Gaudreau et al v. United States of America

Filing 29

MEMORANDUM AND ORDER - It is ordered that plaintiffs' Motion for Summary Judgment 23 is denied. Defendant's Motion for Summary Judgment 21 is granted, and defendant is awarded judgment on plaintiffs' claims. Signed by District Judge John W. Lungstrum on 12/29/2014. (ses)

IN THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF KANSAS

BRIAN T. GAUDREAU and
ELIZABETH A. GAUDREAU,

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Plaintiffs,
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v.
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UNITED STATES OF AMERICA,
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Defendant.
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_______________________________________)

Case No. 13-1180-JWL

MEMORANDUM AND ORDER
Plaintiffs filed this case seeking refunds of federal income taxes. This matter
presently comes before the Court on cross-motions for summary judgment filed by
plaintiffs (Doc. # 23) and defendant United States (Doc. # 21). As more fully set forth
below, the Court concludes as a matter of law that plaintiff Brian Gaudreau did not have
an “economic interest” in certain oil and gas deposits, and that plaintiffs therefore are not
entitled to the depletion deduction and capital gains treatment that they seek.
Accordingly, the Court denies plaintiffs’ motion for summary judgment, and it grants
summary judgment in favor of defendant on plaintiffs’ refund claims.

I.

Background

The following facts are undisputed. Plaintiffs Brian and Elizabeth Gaudreau are
a husband and wife residing in Wichita, Kansas. On November 1, 1988, Brian Gaudreau
began his employment with Stelbar Oil Corporation (“Stelbar”). At the same time,
Stelbar and Mr. Gaudreau executed an “Employee’s Incentive Agreement” (the
“Agreement”). In the Agreement, Stelbar promised to pay Mr. Gaudreau “bonuses”
equal to a percentage of the net income produced by oil and gas properties purchased by
Stelbar through the efforts of Mr. Gaudreau. Mr. Gaudreau eventually received
payments under the Agreement for properties acquired in 1990, 1994, and 1997.
The present case concerns income received by Mr. Gaudreau under the
Agreement in 2006, 2007, and 2008. In their joint tax returns for those years, plaintiffs
treated that income as regular income. Plaintiff subsequently filed amended returns in
which they claimed depletion deductions (for income from proceeds on producing
properties) and capital gains treatment (for income from the sale of properties by Stelbar)
for income received under the Agreement. Defendant denied or failed to act on
plaintiffs’ refund claims. Plaintiffs have thus brought this action for refunds pursuant
to 26 U.S.C. § 7422. Specifically, plaintiffs seek refunds in the amounts of $485,632 for
2006, $19,167 for 2007, and $5,202 for 2008.

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II.

Analysis

Each side seeks summary judgment on plaintiffs’ claims. Summary judgment is
appropriate if the moving party demonstrates that there is “no genuine dispute as to any
material fact” and that it is “entitled to a judgment as a matter of law.” See Fed. R. Civ.
P. 56(a).
The Internal Revenue Code allows for a depletion deduction for “mines, oil and
gas wells, other natural deposits, and timber.” See 26 U.S.C. § 611. The applicable
regulation, Treasury Regulation § 1.611-1, provides that such a deduction may only be
taken by an owner of an “economic interest” in the mineral deposits, as follows in
relevant part:
Annual depletion deductions are allowed only to the owner of an
economic interest in mineral deposits or standing timber. An economic
interest is possessed in every case in which the taxpayer has acquired by
investment any interest in mineral in place or standing timber and secures,
by any form of legal relationship, income derived from the extraction of
the mineral or severance of the timber, to which he must look for a return
of his capital. . . . A person who has no capital investment in the mineral
deposit or standing timber does not possess an economic interest merely
because through a contractual relation he possesses a mere economic or
pecuniary advantage derived from production. For example, an agreement
between the owner of an economic interest and another entitling the latter
to purchase or process the product upon production or entitling the latter
to compensation for extraction or cutting does not convey a depletable
economic interest.
See 26 C.F.R. § 1.611-1(b)(1); see also, e.g., United States v. Swank, 451 U.S. 571, 57980 (1981) (applying this regulation). This regulation, which has remained essentially the
same since it was first promulgated in 1939, was based on language from the Supreme

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Court’s opinions in Palmer v. Bender, 287 U.S. 551 (1933), and Helvering v. Bankline
Oil Co., 303 U.S. 362 (1938). See Parsons v. Smith, 359 U.S. 215, 221-23 (1959) (citing
Palmer, 287 U.S. at 557, and Bankline, 303 U.S. at 367).
The Supreme Court has explained the depletion deduction as “resting ‘on the
theory that the extraction of mineral gradually exhausts the capital investment in the
mineral deposit,’ and therefore the depletion allowance permits ‘a recoupment of the
owner’s capital investment in the minerals so that when the minerals are exhausted, the
owner’s capital is unimpaired.’” See Swank, 451 U.S. at 576 (quoting Commissioner of
Internal Revenue v. Southwest Exploration Co., 350 U.S. 308, 312 (1956)). In Palmer,
the Supreme Court first set forth the relevant test as follows:
The language of the statute is broad enough to provide, at least, for every case in
which the taxpayer has acquired, by investment, any interest in the oil in place,
and secures, by any form of legal relationship, income derived from the extraction
of the oil, to which he must look for a return of his capital.
See Palmer, 287 U.S. at 557. The Supreme Court subsequently divided the test for
determining whether there is the required “economic interest” into two distinct prongs,
see Southwest Exploration, 350 U.S. at 314, set forth by the Tenth Circuit as follows:
(1) there must be an interest, acquired by capital investment, in the
minerals in place; and (2) the return on the investment must be realized
solely from the extraction of the minerals.
See Freede v. Commissioner of Internal Revenue, 864 F.2d 671, 673-74 (10th Cir. 1988)
(citations omitted); see also Rissler & McMurray Co. v. United States, 480 F.2d 684, 686
(10th Cir. 1973) (stating the “economic interest” test as having these two prongs).

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The parties agree that the same “economic interest” test should be used to
determine whether plaintiffs are entitled to capital gains treatment in this case. See
Briscoe v. United States, 536 F.2d 353, 357 (Ct. Cl. 1976) (applying the same “economic
interest” test for the depletion allowance to the issue of capital gains treatment) (citing
Wood v. United States, 377 F.2d 300, 305 (5th Cir. 1967)); see also United States v.
White, 401 F.2d 610, 613 (10th Cir. 1968) (noting that the “economic interest” test from
Palmer came to be used to decide whether a transaction was a sale or lease in capital
gains cases).
Thus, both the depletion refund claims and the capital gains refund claims in this
case turn on whether Mr. Gaudreau had an economic interest as defined by the Supreme
Court and Regulation 1.611-1. In their cross-motions for summary judgment, both sides
argue that the issue may be decided at this stage as a matter of law.
The Court first addresses the first prong of the test. Plaintiffs concede, and the
Supreme Court cases and the applicable regulation confirm, that Mr. Gaudreau must
have made an investment of capital in order to have acquired the requisite economic
interest. Plaintiffs do not argue that Mr. Gaudreau invested any real property, money,
or other personal property to the development of the minerals on these properties.
Rather, plaintiffs argue that the time, skill, and experience provided by Mr. Gaudreau in
locating properties for Stelbar constituted a capital investment for purposes of providing
him with an economic interest. The Court rejects that argument as a matter of law.
The Court concludes that the Supreme Court’s requirement of an investment of
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capital does not allow for the contribution only of such traits as time, skill, and expertise.
The use of the word “capital” clearly connotes an investment of real property, money (or
its equivalent), or other personal property. Plaintiffs have not cited any authority
suggesting that a person may make a “capital investment” of mere service or of such
traits not constituting property, nor has the Court located any such authority. In fact, in
Parsons, the Supreme Court rejected the argument by certain taxpayers seeking a
depletion allowance “that by their contracts to mine the coal, and particularly by
contributing their equipment, organizations and skills to the mining projects as required
by those contracts, they, in legal effect, made a capital investment in, and thereby
acquired an economic interest in, the coal in place.” See Parsons, 359 U.S. at 224
(emphasis added). The Supreme Court ruled in that case that the taxpayers had only
obtained an economic advantage from the production of the mineral, and not an
economic interest, and thus had not made a capital investment in those minerals in place.
See id. at 224-26. The Court has also located one case in which the United States Tax
Court concluded that an engineering company, which had received an assignment of a
mineral interest in exchange for consulting services, had not made a capital investment,
as required under the Palmer test. See James A. Lewis Eng’g, Inc. v. Commissioner of
Internal Revenue, 39 T.C. 482, 491-92 (1962), aff’d on other grounds, 339 F.2d 706 (5th
Cir. 1964). Thus, the Tax Court ruled that the engineering company was not entitled to
an exception provided by the IRS for drillers and equipment dealers who acquire
economic interests through capital expenditures, with respect to the question of whether
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the company had received taxable income. See id.1
Moreover, in Freede, the Tenth Circuit found it “telling” that the Supreme Court
had found an economic interest in only one case—Southwest Exploration—in which “a
fee or leasehold interest in the mineral property was lacking.” See Freede, 864 F.2d at
674. In Southwest Exploration, certain property owners received a share in net profits
from a drilling operation using their property to access deposits lying off the coast of
California. See Southwest Exploration, 350 U.S. at 309. In finding that the property
owners had an economic interest for purposes of the depletion allowance, the Court
relied on the fact that state law required the consent of the property owners for the driller
to acquire the drilling rights, which meant that the property owners had played a “vital
role,” without which there would have been no production. See id. at 315. The driller
expressed its concern to the Court about the possible difficulty in limiting the allowance
“in instances of strangers ‘disassociated from the lease’ who may have contributed an
essential facility to the drilling operation in return for a share of the net profits.” See id.
at 316. In response, the Court noted that the property owners in that case could hardly
be said to be “disassociated from the lease,” and it stressed that its holding was limited

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Because it affirmed the Tax Court on another basis, the Fifth Circuit determined
that it was not necessary to determine “whether there is an exception for compensation
in the form of an assignment of a depletable interest in oil for the engineering services
performed by the petitioner.” See James A. Lewis Eng’g, Inc. v. Commissioner of
Internal Revenue, 339 F.2d 706, 709 (5th Cir. 1964). The Fifth Circuit offered, however,
that on that question, it “would have great difficulty accepting a construction of the Code
that would fly in the face of the general provisions of the tax laws to the effect that
compensation for services must be returned as a part of gross income.” See id.
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to the circumstances of that case, in which “a party essential to the drilling for and
extraction of oil had made an indispensable contribution of the use of real property
adjacent to the oil deposits.” See id. at 316-17; see also Freede, 864 F.2d at 674-75
(noting that the Supreme Court in Southwest Exploration was careful to limit its holding
to the facts before it).
Thus, the Tenth Circuit has emphasized that the Supreme Court has found an
economic interest in the absence of an actual legal interest in the mineral deposit only
in one case involving special circumstances in which the investment of real property was
essentially required by state law. In light of that pattern of rulings noted by the Tenth
Circuit, this Court is convinced that neither the Tenth Circuit nor the Supreme Court
would consider Mr. Gaudreau to have acquired an economic interest based on an
investment of capital in this case, in which he did not acquire any legal interest in the
minerals and did not contribute any real or personal property, but instead invested only
his time, skill, and expertise.
The Court does not agree with plaintiffs that the present case is analogous to
Southwest Exploration. Again, in that case, the Supreme Court relied on the fact that the
involvement of the adjacent property owners was essentially required by state law, and
it was careful to note the “vital” and “essential” role played by those owners, without
whose participation, there would have been no production. Mr. Gaudreau’s role in the
mineral development and production in this case was far less crucial. Plaintiffs insist
that no production would have occurred if Mr. Gaudreau had not first located the
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properties. Mr. Gaudreau’s involvement was not required for the production to occur,
however, as Stelbar might have located those same properties without his help.
Certainly, his locating services do not equate with the contribution of a real property
interest by the landowners, as required by law, to which circumstances the Supreme
Court limited its ruling in Southwest Exploration. Thus, that case does not compel or
even weigh in favor of finding an economic interest here.
Plaintiffs’ claims are also doomed by a consideration of the second prong of the
“economic interest” test from the Supreme Court, which requires that the return on the
capital investment be realized solely from the extraction of the minerals. Plaintiffs argue
that Mr. Gaudreau was compensated for his investment of his time, skill, and experience
(in locating properties for Stelbar to purchase) only through payments under the
Agreement. Specifically, plaintiffs argue that Mr. Gaudreau’s regular salary served as
compensation only for his duties for Stelbar as a landman (which compensation was
consistent with that received by landmen at similar companies), and that his additional
work locating properties was therefore compensated only through the payments under
the Agreement based on the extraction of minerals.
That argument, however, is effectively rebutted by the terms of the Agreement.
The Agreement provided that Mr. Gaudreau was an employee of Stelbar who would be
involved with the activities of a new division that would purchase oil and gas properties;
that the “bonus” arrangement furthered Stelbar’s desire to provide Mr. Gaudreau with
“incentives” to encourage his continued employment and dedication to the success of the
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new division; and that the Agreement was to be deemed a supplement to Mr. Gaudreau’s
basic employment agreement. Thus, the language of the Agreement does not support the
interpretation that Mr. Gaudreau was separately compensated for his landman duties by
his regular salary and for his property-location duties by the bonus payments; rather, the
Agreement indicates that Mr. Gaudreau’s regular duties as an employee of Stelbar would
include work locating properties for the new division, and that the bonus payments were
intended to provide a supplement to his regular salary as an additional incentive for his
good work for that division and for his continued employment. Thus, the Agreement
indicates that Mr. Gaudreau could also look to his regular salary for a return on his
investment of his time, skill, and experience in locating properties.
Moreover, under the Agreement, Mr. Gaudreau would share in profits not only
from the extraction of minerals by Stelbar, but also from the sale of the properties
themselves. Indeed, plaintiffs’ capital gains claims relate to that latter form of income
under the Agreement. Thus, Mr. Gaudreau’s entire interest under the Agreement—
including his investment of time, skill, and experience in locating a property—was not
necessarily compensated solely from the extraction of the minerals, as he could still
receive a share in any additional profit from the sale of that particular property. As the
Supreme Court stated in Southwest Exploration:
The second factor has been interpreted to mean that the taxpayer must
look solely to the extraction of oil or gas for a return of his capital, and
depletion has been denied . . . where payments might have been made
from a sale or any part of the fee interest as well as from production.

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See Southwest Exploration, 350 U.S. at 314 (citing Anderson v. Helvering, 310 U.S. 404,
412-13 (1940)); see also Rissler, 480 F.2d at 687-88 (Tenth Circuit concluding that
second prong of test was not satisfied where the contracts that provided for profits from
extraction also provided for other payments).
Plaintiffs argue that the so-called Parsons factors weigh in favor of finding an
economic interest in this case, but the Court does not agree. In Parsons, the Supreme
Court pointed to seven facts that supported its rejection of a claim of an economic
interest. See Parsons, 359 U.S. at 225. Because those facts were particular to that case,
they are not especially helpful as a test for all cases. Nevertheless, the Court notes that
a number of similar circumstances are also present here—Mr. Gaudreau’s investment
was not in the mineral in place (but was instead in providing a service locating
properties); the landowner (Stelbar) did not surrender or agree to surrender an actual
capital interest in the mineral in place; and the mineral at all times belonged to others.
See id. In Parsons, the Court particularly relied on the fact that although “the parties
might have provided in their contracts that petitioners would have some capital interest
in the coal in place,” “they did not do so—apparently by design.” See id. Similarly, in
the present case, the Agreement did not convey to Mr. Gaudreau any interest in the
minerals; rather, the Agreement specifically provided that Mr. Gaudreau would receive
only “bonuses”, and that he did not receive any ownership interest in the properties.
Thus, the Court cannot say that the Supreme Court’s reliance on certain facts in Parsons
to reject a claim of an economic interest should lead to the opposite result in this case.
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In other words, plaintiffs may be able to distinguish Parsons from this case on the facts,
but distinguishing that case does not make up for the failure to satisfy the requirements
(recognized in Parsons) of a capital investment and having to look solely to extraction
for return of that investment.
Similarly, the Court does not agree that certain factors listed by the Tenth Circuit
in Freede weigh in plaintiffs’ favor. In that case, the court stated as follows:
Whether there is an “interest” in minerals in place depends upon an
evaluation of various factors, including: (1) the degree of legal interest in
the minerals; (2) whether there is significant control over the mineral
deposits; (3) the extent of contribution to the development or operation of
the mineral extraction; (4) risk of loss; and (5) whether the interest is
necessarily depleted as the mineral is extracted.
See Freede, 864 F.2d at 674 (citations omitted). The first factor is not satisfied here, as
Mr. Gaudreau did not obtain any legal interest in the oil and gas on Stelbar’s properties.
As discussed above, with respect to this first factor, the Freede court noted that only in
a single case, Southwest Exploration, had the Supreme Court found an economic interest
in the absence of a fee or leasehold interest in the mineral property, and the Tenth Circuit
stressed that in that case, at least the third factor had been met. The third factor does not
weigh in plaintiffs’ favor in the present case, however, as Mr. Gaudreau’s contribution
to the development and operation of the mineral extraction was minimal, consisting only
of his identification of the property as a potential target for purchase by his employer (at
which time his involvement ended). Nor is the second factor satisfied here, as the
Agreement gave Mr. Gaudreau no control over the mineral deposits. With respect to the

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fourth factor, Mr. Gaudreau did not risk losing any investment of real or personal
property. Finally, with respect to the fifth factor, the Court notes (as it noted above) that
Mr. Gaudreau’s entire interest under the Agreement was not necessarily depleted as the
minerals were extracted from a property because he could still receive a share in any
profit from the sale of the real property itself; and he was still compensated for any
investment of time as an employee of Stelbar. Thus, these factors identified by the Tenth
Circuit weigh overwhelmingly against finding an economic interest in this case (even
apart from the failure to satisfy the two-part test from the Supreme Court and the
regulation).
Much of plaintiffs’ argument focuses on their insistence that the Agreement
provided Mr. Gaudreau with a “net profits interest” in the minerals. Whether or not that
is the case (the Agreement does not contain any such language), plaintiffs have not
provided persuasive authority that the existence of such an interest alone is sufficient to
satisfy the requirement of an economic interest under the Supreme Court’s test and the
regulation. Plaintiffs rely on language from Burns v. Commissioner of Internal Revenue,
78 T.C. 185 (1982), in which the Tax Court, in explaining what a “net profits interest”
is, included the following description from a treatise: “A net profits interest is an
economic interest in oil and gas and is accordingly entitled to the depletion allowance.”
See id. at 209 (citing H. Williams & C. Meyers, Oil and Gas Terms 362 (4th ed. 1976)).
Although that statement seems absolute, the Court cannot conclude that the Tax Court
intended to rule that all net profits interests qualify for the depletion deduction. Indeed,
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in the same opinion, the Tax Court appreciated the distinction that not all net profits
interests were necessarily economic interests, in noting the following: “Numerous
Supreme Court cases deal with net profits interests but the tax implications in those cases
were not whether a given interest was a net profits interest, but rather whether a given
net profits interest was an economic interest entitling its holder to a deduction for
depletion.” See id. at 208. Moreover, in one of the cases cited by the Tax Court for that
statement, Kirby Petroleum Co. v. Commissioner of Internal Revenue, 326 U.S. 599
(1946), the Supreme Court ruled that a right to share in net profits could qualify for the
depletion allowance, but it emphasized that such an interest must amount to an economic
interest based on a capital investment in order to qualify. See id. at 606. Thus, even if
Mr. Gaudreau’s interest could be considered a net profits interest, that fact alone does
not compel a finding of an economic interest here if the requirements for such an
interest—including an investment of capital and the return of that investment solely from
extraction—have not been met.
Plaintiffs also cite to IRS Private Letter Ruling2 200102010, 2001 WL 30741
(Jan. 12, 2001), in which the IRS noted that, under Treasury Regulation § 1.614-1(a)(2),
26 C.F.R. § 1.614-1, the term “interest” means an economic interest in a mineral deposit
and includes net profits interests. That regulation does not state, however, that all net

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Private letter rulings are not binding authority, but may be cited as evidence of
agency interpretation; a court should not defer to an agency’s interpretation of a statute,
however, if that interpretation conflicts with the plain language of the statute. See True
Oil Co. v. Commissioner of Internal Revenue, 170 F.3d 1294, 1032 (10th Cir. 1999).
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profits interests qualify as economic interests. Even if it did mean that, “net profits
interest” would have to be defined in that context to include all requirements for an
economic interest under the Supreme Court’s interpretation of the depletion allowance
and Regulation 1.611-1—which require satisfaction of the two-prong test. Regulation
1.614-1 certainly does not compel the conclusion that Mr. Gaudreau’s interest in net
profits under the Agreement constitutes an economic interest that qualifies for the
depletion allowance.
Accordingly, Mr. Gaudreau cannot satisfy either prong of the applicable test, and
the Court therefore concludes as a matter of law that Mr. Gaudreau did not acquire an
economic interest in the minerals in this case.

Just as a mere agreement for

compensation for extraction of a mineral does not convey a depletable economic interest,
see Treas. Reg. 1.611-1(b)(1), neither does Mr. Gaudreau’s compensation for locating
services qualify as an economic interest in this case—in the parlance of the Supreme
Court and the regulation, Mr. Gaudreau obtained only an economic advantage.
Therefore, plaintiffs are not entitled to the depletion deductions or the capital gains
treatment that they seek. Summary judgment is thus warranted in favor of defendant,
and plaintiffs’ motion for summary judgment must be denied.

IT IS THEREFORE ORDERED BY THE COURT THAT plaintiffs’ motion for
summary judgment (Doc. # 23) is hereby denied.

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IT IS FURTHER ORDERED BY THE COURT THAT defendant’s motion for
summary judgment (Doc. # 21) is hereby granted, and defendant is awarded judgment
on plaintiffs’ claims.

IT IS SO ORDERED.

Dated this 29th day of December, 2014, in Kansas City, Kansas.

s/ John W. Lungstrum
John W. Lungstrum
United States District Judge

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