Summary
In Inaja Land Co. v. Commissioner, 9 T.C. 727, 736 (1947), because it was impossible to allocate with reasonable accuracy a separate cost to easements the taxpayer sold, the Court allocated the taxpayer's cost of underlying land to funds received on sale of the easements.
Summary of this case from Gladden v. Comm'r of Internal RevenueOpinion
Docket No. 9036.
1947-10-21
INAJA LAND COMPANY, LTD., A CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Harrison Harkins, Esq., for the petitioner. E. C. Crouter, Esq., for the respondent.
1. The payment of the sum of $50,000 to petitioner in 1939 by the city of Los Angeles in consideration of the conveyance by it to the city of a right of way and certain easements to divert foreign waters into the Owens River as it flowed through petitioner's land, and releasing the city from all claims and demands, etc., did not constitute taxable income to petitioner under section 22(a), I.R.C.
2. Since, under the circumstances, it was practically impossible to allocate a basis to the easements granted, the net amount received, being less than the petitioner's basis for the entire property, will merely reduce that basis. Burnet v. Logan, 283 U.S. 404. Harrison Harkins, Esq., for the petitioner. E. C. Crouter, Esq., for the respondent.
This proceeding involves deficiencies in Federal income and declared value excess profits taxes for the taxable year 1939 in the amounts of $8,777.22 and $5,393.51, respectively.
The issue is whether petitioner received taxable income of $48,945 under a certain indenture of August 11, 1939, whereby it granted the city of Los Angeles, California, certain easements over its land and settling all claims arising out of the release of foreign waters from the city's Mono Craters Tunnel project. Certain facts have been stipulated and are so found. Facts found other than those stipulated are found from the evidence.
FINDINGS OF FACT.
Petitioner is a stock corporation, organized under the laws of California, with its principal office at 816 South Figueroa Street, Los Angeles, California. Petitioner's income and declared value excess profits tax return for the calendar year 1939 and its capital stock tax return for the fiscal year ended June 30, 1939, were filed with the collector of internal revenue for the sixth district of California.
On or about January 26, 1928, petitioner acquired approximately 1,236 acres of land in Mono County, California, together with all water and water rights appurtenant or belonging thereto, at a cost of approximately $61,000. This property was located along the banks of the Owens River, which flows through and over petitioner's land, involved in this controversy. The land was 2 1/2 miles long and 1 1/2 miles wide at its farthest extremities and included the following classifications:
+-------------------------------+ ¦ ¦Acres ¦ +-----------------------+-------¦ ¦Rocky hill lands ¦419 ¦ +-----------------------+-------¦ ¦Irrigated rocky pasture¦195 ¦ +-----------------------+-------¦ ¦Dry rocky pasture ¦104 ¦ +-----------------------+-------¦ ¦Irrigated meadows ¦358 ¦ +-----------------------+-------¦ ¦Dry tillable brush ¦160 ¦ +-----------------------+-------¦ ¦Total ¦1,236 ¦ +-------------------------------+
When the property was acquired in 1928 there were two small cabins or shacks located thereon. In 1940 petitioner purchased and moved onto the property two cabins, one to replace the southwest cabin and the other as an addition to the caretaker's cabin. In the years prior to 1939, with the consent of the board of directors, four members, at their own expense, had each erected a cabin for his own use, and in 1940 two members at their own expense each purchased and moved onto the property an additional cabin.
Petitioner's purpose in acquiring its properties was to operate a private fishing club thereon, with incidental rental of its properties for grazing livestock. It has conducted these activities since the time of its incorporation to date.
Petitioner's organization consists of twenty-five members, each owning twenty shares of stock. It has a president, a vice president, a secretary-treasurer, an assistant secretary, and a board of five directors. The members pay no dues, but the stock is assessable. An annual assessment, with the exception of one or two years, has been levied to cover expenses and amortization of loans.
The principal value of petitioner's lands to petitioner arose from the fishing facilities offered by the Owens River as it flowed through and over petitioner's land; but it also had some value for grazing purposes. The property was not used for agricultural purposes, other than livestock grazing. Aside from the receipt of the amount in controversy, the only sources of income are, and have been, its receipts from guest card fees and its receipt of grazing rentals. The amounts of guest card fees received by petitioner in the years 1939 to 1946, inclusive, and the amount of grazing rentals for the years 1936 to 1946, inclusive, are as follows:
+-------------------+ ¦ ¦Guest¦Grazing ¦ +----+-----+--------¦ ¦Year¦fees ¦rentals ¦ +----+-----+--------¦ ¦1936¦ ¦$300 ¦ +----+-----+--------¦ ¦1937¦ ¦300 ¦ +----+-----+--------¦ ¦1938¦ ¦300 ¦ +----+-----+--------¦ ¦1939¦$330 ¦300 ¦ +----+-----+--------¦ ¦1940¦310 ¦300 ¦ +----+-----+--------¦ ¦1941¦130 ¦550 ¦ +----+-----+--------¦ ¦1942¦105 ¦550 ¦ +----+-----+--------¦ ¦1943¦145 ¦1,000 ¦ +----+-----+--------¦ ¦1944¦110 ¦1,000 ¦ +----+-----+--------¦ ¦1945¦275 ¦1,000 ¦ +----+-----+--------¦ ¦1946¦340 ¦1,000 ¦ +-------------------+
Each stockholder is entitled to the use of the properties for guests for not exceeding eight guest days a season, and each day or fraction of a day a guest uses the privileges of petitioner is counted as one guest day. The fee collectible, either from the stockholder or the guest, is $5 per day. Petitioner's rules regarding guests and guest card fees are designed to restrict the number of guests and not to develop a source of revenue. The decline in guest card fee receipts following 1939 was due in part to poor fishing on account of increased flow and muddy water and, in later years, to gasoline rationing. The increase in grazing rental following the year 1939 was not due to any increase in grazing area or the number of grazing cattle, but to the fact that higher prices for cattle and cattle fodder enabled petitioner to demand higher grazing rentals, and for the year 1943 and subsequent years the leases were revised to free the lessee from the requirement of maintaining two men to keep poachers off petitioner's property.
The Department of Water and Power of the City of Los Angeles, a municipal corporation, is responsible for the construction, operation, and maintenance of the water supply of that city. On or about September 25, 1934, the Department of Water and Power commenced the construction of Mono Craters Tunnel in Mono County (the west portal of this tunnel being in Mono Basin and the east portal being in the Owens River Drainage Basin.) On or about January 18, 1940, the westerly aqueduct connecting this tunnel with Grant Lake Storage Reservoir was completed. On or about April 4, 1940, the first diversion of Mono Basin waters into the west portal of the tunnel was commenced. The east portal of the Mono Craters Tunnel opens into the Owens River at a point approximately two miles up the river from petitioner's property. In the operation of the Mono Craters Tunnel the city of Los Angeles has stored waters in the Grant Lake Storage Reservoir and Walker Lake, and natural storage has occurred in unregulated lakes, all in the Mono Basin. The object of the tunnel project was, and the result accomplished is, to divert waters which would naturally remain in the Mono Basin into the Owens River at a point upstream from petitioner's lands. These waters flow through or over petitioner's lands. The waters are recaptured from the river by the city at a point below petitioner's lands and are diverted into the water supply system of the city of Los Angeles. The waters flowing out of or released from the east portal of the Mono Craters Tunnel are ‘foreign waters‘ (that is, waters brought into the watershed from another source by artificial means) with respect to the Owens River Drainage Basin, and would not naturally flow into this river if it were not for the tunnel.
During the entire period of the construction of the Mono Craters Tunnel, seepage waters from the tunnel in a substantial amount of between 10 and 15 cubic second feet flowed out of the east portal of the tunnel into the Owens River and through and over petitioner's lands. These seepage waters were polluted to a substantial extent by concrete dust, sediment, and foreign matter, which injured and killed fish and interfered with the fishing on petitioner's lands.
Prior to the settling of the rights of petitioner and the city of Los Angeles by the execution of an indenture dated August 11, 1939, except as hereinafter stated, the city was not possessed of, and had not acquired, either by way of condemnation, prescription, user, grant or license, any right to divert, release, or suffer the release of waters into the Owens River in such a manner that such waters would flow through or over petitioner's lands, or to deposit or permit the deposit of foreign matter in or to pollute the Owens River as it flowed through petitioner's land; nor had the city compensated petitioner in respect to these matters. Petitioner had not given the city any release or acquittance with respect thereto, except for the period from November 12 to December 2, 1935, when petitioner gave the city a revocable license to ‘dump‘ waters into the river, and the city engineer was given permission to enter on petitioner's lands for the purpose of making surveys.
Between September 25, 1934, the date the Mono Craters Tunnel project was commenced, and August 11, 1939, petitioner and its attorneys complained to the city and its officials concerning trespasses and invasions by the city and its employees and against unauthorized fishing and poaching by city employees upon petitioner's lands and rights. Petitioner threatened to institute injunctive and other legal proceedings. After extended negotiations, petitioner and the city entered into an arm's length agreement settling their differences on August 11, 1939. The indenture of August 11, 1939, after reciting that petitioner, grantor, is the owner of certain described lands and that the city of Los Angeles, as grantee, is constructing and intends to construct a tunnel known as Mono Craters Tunnel, contains the further recital, covenants and provisions material hereto, as follows:
(e) WHEREAS, a dispute has arisen between the parties hereto wherein Grantor claims that it has been and is being damaged by reason of the discharge into said Owens River, at a point upstream from Grantor's land, of foreign waters, and that such damage will continue henceforth, and in a greater degree when said tunnel is completed and in use, and said Grantor has threatened to sue for damages and for an injunction, and the Grantee desires to obtain from Grantor the right to discharge all such foreign water into said river in the future, and the parties hereto are desirous of settling their differences, and for these purposes the parties have executed, delivered and accepted this indenture for the hereinafter mentioned consideration, rights and covenants.
I. FOR AND IN CONSIDERATION of the sum of Fifth Thousand Dollars ($50,000.00), lawful money of the United States, paid by the Department of Water and Power of The City of Los Angeles, receipt of which is hereby acknowledged by Grantor, and of the covenants, conditions and promises on the part of Grantee herein contained:
(A) The Grantor has released and forever discharged and by these presents does for itself, its successors and assigns, release and forever discharge The City of Los Angeles and the said Department of Water and Power of said City of and from all manner of actions, causes of action, suits, controversies, trespasses, damages, claims and demands whatsoever, in law or in equity, which it now has, or ever had, or may have against said City and said Department of Water and Power by reason of the discharging, releasing and emptying of foreign waters from the easterly portal of the Mono Craters Tunnel into the Owens River at a point upstream from Grantor's lands resulting in the said waters flowing in and outside of the channel of the Owens River across and over grantor's land, and by reason of discharging, releasing and emptying waters from any and all other sources into said Owens River resulting in said waters flowing in and outside of the channel of the Owens River across and over Grantor's land and, further, by reason of any and all other acts of whatsoever kind or nature of said Department, its employees, officers, or agents, upon, in connection with or pertaining to Grantor's land, and any and all adjoining lands owned by Grantor, and for all time up to and including the date of the execution and delivery of this agreement, and its acceptance by Grantee.
(B) The Grantee, both for itself and for the Department of Water and Power of The City of Los Angeles, has released and forever discharged and by these presents does for itself, its successors and assigns, release and forever discharge the Grantor of and from all manner of actions, causes of action, suits, controversies, trespasses, damages, claims and demands whatsoever, in law or in equity, which said City or said Department of Water and Power may have for all time up to and including the date of the execution and delivery of this agreement, and its acceptance by Grantee.
(C) The Grantor does hereby and by these presents grant, convey and transfer unto the Grantee all those certain permanent and exclusive rights of way and easements at any time and from time to time to convey all foreign waters into the channel of the Owens River at a point therein near said easterly portal and upstream from Grantor's land, over, through and across said lands by natural gravity flow in the flood channel or channels of said Owens River and over, through and across such other portions of Grantor's land as may be inundated and overflowed at high stages of flow, without being materially diminished in quantity or being materially impaired in quality by any act of Grantor, its successors or assigns, for the purpose of being recaptured by Grantee and used at any time or place of diversion downstream from said hereinafter described lands; and said easement shall include the right so to convey said foreign waters even though, when combined with the natural waters flowing in said Owens River, they exceed the safe carrying capacity of said channel or channels of said Owens River as it now exists or as said channel or channels hereafter may exist upon said Grantor's lands, or damages or injuries (sic) said lands by inundation, flooding, overflowing the existing channel or channels, cutting a new channel or channels from time to time, silting, cutting, washing, raising the underground water level or in any other manner whatsoever or at all.
Reserving unto Grantor, its successors and assigns, the following:
1. The right and privilege, at its own expense, of directing the flow of said waters upon, over and across Grantor's lands and/or confining the area overflowed by said foreign waters and natural waters by dredging, deepening, cleaning out or straightening any existing channel of said Owens River, by dredging an additional channel or channels on Grantor's lands or by any other reasonable manner or method, provided that the same is consistent with good engineering practice in the operation of Grantee's municipal water system and does not interfere with the reasonable flowage of said discharged waters upon, over, across and off of Grantor's lands.
2. All waters and water rights, riparian, appropriated or of whatsoever kind or nature, now owned or possessed by Grantor.
3. The exclusive fishing, hunting and trapping rights and privileges in and about all waters, both foreign and natural, flowing in said Owens River, its branches, tributaries, flood waters and back waters, all rights to use said lands for the purpose of agriculture, horticulture, bee-raising, farming, ranching, raising and/or pasturing livestock, the erection or maintenance of structures incidental or convenient thereto, the use of said lands for the construction and maintenance of residential ranch or farm cabins or lodges, or structures incidental thereto, provided that the same does not interfere with the full, free and complete possession, use and enjoyment by grantee of all the rights herein granted.
The grantee also covenants to perform certain other conditions regulating and limiting the amount of water released by the grantee.
Petitioner expended in 1939 the sum of $1,055 for attorneys' fees and costs in connection with the settlement with the city.
Under the indenture of August 11, 1939, the petitioner reserved substantial beneficial interests in its properties and has continued to function and operate as a fishing club, with incidental leasing out of its lands for grazing livestock from the date of the indenture to the present time. The indenture permits the city to release foreign waters into the Owens River in such quantities that the total of the foreign and natural waters flowing into that river as it enters petitioner's lands shall not exceed 400 cubic feet per second. The Mono Craters Tunnel has a capacity of 365 cubic feet per second. The natural flow of the Owens River as it enters petitioner's lands was not less than 35 cubic feet per second for the years 1939 to 1946, inclusive. The natural flow of the Owens River through petitioner's lands in terms of mean annual cubic feet per second, and the highest daily average released from the east portal of the Mono Craters Tunnel, are as follows:
+-------------------------------------+ ¦ ¦ ¦Released from ¦ +----+---------------+----------------¦ ¦Year¦Natural flow, ¦tunnel, feet per¦ +----+---------------+----------------¦ ¦ ¦feet per second¦second ¦ +----+---------------+----------------¦ ¦1939¦55.8 ¦20. ¦ +----+---------------+----------------¦ ¦1940¦45.9 ¦110.9 ¦ +----+---------------+----------------¦ ¦1941¦56.1 ¦266. ¦ +----+---------------+----------------¦ ¦1942¦64.1 ¦173.9 ¦ +----+---------------+----------------¦ ¦1943¦61.3 ¦169.5 ¦ +----+---------------+----------------¦ ¦1944¦53.7 ¦140. ¦ +----+---------------+----------------¦ ¦1945¦59.4 ¦206.8 ¦ +----+---------------+----------------¦ ¦1946¦60.3 ¦19.8 ¦ +-------------------------------------+
The amounts of water released from the Mono Craters Tunnel into Owens River in the years 1939 to date have resulted in substantial injury and damage to petitioner and its properties in that (a) the quality and quantity of the fish have been reduced; (b) grazing lands have been damaged and grazing fodder reduced from 25 per cent to 35 per cent below its former quality and quantity; (c) irrigation ditches and intake gates have been damaged, necessitating repairs; (d) the river banks have been cut and undermined and the character of the stream altered; and (e) the meadow lands have been flooded for extended periods. Petitioner has been put to an expense of $13,800 in constructing a diversion ditch in an attempt to control the waters flowing through and over its property. It also expended $1,409.30 in 1939 and 1940 in restocking the Owens River with some 50,000 small fry and some 3,000 full sized fish in an attempt to replace fish destroyed by the Mono Craters Tunnel project. Petitioner has not used and does not have need to use the Mono Craters Tunnel waters or the diversion ditch for irrigation purposes.
The adjusted basis of petitioner's properties was more than $50,000 on January 1, 1939. Disregarding the sum in controversy, no event occurred in 1939 which would cause or require the adjusted basis of these properties to be reduced below $50,000 for the taxable year involved.
The petitioner's income and excess profits tax return for the taxable year 1939 did not report receipt of any income from the city of Los Angeles, but included a schedule which reported receipt of $50,000 from the city in connection with a certain written agreement and settlement of certain specified matters, wherein expenses amounted to $1,055, and petitioner received a net amount of $48,945. In his deficiency notice the respondent included the sum of $48,945 as taxable income to petitioner under section 22(a) of the Internal Revenue Code.
OPINION.
LEECH, Judge:
The question presented is whether the net amount of $48,945 received by petitioner in the taxable year 1939 under a certain indenture constitutes taxable income under section 22(a), or is chargeable to capital account. The respondent contends: (a) That the $50,000, less $1,055 expenses incurred, which petitioner received from the city of Los Angeles under the indenture of August 11, 1939, represented compensation for loss of present and future income and consideration for release of many meritorious causes of action against the city, constituting ordinary income; and, (b) since petitioner has failed to allocate such sum between taxable and nontaxable income, it has not sustained its burden of showing error. Petitioner maintains that the language of the indenture and the circumstances leading up to its execution demonstrate that the consideration was paid for the easement granted to the city of Los Angeles and the consequent damage to its property rights; that the loss of past or future profits was not considered or involved; that the character of the easement rendered it impracticable to attempt to apportion a basis to the property affected; and, since the sum received is less than the basis of the entire property, taxation should be postponed until the final disposition of the property.
The recitals in the indenture of August 11, 1939, indicate its principal purpose was to convey to the city of Los Angeles a right of way and perpetual easements to discharge water upon and flood the lands of petitioner, in connection with the water supply of the city. Among its covenants are reciprocal releases by the respective parties. The respondent relies heavily on the language of the release by petitioner as grantor, contained in paragraph (A) of the indenture, which is set forth in full in our findings of fact. We think the respondent places too much emphasis upon the release provision of the indenture. It is usual and customary in agreements of this character to incorporate a provision for the release and discharge of any possible past, present, or future claims and demands. The mutuality of the releases indicates the purpose was precautionary and protective rather than descriptive and in recognition of asserted claims and demands. Paragraph (e) of the indenture recites that ‘a dispute has arisen between the parties hereto wherein Grantor claims that it has been and is being damaged by reason of the discharge into said Owens River * * * of foreign waters, and that such damage will continue henceforth * * * .‘ The character of the damage is not specified or otherwise indicated. The record reveals, through the testimony of petitioner's officers and its attorneys who carried on the negotiations culminating in the agreement, that no claim for damages for lost profits or income was ever asserted or considered. Of primary concern was the fact that, if the city were permitted to continue interference with petitioner's rights as riparian owner, the city might acquire, by prescription or user, the right to direct foreign waters into the Owens River, flooding petitioner's lands and interfering with its fishing rights by polluting the stream. The threat of an injunction suit was to protect petitioner against the city acquiring such rights without making proper compensation therefor. The evidence does not disclose any claim for or loss of income. There is some evidence that employees of the city, from time to time, engaged in unauthorized fishing and poaching upon petitioner's lands. The remedy of the petitioner for such wrongful acts would be against the individuals and not against the municipality, since clearly such tortious acts were not within the scope of their employment. Obviously, no part of the consideration received by petitioner from the city was paid for the release of such claims and demands. The recital in the indenture that petitioner, as grantor, released the city from all claims and demands ‘by reason of any and all other acts of whatsoever kind or nature of said Department, its employees, officers, or agents, upon, in connection with or pertaining to Grantor's land‘ embraces such acts as were within the scope of their employment. The record does not disclose the existence of such acts, if there were any. No claims or demands based on acts of that character had been made. We conclude that petitioner has satisfactorily established that the $50,000 it received in 1939 was consideration paid by the city for a right of way and easements and for resulting damages to its property and property rights.
The respondent further contends that petitioner has failed to allocate any portion of the $50,000 to nontaxable recovery of capital. He argues that the payment was a ‘lump sum‘ settlement related to many things which were not connected with petitioner's capital, such as loss of grazing rentals, guest card fees, and loss of fish from pollution. The record establishes that the grazing rentals were constant and that the guest fees were not intended to develop a source of operating revenue, but merely to restrict the number of guests. Pollution of the stream is an injury to property. The loss of fish as a result of the pollution of the river could form no basis for a claim, since fish in their wild state belong to the sovereign. In support of his position the respondent relies upon Raytheon Production Corporation, 1 T.C. 952; affd., 144 Fed.(2d) 110; certiorari denied, 323 U.S. 779; R. J. Durkee, 6 T.C. 773; since reversed, 162 Fed.(2d) 184. In the Durkee case, the Circuit Court says:
It is settled that since profits from business are taxable, a sum received in settlement of litigation based upon a loss of profits is likewise taxable; but where the settlement represents damages for lost capital rather than for lost profits the money received is a return of capital and not taxable. * * * (Citing many cases.) The difficulty is in determining whether the recovery is for lost profits or for lost capital. The test is as stated by this Court in Farmers' & Merchants' Bank v. Commissioner, supra, and approved in Swastika Oil & Gas Company v. Commissioner, supra, namely, ‘The fund involved must be considered in the light of the claim from which it was realized and which is reflected in the petition filed.‘
Upon this record we have concluded that no part of the recovery was paid for loss of profits, but was paid for the conveyance of a right of way and easements, and for damages to petitioner's land and its property rights as riparian owner. Hence, the respondent's contention has no merit. Capital recoveries in excess of cost do constitute taxable income. Petitioner has made no attempt to allocate a basis to that part of the property covered by the easements. It is conceded that all of petitioner's lands were not affected by the easements conveyed. Petitioner does not contest the rule that, where property is acquired for a lump sum and subsequently disposed of a portion at a time, there must be an allocation of the cost or other basis over the several units and gain or loss computed on the disposition of each part, except where apportionment would be wholly impracticable or impossible. Nathan Blum, 5 T.C. 702, 709. Petitioner argues that it would be impracticable and impossible to apportion a definite basis to the easements here involved, since they could not be described by metes and bounds; that the flow of the water has changed and will change the course of the river; that the extent of the flood was and is not predictable; and that to date the city has not released the full measure of water to which it is entitled. In Strother v. Commissioner, 55 Fed.(2d) 626, the court says:
* * * A taxpayer * * * should not be charged with gain on pure conjecture unsupported by any foundation of ascertainable fact. See Burnet v. Logan, 283 U.S. 404; 51 S.Ct. 550, 75 L.Ed. 1143.
This rule is approved in the recent case of Raytheon Production Corporation v. Commissioner, supra. Apportionment with reasonable accuracy of the amount received not being possible, and this amount being less than petitioner's cost basis for the property, it can not be determined that petitioner has, in fact, realized gain in any amount. Applying the rule as above set out, no portion of the payment in question should be considered as income, but the full amount must be treated as a return of capital and applied in reduction of petitioner's cost basis. Burnet v. Logan, 283 U.S. 404.
Reviewed by the Court.
Decision will be entered for the petitioner.