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Percentage Depletion of Imaginary


Of all the dispensations . . . percentage depletion is the most remarkable achievement. It enables certain taxpayers to reduce their incomes by imaginary costs. Other taxpayers are not considered so deserving. They may only deduct what they spend.

.— Louis Eisenstein, Ideologies of Taxation[1]

The proposal would limit the exclusions allowed under percentage depletion allowed for oil and other mineral interests, to the taxpayer’s adjusted basis in the interest.

The percentage depletion allowance arose as a rough measure of a taxpayer’s capital but considering capital to be the initial value of the property. Identifying initial value of property with capital was a common conception when percentage depletion was adopted, competing with cost as the definition of capital. We now define capital, however, as simply the invested cost.

Tax should be neutral among alternative investments. Subsidies, if any, should be given via government spending because Congress does not consider the costs of the subsidy to be real money if the subsidy is off budget. Percentage depletion encourages cheaper oil, if it is passed on to customers, and cheaper oil is dangerous because it discourages conservation and development of alternative sources of energy. The price of oil is high enough now to encourage exploration and development.

Current law denies percentage depletion to foreign production, and to large integrated oil companies, and limits independents to depletion on production of $18 million per year. The proposal would continue the disqualifications.

A. Current Law

1. Origin of the percentage depletion allowance. Under code section 611, the holder of an economic interest in oil, gas, or mineral deposits may take a reasonable allowance for depletion of the interest. The normal function of depletion is to recover the taxpayer’s capital costs that are lost as the deposit is used up. Depletion is, in theory, like ‘‘depreciation of machinery, or the using up of raw materials in manufacturing’’[2] — that is, a mechanism for recovery of costs. An income tax is a tax on profits, and to compute income, costs must be subtracted.

Percentage depletion, while posing as a capital recovery mechanism, is a deduction of part of revenue without regard to costs. Percentage depletion continues the exclusion after the taxpayer has recovered its costs. The taxpayer also gets to deduct investment costs separately, including by expensing oil drilling costs, and expensing of the costs of exploring for and developing other minerals. Taxpayers also pay for many of the costs by giving out an economic interest in the deposits rather than giving out cash, which gives the developer no basis in the developed deposits. Once the taxpayer has recovered basis, the system is allowing deduction of imaginary costs.

A taxpayer takes the higher of cost depletion or percentage depletion. Cost depletion is a reasonable description of the taxpayer’s losses, usually better in fact, than depreciation. Cost depletion allows a taxpayer’s total cost for an oil or mineral deposit to be recovered pro rata as units, whether measured in barrels or tons, are extracted from the deposit and sold. Cost depletion is much like an inventory rule for a bookseller that says that the wholesale costs of a large order of books can be deducted as each book is sold.

Percentage depletion, by contrast, allows the taxpayer to exclude an arbitrary percentage of gross income from the property. Percentage depletion, the Supreme Court has said, is a ‘‘rule of thumb’’ to measure a taxpayer’s loss because of exhaustion of the deposit,[3] but the rule of thumb measure is too high whenever it exceeds cost depletion. The percentage depletion deduction is computed without regard to basis, and the exclusion continues even after basis has been fully recovered.

Percentage depletion arose as a simplified substitute for ‘‘discovery value’’ depletion. In 1918, during wartime conditions, Congress allowed wildcat oilmen to use the fair market value of the oil wells, appraised within 30 days of discovery, as their tax basis.[4 ] Using FMV at discovery as the basis misstates income when value exceeds cost. In 1926, for example, a congressional investigation committee noted with disapproval that Texas Gulf Sulfur Co. had claimed a discovery value basis of $39 million on an oil property that it had purchased for $200,000.[5] Depletion in excess of cost meant that some of the cash profit withdrawn from the property was not taxed. Discovery value basis meant that Texas Gulf Sulfur did not pay tax on $38.8 million of real income over the

course of the extraction.

In 1918, discovery value basis drew support from the concept, then still acceptable, that basis was supposed to be initial value. Early in the income tax, there was ambiguity whether capital referred to the initial value of the property or to its cost. Capital was once thought of as a thing, whatever its value.6 The modern tax term ‘‘basis’’ is primarily a monetary account that keeps account of investment costs that have been paid, but not yet deducted. Over time the phrase ‘‘recovery of basis’’ has come to replace the older phrase ‘‘recovery of capital,’’ and the capital to be recovered is now thought to be cost, rather than initial value.

It was once thought that giving the taxpayer an FMV basis at the start of the period was a constitutional requirement.[7] In Doyle v. Mitchell Bros.,[8] decided in early 1918, the Supreme Court said that to determine income, ‘‘we must withdraw from the gross proceeds an amount sufficient to restore the capital value that existed at the commencement of the period under consideration.’’ It also allowed the taxpayer to compute income by deducting the fair market value of its inventory as of the starting date of the income tax, as it sold the inventory.[9] The only statutory definition of basis in 1918, when discovery basis was under consideration, provided that the taxpayer would have a basis equal to the FMV of the property at the start of the individual income tax, March 1, 1913.[10]

Prof. John Potts has argued that the March 1913 basis was once perceived as the general rule, and a basis equal to cost was originally just an afterthought.[11 ] As the concept of capital later became settled as a concept of basis or cost, the Supreme Court said that Congress could in fact tax values that arose before the tax, when realization of the gains occurred after the start of the tax.[12] Indeed, the

Court by 1936 expressed irritation at taxpayer claims that the Constitution protected values at enactment from an income tax.[13] Still in the early days of the tax, the conception of capital was thought to protect pre-1913 appreciation from tax because capital was an initial value.

In the first 25 years of the income tax, moreover, the courts kept finding that business entities had a basis for property contributed to the entity equal to the FMV of the property when it was received — even though the shareholder or partner had not paid tax on the gain built into the property at the time of the contribution.[14] For nontax purposes, even a sole proprietorship states assets at their initial value whenever a new enterprise is started.[15] The finding of a step-up in basis without recognition of gain meant that the gain built up in the hands of the contributor disappeared from the tax base. Unrestrained, it is difficult to imagine why anyone would pay tax on gain when a contribution to a controlled business entity would strip the property of taxable gain. The courts allowed the step-up even in obviously abusive situations.[16] Congress stepped in, again and again, to overcome the court-found rule that basis represented value of the property when the entity received it and replaced initial-value basis with a carryover of the transferor ’s basis.[17] Carryover of basis adopts the commonsense concept that the only investment of capital and the only cost were the investment made by the transferor.[18]

Over time, it came to be recognized that what needed to be recovered was the cost invested, not the initial value of the property, but the initial-value error has an extraordinary hold and perseverance. Indeed, section 1014’s provision for a step-up in basis at death to include fictitious costs never invested by anyone is a residuum of the argument that capital is supposed to represent an initial value in the hands of the taxpayer.[19]

Congress faced the choice in 1918 of using real investment costs of oil and gas deposits instead of discovery value as the recoverable basis. The Revenue Act of 1918 enacted both the discovery value basis and also the general rule that basis is equal to cost.[20] The Treasury regulations of 1913 has provided that depletion deductions were based on cost, and not the estimated value of the oil and gas.[21] Still, the initial-value argument, thought in 1918 to be of possible constitutional dimension, allowed Congress in 1918 to give a privilege or advantage to the wartime production of oil, without the accounting being considered a tax expenditure or intentional misdescription.

Discovery cost depletion proved to be an administrative nightmare because no one in fact knew or could ascertain the value of the deposit at the eureka point when the oil or gas was discovered. Taxpayers routinely overstated value in the face of uncertainty, and the IRS engineer auditing the issue had a nearly impossible job of guessing the size of the deposit at time of the discovery, using only the crude technology then available, guessing when the barrels of oil would be sold and at what price, and then discounting that price at some discount rate to a value at discovery.[22] In 1926 Congress replaced discovery value depletion with an arbitrary exclusion of 27.5 percent of the gross receipts.[23] The House suggested 25 percent, the Senate suggested 30 percent, and the conference committee compromised at 27.5 percent.[24] The change from discovery value to 27.5 percent exclusion was said to be in the interests of ‘‘simplicity and certainty in administration,’’ but to be equal to the depletion previously allowed.[25] The Supreme Court later said that the percentage depletion ‘‘was in the interest of convenience and in no way altered the fundamental theory of the allowance.’’[26] The Senate floor manager of the 1926 act, David Reed of Pennsylvania, argued that if he discovered a gold mine, basing depletion on cost ‘‘would not allow me an adequate return on my ‘real capital.’’’[27]

To Reed, ‘‘real capital’’ meant the value of the gold mine, not its invested cost.

‘‘Tax dispensations have a faculty for expanding as they age,’’ Louis Eisenstein argued.[28] Other extractive industries believed that they needed to catch up with the fictional costs allowed to oil and gas, and over the years Congress extended percentage depletion to other deposits. At one point Congress added new minerals to the list for the simple reason that they had as good a claim for percentage depletion as minerals already enumerated.[29]

Under current law (with some conditions and details left out), the percentages allowed are as follows:

· 22 percent: sulfur, uranium, anorthosite, clay, laterite, nephelite syenite, asbestos, bauxite, celestite, chromite, corundum, fluorspar, graphite, ilmenite, kyanite, mica, olivine, radio-grade quartz crystals, rutile, block steatite talc, and zircon and ores of the following metals: antimony, beryllium, bismuth, cadmium, cobalt, columbium, lead, lithium, manganese, mercury, molybdenum, nickel, platinum and platinum group metals, tantalum, thorium, tin, titanium, tungsten, vanadium, and zinc.

· 15 percent: gold, silver, copper, iron ore, oil and natural gas, and oil shale.

· 14 percent: metal mines, rock asphalt, vermiculite, ball clay, bentonite, china clay, sagger clay, and clay used for its refractory properties.

· 10 percent: asbestos, brucite, coal, lignite, perlite, sodium chloride, and wollastonite.

· 7.5 percent: clay and shale used or sold for use in the manufacture of sewer pipe, brick, or aggregate.

· 5 percent: gravel, peat, pumice, sand, scoria, shale, stone, bromine, and calcium chloride (from brine wells).

· 14 percent: all other minerals, including, but not limited to, aplite, barite, borax, calcium carbonates, diatomaceous earth, dolomite, feldspar, fullers earth, garnet, gilsonite, granite, limestone, magnesite, magnesium carbonates, marble, mollusk shells, phosphate rock, potash, quartzite, slate, soapstone, ornamental stone, thenardite, tripoli, trona, certain bauxite, flake graphite, fluorspar, lepidolite, mica, spodumene, and talc

· 5 percent: any other mineral sold as rip rap, ballast, road material, rubble, concrete aggregates, or for similar purposes.[30]

The percentage depletion allowance remained substantially intact until the OPEC oil embargo of 1973 caused a quick quadrupling of gasoline prices. In 1975, in the face of the OPEC price shock, Congress took away percentage depletion for the major integrated oil companies and for overseas production.[31] Congress, however, left a 15 percent depletion allowance for independent oil and gas producers who have no connection to refining or retailing, for amounts of up to 365,000 barrels or roughly $18 million a year.[32 ] Taxpayers no longer eligible for percentage depletion use cost depletion instead.

Depletion for deposits other than oil and gas were not affected in 1975.[33] However, since 1986 section 291, reducing ‘‘corporate preferences,’’ requires corporations (but not individuals) to reduce their depletion on iron ore and coal deposits by 20 percent of the excess of depletion over adjusted basis, thereby leaving 80 percent of the allowance in excess of basis for the deposits affected.

2. Thin basis. Depletion in excess of basis is important for the extractive industries because the tax accounting for the industries allows a basis that is a modest or trivial fraction of the real cost of the investment. Basis is lower than real investment, first, because of the expensing or quick deduction of early investment costs. As to oil and gas, the taxpayer may deduct the costs of drilling for oil, as if it were a lost cost when made, even when a program is successful.[34] The taxpayer may amortize the geological and geophysical costs of identifying promising properties over two years.[35] As to other mineral deposits, a taxpayer may deduct the costs of exploring to ascertain the ‘‘existence, location, extent or quality of any deposit of ore or other mineral’’[36] and then may expense the costs of developing the mine or the deposit.[37]

Basis is also low for the taxpayer developing the well or mine because the enterprise pays other parties by giving the various parties an economic interest in the successful well or mine, rather than giving out cash. In 1941 the IRS ruled that when the enterprise pays the landowner (for the rights to explore and develop the deposit), the drillers, equipment suppliers, and the investors who contribute materials and services in connection with the development of a mineral property by giving them an economic interest in the property, the receipt of the economic interest does not result in realization of compensation or income. The contributors are viewed as not performing services for compensation, but as making a contribution to a ‘‘pool of capital’’ and receiving an interest in that pool in return.[38] Absent the pool of capital doctrine, receipt of the interest in payment for services would be ordinary income immediately, measured by the value of the interest.[39] Absent the pool of capital doctrine, the developer paying with a property interest would also have to recognize gain on the property transferred, measured by appreciation of its cost over its value.[40]

Under the pool of capital doctrine, paying with economic interests results in recognition to neither the transferor nor the recipient. The recipients get to take the percentage depletion even if, for instance, they contribute services that had no basis.

An IRS ruling later limited the pool of capital doctrine to services and capital related directly to the drill site for which an economic interest was given.[41] The tax planners responded by giving out profits interests in partnerships, called carried interests.[42] Giving partnership income interests continues the privileges of nonrecognition to both the transferor and recipient that was allowed under the pool of capital doctrine.[43]

The owners of the land the oil is drilled on also usually have zero basis for their depletable interests because none of the cost of the land can be allocated to the well. The economic interest it receives for allowing drilling has no basis but still gets the percentage exclusion of income from a successful well. The landowner is allowed to allocate part of its cost for the land against the royalty it receives for allowing exploration, drilling, or mining on the land, only if it knew of the deposit when it purchased the land and paid a discernible price for it.[44]

To impose an income tax at the statutory tax rates on the extractive industries, costs would have to be capitalized until the taxpayer’s basis is equal to the FMV of its investment. ‘‘Income’’ in financial economics is the interest on a bank account that matches the investment under examination. An income tax can identify the interest from an investment, and reduce it by the statutory tax rate, only if the balance of the bank account that describes the investment is equal to the taxpayer’s adjusted basis. Alternatively stated, a tax system can reduce an investment’s pretax income by the statutory tax rate if and only if the taxpayer has an adjusted basis at the end of each year equal to the value of the investment.[45] The understatement of basis should be fixed, as a separate matter.

The low-basis issue is directly related to the proposal here, however, because understatement of basis makes depletion in excess of basis more important. For many economic interests in oil and gas and mining, depletion limited to cost basis would generate zero deductions.

If the developer’s basis in the deposit were not such a small percentage of actual investment, percentage depletion would rarely be used. Assume, for example, a developer invests $100x, extracts a constant amount of barrels every year, and achieves a 10 percent rate of return. An exclusion of 15 percent of revenue would recover 100 percent of the $100x cost basis only if deposit lasted for almost 66½ years.[46] Cost depletion is the better option if the deposit will be depleted in even amounts in less than 66½ years and the full $100x cost must be recovered by depletion.

Percentage depletion is analogous to the never-ending exclusion that was once allowed for pensions and other annuities. Under section 72, receipts from pensions and other annuity contracts are taxed by excluding a percentage of each payment based on the ratio of the taxpayer’s overall investment in the contract to the expected total payments from the contract.[47] Expected total payments are computed looking to the taxpayer’s life expectancy over which the pension is to be paid.[48] The rule looks globally to find an expected percentage and applies the percentage to each receipt. Before 1986, the exclusion ratio was a rule of thumb that, like percentage depletion, was not limited by actual invested cost or basis and could continue indefinitely. Before 1986, a taxpayer who lived beyond his life expectancy would recover more than basis by the exclusion. The Tax Reform Act of 1986 limited the exclusion to basis,[49] ending the prior exclusion based on fictitious costs.[50]

B. Reasons for Change

1. The dangers in cheap oil. Accounting applied to the extraction of oil and gas and to the mining of other minerals does not accurately reflect the taxpayer’s income. Some of the misdescription arises from failure to capitalize the full investment costs of the exploration and development, and some of the misdescription arise because percentage depletion allows deductions in excess of the taxpayer’s adjusted basis. The misdescription entailed in the accounting for oil and gas reduces the real impact of tax to a fraction of the statutory tax rates, sometimes, as shown below, into the range of a negative tax rate.

If the advantage of low tax or subsidy is passed on to customers, customers get a false sense of the true costs of oil and they adapt to the falsely cheap prices by overconsuming oil. Cheap oil to consumers is especially dangerous now because we rely on foreign sources from dangerous parts of the globe for our oil[51] and because the overconsumption of oil contributes to global warming. Cheap oil undercuts conservation and the development of alternative energy sources. Consumers should start to adapt to the future in which oil will become very expensive because the adaptation will take considerable time.

If the subsidy from percentage depletion is not passed on to customers, the subsidy just contributes to the net worth of taxpayers holding oil interests. A basic sense of fairness suggests that those with equal ability to pay tax should pay equal taxes whether they are in oil or some other industry. Holders of oil interests undoubtedly consider the subsidy to be part of their entitlement or endowment, but as long as a comprehensive income tax is applied fairly to other industries and investments, oil and gas and other extractive industries should be brought into a neutral income tax system.

The federal budget is running large unsustainable deficits. Deficits may be necessary for short-term stimulus, but in the coming years, we must find revenue sources that will do the least damage to the economy to pay for the borrowed money used to fund the deficits. Increasing tax rates increases the deadweight loss from tax by the square of the tax increase.[52] One can minimize the damage from tax by going first after the low-tax troughs as the sources for needed revenue.

Reducing, or even eliminating, the tax-advantage subsidy to the extractive industries would improve the efficiency of consumer choices because prices will then reflect real, unsubsidized costs. In general, in a capitalist system, the decisions reached by supply and demand and evidenced in unsubsidized price are presumed to represent the best decisions about the use of limited resources. If Congress decides to subsidize oil and gas investments, it should do so carefully and only with budgeted costs. The government acts rationally, weighing costs and benefits, only through a competitive federal budget. Costs are considered to be real money only if they are categorized as government spending and run the gantlet of a federal budget. Subsidies that are off budget do not get engineered to maximize benefit and minimize government cost.

When the subsidy to the industry is based on the deduction of imaginary costs arising by historical accident from a now archaic concept of capital, that gives no one faith that the subsidy is well engineered. A system premised on imaginary costs cannot be assumed to be either wise or just.

The market price for oil and gas and for other minerals is now high enough to provide a sufficient incentive for their exploration and development. Congress has provided two focused subsidies for special cases when the market price alone might not provide a sufficient subsidy, but both of those subsidies disappear when the price of oil is as high as it is. There is a tax credit for marginal wells[53] and a tax credit for tertiary recovering techniques, primarily the injections of various liquids into the deposit to help extract oil.[54] The marginal well credit disappears when the price of oil exceeds $18 per barrel[55] and the tertiary recovery credit disappears when the price of oil exceeds $34 per barrel[56] (both with inflation adjustments). If those special cases no longer need a subsidy when the price exceeds 18 and 34 dollars per barrel, ordinary drilling and recovery should have its subsidy removed at a lower price per barrel. The price of oil, now at more than $40 a barrel,[57] provides the free market incentive to develop oil. No further subsidy is needed beyond the wisdom of supply and demand.

The Government Accountability Office recently estimated that increasing the royalties charged for offshore oil drilling to the norms charged by other land owners could bring in revenue of $225 million a year.[58] Imposing tax on oil and gas under normal income tax principles would raise revenue, consistent with a royalty increase. The Congressional Budget Office has identified the revenue loss in depletion in excess of basis at $1.4 billion a year for oil and gas and $100 million a year for other minerals.[59]

2. The range of tax rates: 30 percent to negative 10 percent. Tax accounting for oil and other minerals reduces the economic rate of tax to considerably below the statutory tax rate and sometimes reduces tax rates into the negative range. As shown below, deduction of the excess over basis reduces the rate from a 35 percent statutory tax rate to a rate between 30 percent and minus 9.4 percent. For negative tax rates, the system becomes a subsidy delivery vehicle and not a revenue-producing tax system at all. A value commonly held by the electorate is that special care has to be given to government subsidies beyond forgiveness of tax, even while reductions in positive tax burdens can be tolerated or even applauded.[60] Percentage depletion sometimes falls into the range of special care.

The best measure of the impact of tax is to ask how much tax reduces the pretax internal rate of return from the investment. The impact of the percentage depletion allowance on pretax return has a range that depends on how much of the value of the investment has been captured as capital expenditures — that is, the ratio of investment value represented by adjusted basis.[61] At the high end, if adjusted basis captured all the cost of the investment, percentage depletion in excess of basis would just exempt the allowed percentage of the income from the project. Thus the exclusion for independent oil producers, at 15 percent, leaves taxable income at 85 percent of economic income and means that the statutory 35 percent tax rate is really 85 percent of 35 percent or 30 percent.[62]

Taxpayers who have no deductible costs for their depletable interest — including service providers who received their interest for services and land owners who receive a royalty for interests in deposits they did not know about at purchase — are subject to the 30 percent effective tax rate.

At the other end of the spectrum, if we assume that investment costs are entirely expensed, the 15 percent exclusion of revenue beyond basis is causing a negative tax of about 10 percent of the real income. Assume that a drilling program involving investment of $100x will generate a pretax return of 10 percent over a 30-year production life — that is, a cash flow of $10.6x per year for 30 years.[63] If the full $100 is expensed or excluded from tax, the after tax cost is only $65 given the 35 percent or $35 tax that is avoided upfront. The expensing acts like a reimbursement or copayment by the government of 35 percent of the cost. The 15 percent exclusion regarding the $10.6x revenue means a tax of 35 percent * 85 percent or 30 percent of the assumed $10.6x revenue, or $7.45x after tax each year.[64] The after-tax situation is investment of $65 and return of $7.45x, which represents a 10.94 percent return.[65] Tax thus improved the return from the well from 10 percent pretax to 10.94 percent after-tax and the 0.94 percent improvement is 9.4 percent of the pretax situation.

C. Explanation of the Provision

The proposal would amend section 611, which governs all depletion, to limit depletion to the taxpayer’s cost. The proposal would renumber the current section 611(b) (special rules) to become subsection (c) and add a new subsection (b), reading as follows:

Subsection 611(b) DEPLETION LIMITED TO BASIS. The amount deductible as depletion shall not exceed the adjusted basis of the property for the purposes of determining loss.\

[1]Louis Eisenstein, Ideologies of Taxation, 123 (1961).

[2]Anderson v. Helvering, 310 U.S. 404, 408 (1940).

[3]Helvering v. Mountain Producers Corp., 303 U.S. 376, 381 (1938).

[4]Revenue Act of 1918, P.L. 65-254, sections 214(a)(10) and 234(a)(9), 40 Stat. 1057, 1067, 1078 (1919).

[5]Select Senate Committee on Investigation of the Bureau of Internal Revenue, 69th Cong., 1st Sess. at 18 (1926 Confidential Comm. Print) cited by staff of the Joint Committee on Taxation, 81st Cong., 2d Sess., Legislative History of Depletion Allow-ances at 6 (1950 CIS index H 8266).

[6]Marjorie Kornhauser, ‘‘Section 1031: We Don’t Need An-other Hero,’’ 60 S. Cal. L. Rev. 397, pp. 412-420 (1987); Lawrence Seltzer, The Nature and Tax Treatment of Capital Gains and Losses, pp. 26-35 (1951); Roswell Magill, Taxable Income, p. 41 (rev. ed. 1945) (lawyers trained to view land as corpus find the broad

‘‘res’’ theory of capital to be natural); cf. Nathan Issacs, ‘‘Principal — Quantum or Res?’’ 46 Harv. L. Rev. 776 (1933) (discussing whether capital refers to property or amount invested in trust accounting).

[7]Joseph Klein, Federal Income Taxation, 869 (1929) (saying constitutional limitations prevent Congress from taxing preenactment gain); Roberts, ‘‘Basis for Property Acquired for Stock,’’ 40 J. Acct. 100, p. 102 (1925) (arguing that corporate carryover of shareholder basis (now section 362) was unconstitutional because fair market value of contributed property constituted corporate ‘‘capital’’); and George Holmes, Federal Taxes, 497 n. 78, 509 n. 57 (1923 ed.) (gain accrued before the income tax cannot constitutionally be taxed).

[8]247 U.S. 179 (May 29, 1918).

[9]Id. at 185.

[10]Revenue Act of 1916, ch. 463, section 2(c), 39 Stat. 756, 758 (corresponding to section 1012).

[11]John Potts, ‘‘Did Your Law Professor Tell You Basis Means Cost? The Recognition Theory of Basis,’’ 22 Valparaiso L. Rev. 233, 241 (1988).

[12]MacLauglin v. Alliance Ins. Co., 286 U.S. 244, 250 (1932) (application of 1928 tax to insurance company investments).

[13]United States v. Safety Car Heating & Lighting Co., 297 U.S. 88, 96 (1936) (criticizing claims that all Mar. 1, 1913, values were constitutionally protected capital).

[14]See, e.g., Himelhoch Bros. & Co. v. Commissioner, 26 B.T.A 541 (1932) and cases there cited (applying initial value basis to property received from shareholders in years before Congress mandated carryover of basis); Rosenbloom Finance Co. v. Commissioner, 24 B.T.A. 763, 772 (1931) (giving corporation initial value basis on property contributed by shareholder without return of more stock), rev’d 66 F.2d 556 (3d Cir. 1933) (finding the contribution was a gift subject to carryover basis rules for gifts), cert. denied, 290 U.S. 692 (1933); Archbald v. Commissioner, 27 B.T.A. 837, 843 (1933), aff’d per curiam 70 F.2d 720 (2d Cir. 1934), cert. denied 293 U.S. 594 (1934) (step-up in basis for property contributed to partnership); and Chisholm v. Commissioner, 79 F.2d 14, 15 (2d Cir. 1935) (Hand, J.) (finding a basis step-up in an abusive transaction).

[15]Stephen Gilman, Accounting Concepts of Profit, pp. 61-63 (1939).

[16]See, e.g., Chisholm v. Commissioner, 79 F.2d 14, 15 (2d Cir. 1935) (Hand, J.) (taxpayers negotiated sale as individuals and avoided tax on gain by a quick eve-of-sale contribution of the property to their partnership). The nonrecognition of gain on the contributed property should have implied as a matter of law that nothing had happened to merit either recognition of the gain or a change of cost or basis accounts. The negotiations, quick contribution, and quick sale were, moreover, part of a common plan or step transaction.

[17]See, e.g., Revenue Act of 1924, section 204(a)(3), 43 Stat. 253, 258 (now section 1015(b)) reversing retroactively Francis v. Commissioner, 15 B.T.A. 1332, 1340 (1929); Revenue Act of 1924, section 204(a)(8), 43 Stat. 253, 259 (now section 362(a)(1)) changing, e.g., Himelhoch Bros. & Co. v. Commissioner, 26 B.T.A. 541 (1932) (corporation gets step-up in basis); Revenue Act of 1932, section 113(a)(8), 48 Stat 683 (now section 362(a)(2)) changing, e.g., Rosenbloom Finance Co. v. Commissioner, 24 B.T.A. 763 (1931), rev’d 66 F.2d 56 (3d Cir.), cert. denied 290 U.S. 692 (1933); and Revenue Act of 1934, section 113(a)(13) (now section 723) changing, e.g., Archbald v. Commissioner, 27 B.T.A. 837, 843

(1933), aff’d per curiam 70 F.2d 720 (2d Cir. 1934), cert. denied 293 U.S. 594 (1934) (partnership got a step-up in basis).

[18]Cf. Taft v. Bowers, 278 U.S. 470, 482 (1929) (gifted property had ‘‘only a single investment of capital — that made by the donor ’’).

[19]The stated rule for what is now section 1014 was that Congress was just conforming the statute to the existing Treasury rule. S. Rep. No. 275, 67 Cong., 1st Sess. 10-11 (1921). For a proposal to repeal the recognition of fictitious costs, see, e.g., Calvin H. Johnson, ‘‘The Elephant in the Parlor: Repeal of Step-Up in Basis at Death,’’ Tax Notes, Dec. 8, 2008, p. 1181, Doc 2008-24389, or 2008 TNT 237-31.

[20]Revenue Act of 1932, P.L. 72-154, section 114(b)(4), 47 Stat. 169, 203.

[21]Treas. reg. 33, art. 144, 16 Treas. Dec. Int. Rev. 65 (1913).

[22]On the difficulties, see, e.g., Select Senate Committee on Investigation of the Bureau of Internal Revenue, 69th Cong., 1st Sess. (1926 Confidential Comm. Print); Sen. David Reed, Debate on the Revenue Act of 1926, 67 Cong. Rec. 3766.

[23]Revenue Act of 1926, ch. 27, section 204(c)(2), 44 Stat. 9, 16 (1926).

[24]Seidman’s Legislative History of the Federal Income Tax Laws, pp. 1938-1861, at pp. 582-583 compares the House’s, Senate’s, and final legislation.

[25]Conference Committee Report on Revenue Act of 1926, H. Rep. 356, 69th Cong., 1st Sess. 31-32 (1926).

[26]Helvering v. Bankline Oil Co., 303 U.S. 362, 367 (1938).

[27]67 Cong. Rec. 3766. (Reed).

[28]Eisenstein, supra note 1, at p. 125.

[29]See, e.g., Ways and Means Committee, H. Rep. 586, 82 Cong., 1st Sess. at 29-30 (1951).

[30]Section 613.

[31]Tax Reduction Act of 1975, P.L. 94-12, section 501, 89 Stat. 36.

[32]Section 613A(c) (exemption) and (c)(3) (limitation of exemption to 1,000 barrels a day). At $50 per barrel, the exemption allows the full 15 percent percentage depletion on up to $18 million in revenue per year.

[33]Tax Reform Act of 1986, P.L. 99-514, section 412(b), 100 Stat. 2085 (1986) amending section 291(a)(2).

[34]Section 263(c).

[35]Section 167(h), added by Energy Tax Incentives Act of 2005, P.L. 109-58, section 1329(a).

[36]Section 617.

[37]Section 616.

[38]GCM 22730, 1941-1 C.B. 214.

[39]The general rule is that a taxpayer who receives any oil interest as compensation must include the FMV of the interest as ordinary income. See, e.g., Leland J. Allen v. Commissioner, 5 T.C 1232 (1945), acq. 1946-1 C.B. 1.

[40]Rev. Rul. 83-46, 1983-1 C.B. 16; Rev. Rul. 77-176, 1977-1 C.B.

[41]Rev. Rul. 77-176, 1977-1 C.B. 77.

[42]Frank M. Burke Jr., ‘‘Oil and Gas Taxation From 1972 to

[46]A $100 investment that gives a 10 percent return will give 1992: A Study in Questionable Tax Policy and Administration,’’ Tax Notes, Nov. 12, 1992, p. 871.

[43]Rev. Proc. 2001-43, 2001-2 C.B. 191, Doc 2001-20855, 2001 TNT 150-11 (transfer of a profits interest for services is taxable to neither a new partner nor the partnership); Notice 2005-43, 2005-1 C.B. 1221, Doc 2005-11236, 2005 TNT 98-37 (saying that the IRS intends to issue proposed regulations that will exempt receipt of partnership interest if the recipient would receive nothing in liquidation if the partnership were liquidated immediately).

[44]See, e.g., Plow Realty Co. v. Commissioner, 4 T.C. 600 (1945).

[45]The argument arises from Paul Samuelson, ‘‘Tax Deductibility of Economic Depreciation to Insure Invariant Valuations,’’ 72 J. Pol. Econ. 604 (1964). See, e.g., Johnson, ‘‘The Effective Tax Ratio and the Undertaxation of Intangibles,’’ Tax Notes, Dec. 15, 2008, p. 1289, Doc 2008-24799, or 2008 TNT

242-46; also available at https://www.utexas.edu/law/faculty/calvinjohnson/effective-tax-ration.pdf.

[46]A $100 investment that gives a 10 percent return will give net revenue of $10.02x per year for 66.5 years, and the 15 percent exclusion would recover 15 percent * $10.02, or $1.50x. Then 66.5* 1.50 = 100x. Lower discount rates than 10 percent would reduce the attractiveness of percentage depletion.

[47]Section 72(b)(1).

[48]Section 72(c)(3).

[49]Section 72(b)(2) (‘‘exclusion limited to investment’’) added by P.L. 99-514, section 1122(c)(2).

[50]Even though the pre-1986 rule for annuities did not end the exclusion when basis had been recovered, the exclusion better reflected income than does percentage depletion. A taxpayer who did not know that he would live longer than the life expectancy indicated by the IRS mortality tables would not know that the exclusion would be a benefit. Annuitants who died before their mortality-table life expectancy lost tax recognition of their investment. The mortality tables were not kept up to the general extension of life expectancies, but the exclusion departed less from true cost than percentage depletion does.

[51]See, e.g., William M. VanDenburgh, ‘‘Raise Federal Gas Tax Now or Pay OPEC Later,’’ Tax Notes, Jan. 26, 2009, p. 533, Doc 2008-26834, or 2009 TNT 15-48 (arguing for increased tax on oil and gas to reduce dependence on foreign oil).

[52]See, e.g., N. Gregory Mankiw, Principles of Economics, p. 165 (1998) (showing dead weight loss as an area of a triangle, which increased by the square of the linear increase in price caused by tax rate increase).

[53]Section 45I, added by Omnibus Budget Reconciliation Act of 1990, P.L. 101-508, section 11511.

[54]Section 43, added by American Jobs Creation Act of 2004, P.L. 108-357, section 341.

[55]Section 45I(b)(2)(A).

[56]Section 43(b)(1).

[57]See https://www.bloomberg.com/energy/ (quoting price for ‘‘dated Brent spot’’ at $41.15 a barrel on Feb. 20, 2009).

[58]GAO, May 1, 2007, letter to Sen. Jeff Bingaman, D-N.M., chair of the Senate Energy and Natural Resources, ‘‘Oil and Gas Royalties: A Comparison of the Share of Revenue Received From Oil and Gas Production by the Federal Government and Other Resource Owners,’’ available at https://www.gao.gov/new.items/d07676r.pdf (estimating revenue of $4.5 billion over20years).

[59]Congressional Research Service, Tax Expenditures: Compendium of Background Material on Individual Provisions, 110th Cong., 2d Sess. (Comm. Print 2008).

[60]A high tax rate on some investments and comparative low tax rate on competing investments will distort investor decisions and presumptions and increase the dead weight loss caused by tax, even when the comparatively low rate is not a negative tax or subsidy. Still, negative taxes are likely to cause more distortion than merely comparatively low rates.

[61]Johnson, supra note 45, describes the logic in full.

[62]85% * 35% = 29.75%.

[63]Under the standard formula for present value of annuity, $100 = $10.6 * {1 (1 + i)-30 / i} when i is equal to 10%.

[64]$10.6 35% * 85% ($10.6) = $10.6 $3.15 = $7.45.

[65]$65 = $7.45 * {1 (1 + i)-30 / i}, when i is equal to 10.94%.

Previously published by the University of Texas – School of Law, March 2009

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