Commissioner of Internal Revenue v. Engle

PETITIONER: Commissioner of Internal Revenue, Philip D. Farmar, et al.
RESPONDENT: Fred L. Engle et ux., United States
LOCATION: Internal Revenue Service Building

DOCKET NO.: 82-599
DECIDED BY: Burger Court (1981-1986)
LOWER COURT: United States Court of Appeals for the Seventh Circuit

CITATION: 464 US 206 (1984)
ARGUED: Oct 11, 1983
DECIDED: Jan 10, 1984
GRANTED: Jan 10, 1983

ADVOCATES:
Carter G. Phillips - on behalf of the Petitioner, Commissioner of Internal Revenue and the Respondent, United States
Marvin K. Collie - on behalf of the Petitioner, Farmar, et al
Thomas J. Donnelly - on behalf of the Respondent, Engle, et ux

Facts of the case

Fred and Mary Engle filed a joint federal income tax return in 1975. During that year, Fred Engle acquired two oil and gas leases covering a total of 240 acres in Wyoming. The Engles claimed a percentage depletion deduction on advance royalties from the oil and gas leases, but the Commissioner of Internal Revenue rejected their claim because the deduction was not based on average daily production from the property’s oil and gas leases, as required by the Commissioner’s interpretation of 26 U.S.C. § 613A of the Internal Revenue Code. The Tax Court upheld the Commissioner’s determination, with one dissent. The United States Court of Appeals, Seventh Circuit, reversed, holding that § 613A authorized depletion allowances on advance royalties so long as there was eventual production from the property.

Also in 1975, the families of Philip D. Farmar and A. A. Sugg, joint owners of 46,515 acres of land in Irion County, Texas, leased their oil and gas interests to various lessees. Under these leases, the Farmars and Suggs received royalties and annual cash bonuses from the lessees. The bonuses were payable even when the property produced no oil or gas. The Farmars and Suggs claimed percentage depletion deductions on both the royalties and bonuses, but the Commissioner disallowed the deductions on the royalties because they were not based on average daily production from the property. In a consolidated suit, the Court of Claims held that Congress only allowed for depletion deductions from actual production during the taxable year.

In the Tax Reduction Act of 1975, Congress eliminated percentage depletion deductions for major oil producers. § 613A(d), however, authorized any qualified independent gas or oil producer or royalty owner to compute the allowance for percentage depletion in accordance with gross income from the property. The act stipulated that the allowance was tied to the taxpayer’s average daily production so as not to exceed the taxpayer’s depletable quantity. The Farmars and Suggs and the Commissioner filed petitions for writs of certiorari; the Supreme Court of the United States granted their petitions and consolidated their cases.

Question

Did 26 U.S.C. § 613A of the Internal Revenue Code authorize percentage depletion deductions on advance royalties and bonuses from oil and gas leases for independent producers?

Media for Commissioner of Internal Revenue v. Engle

Audio Transcription for Oral Argument - October 11, 1983 in Commissioner of Internal Revenue v. Engle

Warren E. Burger:

Mr. Phillips, I think you may proceed whenever you are ready.

Carter G. Phillips:

Mr. Chief Justice, and may it please the Court:

The issue in these consolidated cases is whether Section 613A of the Internal Revenue Code permits a lessor of oil and gas property who receives an advance payment upon the execution of a lease, the advance payment either in the form of a lease bonus or an advance royalty, is entitled to a percentage depletion deduction against those royalties even though no oil or gas allocated to that income is produced during the taxable year.

The facts in both of these cases are not disputed.

In the Farmar case in 1976 taxpayers leased the mineral estate of lands they owned in Texas to two companies interested in oil and gas exploration.

Part of the compensation for that agreement was a substantial lease bonus to be paid in installments, and that was in no way dependent upon the actual production of oil or gas.

Instead, it was based on the acreage of the lease.

Taxpayers also included in that agreement a provision allowing them to receive royalties for any oil or gas actually produced.

During the 1976 tax year oil and gas was extracted from those properties, and a royalty was paid.

Taxpayers in their 1976 federal income tax returns claimed a 22 percent depletion deduction for both the lease bonus payment and the royalty.

In the Engle case in 1975 the taxpayers assigned a lease to properties they had in Wyoming to producers in return for an overriding royalty.

As part of the compensation scheme there the taxpayers in this case received an advance royalty of $7600.

During the 1975 tax year there was, however, no production.

Nevertheless, the taxpayers on their federal income tax returns for 1975 claimed a 22 percent depletion deduction for the advanced royalties that they had received.

In both of these cases the Commissioner assessed a deficiency by disallowing the percentage depletion deductions for payments that were received that had no relationship to any actual production during the taxable year.

The Farmars paid the deficiency and filed suit for return of the monies in the Court of Claims.

The Engles, on the other hand, brought a proceeding in the Tax Court.

The Court of Claims unanimously and the Tax Court by a vote of 14 to 1 upheld the Commissioner's decision and determined that Section 613A did not allow deductions in the absence of production during the taxable year.

The Engles appealed the judgment of the Tax Court to the Seventh Circuit which reversed.

Both the Commissioner and the Farmar's filed separate petitions to this Court.

They were granted and the case consolidated.

Prior to 1975 it was clear that the lease bonuses and advance royalties at issue in this case would have been subject to the percentage depletion deduction.

Prior to 1975 under Section 611 of the Internal Revenue Code which allows a deduction for a reasonable allowance for depreciation and Section 613 which allows a deduction for gross income from the oil or gas producing property this Court had concluded the only statutory condition for allowance of the depletion deduction was the existence of gross income, and since this Court had also concluded that advance payments either in the form of lease bonuses of advance royalties were gross income from the property the deduction was permitted.

Sandra Day O'Connor:

Mr. Phillips, even after 1975 are bonuses and advance royalties income from the property?

Carter G. Phillips:

Yes, ma'am.

I believe they would still remain as income from the property.

Sandra Day O'Connor:

That would be consistent with our decision in Herring, the old decision.

Carter G. Phillips:

Yes, Your Honor.

We do not dispute that decision in this case.

Sandra Day O'Connor:

Well, is there anything in the statute we are talking about here or the amendments that specifically changes the definition of gross income to exclude bonuses and advance royalties or that overrules Herring?