § 4940. Essentially, taxpayer contends that the use of "substitute basis" conflicts with § 4940(c) (4) (B) and, therefore, § 4940(c) (4) (B) must control, as required by § 4940(c) (1). Section 4940(c) (4) (B) provides in pertinent part:

(4) Capital gains and losses. For purposes of paragraph (1) in determining capital gain net income

(B) The basis for determining gain in the case of property held by the private foundation on December 31, 1969, and continuously thereafter to the date of its disposition shall be deemed to be not less than the fair market value of such property on December 31, 1969.

According to taxpayer's construction of the statute, because § 612 provides that the basis for gain on the sale of property shall be the basis used for calculating depletion, § 4940(c) (4) (B) applies rather than § 1011. Taxpayer argues that § 4940(c) (4) (B) does provide the basis for determining gain, and the basis provided is the fair market value. Because the § 1015 substituted basis conflicts with § 4940(c) (4) (B), § 4940(c) (4) (B) controls. Therefore, taxpayer would be able to use a $400,000¹⁰  basis for depletion resulting in a depletion deduction of $26,820. Allowance of the deduction would reduce taxpayer's net investment income thereby generating a refund for the 4% excise tax.

In light of the clear statutory language taxpayer's contention must fail, and we therefore hold that the regulation is valid. Taxpayer fails to overcome the language of § 4940(c) (4) that limits the applicability of § 4940(c) (4) (B) to the determination of net capital gain. According to the plain meaning of § 4940(c) (4), the market value of taxpayer's interest is only to be used in § 4940(c) (1) to determine now much net capital gain is to be included in net investment income. By the section's language, market value basis is limited to use in determining net capital gain. Its use to determine a basis for depletion deduction is plainly outside that limitation. Had the section provided "For the purposes of paragraph (1)" taxpayer's contention would have more merit. The limitation "in determining net capital gain" exists, however, and with those words taxpayer's argument must fail.

In addition to the claim of inconsistency, taxpayer claims that the regulation is unreasonable.¹¹  As we have demonstrated, however, the regulation is not only consistent with the statute, the regulation is compelled by the statute. The regulation only states the result of the operation of the statutory framework. When a regulation is so consistent as to be compelled by the statute, it would be impossible to hold that the regulation is unreasonable unless we would be prepared to hold the statute unreasonable as well. The unreasonableness of the statute has been neither claimed nor argued.

Taxpayer also advances the claim that the regulation is unconstitutional as violative of the Sixteenth Amendment. This claim would more correctly attack the constitutionality of the statute rather than the regulation. Construing the claim as an attack on the statute avails the taxpayer little. Taxpayer neither provides authority for its position for advances a cogent theory of unconstitutionality. Under the circumstances we find taxpayer's claim meritless. First, the depletion deduction is a matter of legislative grace, Parsons v. Smith, 359 U.S. 215, 219, 79 S. Ct. 656, 3 L. Ed. 2d 747 (1959), not constitutionally compelled. Additionally, the purpose for the depletion deduction is the recovery of cost or investment, Parsons v. Smith, supra at 220, 79 S. Ct. 656. Taxpayer, however, had no investment or cost in the royalty interest to recover.

AFFIRMED.