Petitions for Review from the United States Board of Tax Appeals.
Before BUFFINGTON, DAVIS, and THOMPSON, Circuit Judges.
The three above-entitled causes, involving substantially the same questions, were heard together by the United States Board of Tax Appeals and were disposed of in a single opinion.
The issues raised relate to the taxability of a certain stock transaction as hereinafter stated.
In 1917 five persons, M. L. Benedum, F. B. Parriott, J. L. Kirkland, W. E. Wrather, and H. B. Lantz, hereinafter called the lessees, acquired thirty-one undeveloped oil and gas leases, known as the "Duke-Knoles leases," covering approximately 4,000 acres of land, principally in Comanche county, Tex. The lessor retained a one-eighth interest in the leases. Benedum owned six-sixteenths of the leases, Parriott three-sixteenths, Kirkland three-sixteenths, Wrather two-sixteenths, and Lantz two-sixteenths.
In the spring of 1918 drilling for oil was begun by them, and on September 2, 1918, the first well was completed. This well at first produced about 600 barrels daily. The initial work of drilling was begun and paid for by the lessees in proportion to their interests, but on October 31, 1918, they incorporated the Tex-Penn Oil Company, hereinafter called "Tex-Penn," under the laws of West Virginia, with a capitalization of $2,000,000, consisting of 80,000 shares of stock of $25 par value per share, for the purpose of taking over the development and operation of the leases.
Upon its organization the lessees subscribed for 4,000 shares in proportion to their interests in the leases. Cash to the amount of $100,000 was paid in for this stock which was immediately paid back by Tex-Penn to the lessees for a two-eighths interest in the leases. The lessees thus reserved a five-eighths interest in the leases, one-hlaf of which was to be paid to Parriott, president and manager of Tex-Penn, to make up any deficit in its operation. A further reservation was made giving the lessees the right to purchase within five years the remainder of the Tex-Penn stock at par.
During the latter part of 1918 and the early part of 1919, Parriott, representing himself and the other lessees, purchased 9,120 shares of the stock of Tex-Penn, paying $25 a share, or an aggregate of $228,000. This added to the 4,000 shares made the total number of shares of stock outstanding and owned by the lessees 13,120. The total of $228,000 paid for the stock was spent by Tex-Penn in the development of the leases.
Tex-Penn continued the development of the leases, and on December 28, 1918, a well known as "G. W. Knoles No. 1" was drilled and produced 500 barrels daily. Later, in January of 1919, this well was deepened and it immediately began to produce 6,000 barrels daily. By July, 1919, twelve wells had been drilled upon the properties. The first well produced 600 barrels daily, the second 6,000, as above stated, the third gas, the fourth gas, the fifth 100, the sixth 25, the seventh gas, the eighth 120, the ninth 130, the tenth 530, the eleventh 50, and the twelfth was dry.
Early in 1919 Benedum and Parriott conceived the idea of consolidating various oil producing and refining properties and distributing facilities into a single company so as to constitute an integrated unit with facilities for the production, refining, and distribution of oil and gas product. At that time they were interested in or owned three other corporations known as the "Riverside Eastern Oil Company," incorporated under the laws of West Virginia, and the "Pittsburgh-Texas Oil & Gas Company," also incorporated under the laws of West Virginia. It was proposed to consolidate the properties of these companies with those of Tex-Penn and with the five-eighths interest in the Duke-Knoles leases which the lessees had reserved.
After conferring with certain bankers of Philadelphia and New York, the Transcontinental Oil Company, hereinafter called "Transcontinental," was incorporated under the laws of Delaware on June 18 1919, with 2,000,000 shares of stock of no par value "for the purpose of creating in this single corporation an integrated unit combining all the phases of the oil business from the production of crude oil to the marketing of the refined products."
The original estimate of cash necessary to carry out this transaction was $23,000,000 allocated as follows: $8,500,000 for working capital for Transcontinental; $12,000,000 to the five lessees as compensation for Tex-Penn properties, and for their individual interests in the Riverside Eastern and Western Companies and the Pittsburgh-Texas Oil & Gas Company; $1,250,000 each to the Riverside Companies to pay off their preferred stock at par.But the bankers, who were to finance this enterprise, were unable to raise more than $20,000,000 which required a deduction of $3,000,000 in order to put through the deal. It was proposed that the lessees consent to a reduction of $3,000,000 from the $12,000,000 they were to receive, but none would agree to a reduction except Benedum, who consented to a reduction of the entire $3,000,000 from his share.
Accordingly, there was conveyed to Transcontinental, the Tex-Penn properties, the five-eighths interest of the lessees in the leases, and all the properties of the Pittsburgh-Texas, Riverside Eastern and Riverside Western Companies. The bankers agreed to purchase 500,000 shares of Transcontinental at $40 per share, amounting to $20,000,000 to be turned over to Transcontinental "to be used by it as working capital and for the acquirement of its properties." The bankers were to receive 25,000 shares of Transcontinental stock as their commission and further were to have the right to purchase 225,000 additional shares as $1 per share.
In the acquisition of the various properties by Transcontinental, Mr. J. M. Holliday acted as agent for that company and the bankers, and Parriott represented the lessees and Tex-Penn.
The plan was carried out. The Tex-Penn properties were to be transferred to Transcontinental free and clear of all encumbrances. In order to make a reliable estimate of the necessary amount, Transcontinental had an auditor examine the books of Tex-Penn, and it was his opinion that it would require $350,000 in addition to the $286,891.29 available for that purpose.
Three of the lessees, Wrather, Kirkland, and Lantz, did not want to continue with Transcontinental and demanded their share in cash rather than stock. They owned seven-sixteenths of the five-eighths interest of the lessees in the oil leases on the tract of land known as "Duke-Knoles Pool." Their share amounted to $5,250,000 and this they were to receive in cash. Accordingly Transcontinental paid and issued its stock as follows:
Riverside Eastern $1,250,000 41,666
Riverside Western 1,250,000 41,667
Parrio tt, attorney 5,250,000 . . .
Benedum and Parriott 3,400,000 1,007,834