                      114 T.C. No. 15



                UNITED STATES TAX COURT



   CHARLES E. AND SHERRIE R. STRANGE, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 8602-98.                     Filed March 29, 2000.



     Ps paid State nonresident income tax to nine
States on net royalty income derived from their
interests in oil and gas wells located within those
States. Ps reported all their royalty income on
Schedules E, Supplemental Income and Loss, which they
attached to their Federal income tax returns. In
calculating their total net royalty income, petitioners
deducted the State income taxes they paid.
Consequently, petitioners deducted the State
nonresident income taxes in computing their adjusted
gross income for the years at issue.
     Held, the addition of sec. 164(a)(3), I.R.C., by
the Revenue Act of 1964, Pub. L. 88-272, sec. 207(a),
78 Stat. 19, 40, did not change the existing law with
respect to the deduction of State income taxes.
     Held, further, State nonresident income taxes are
not "attributable" to property held for the production
of royalties and, therefore, are not deductible under
                               - 2 -

     sec. 62(a)(4), I.R.C., in computing Ps' adjusted gross
     income.
          Held, further, State nonresident income taxes are
     not deductible as a trade or business expense under
     sec. 62(a)(1), I.R.C. Tanner v. Commissioner, 45 T.C.
     145 (1965), affd. per curiam 363 F.2d 36 (4th Cir.
     1966), followed.



     L. Robert LeGoy, Jr. and Kurt O. Hunsberger, for

 petitioners.

     Paul L. Dixon, for respondent.



                              OPINION


     PARR, Judge:   Respondent determined deficiencies of $3,955,

$5,379, and $3,983 in petitioners' Federal income taxes for the

taxable years 1993, 1994, and 1995, respectively.   The sole issue

for decision is whether State nonresident income taxes paid on

net royalty income are deductible for purposes of determining

adjusted gross income.   We hold they are not.

                            Background

     This case was submitted fully stipulated under Rule 122.1

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   Petitioners resided in




     1
      Unless otherwise indicated, all Rule references are to the
Tax Court Rules of Practice and Procedure, and all section
references are to the Internal Revenue Code in effect for the
taxable years at issue.
                               - 3 -

Las Vegas, Nevada, at the time they filed their petition in this

case.

     During the years at issue, petitioners owned interests in

oil and gas wells (the properties) located in the States of

Alabama, California, Colorado, Louisiana, Michigan, Mississippi,

New Mexico, Oklahoma, and Utah (the nine States).

     Each of the nine States imposed an income tax on

nonresidents who derived income from an income-producing activity

within that State.   Petitioners received royalties from the

properties and paid a nonresident income tax to each State on the

net royalty income (gross royalty income minus production taxes,

overhead and operating expenses, and allowances for depletion)

derived from the properties located only within that State.

     Petitioners reported all their royalty income on Schedule E,

Supplemental Income and Loss, which they attached to their

Federal income tax returns.   In calculating their total net

royalty income, petitioners deducted the State income taxes they

paid in addition to the expenses that they deducted in

calculating their State nonresident incomes.   Consequently,

petitioners deducted the State nonresident income taxes in

computing their adjusted gross income for the years at issue.    In

computing their taxable income, petitioners elected to take the

standard deduction allowed by section 63 instead of itemizing

their deductions.
                                 - 4 -

                              Discussion

     Section 164(a)(3) provides inter alia that State income

taxes are allowed as a deduction for the taxable year within

which they are paid or accrued.     This section was added to the

Code by the Revenue Act of 1964 (the Act), Pub. L. 88-272, sec.

207(a), 78 Stat. 19, 40.    Before the Act, the Code did not

specifically list the deductible taxes.     Thus, according to

petitioners, the preexisting law was changed by the Act to

provide "unequivocally"    for the deduction of the State income

taxes for the purpose of calculating adjusted gross income, and,

when read together, sections 62(a)(4) and 164(a)(3) "specifically

provide that state [sic] income taxes attributable to property

held for the production of royalties are deductible from an

individual's gross income to compute the individual's adjusted

gross income."   We disagree.

     The general rule under the law before the Act was that State

and local income taxes paid or accrued by an individual were

deductible as itemized deductions for Federal income tax

purposes.   See H. Rept. 749, 88th Cong., 1st Sess. (1963), 1964-1

C.B. (Part 2) 125, 171-172.     The Act specifically provides for

the continued deductibility of State and local income taxes in

this manner, while, in the interest of tax equity and ease of

compliance, denying the deduction of certain other taxes,

devoting any revenue gain from the denial of those other
                               - 5 -

deductions to further tax rate reductions.   See id., 1964-1 C.B.

(Part 2) at 173-174.   Accordingly, the Act did not change the

existing law with respect to the deduction of State income taxes.

     Section 62(a)(4) provides that, in the case of an

individual, the term "adjusted gross income" means gross income

minus, inter alia, the deductions allowed by part VI (section 161

and following), which are attributable to property held for the

production of rents or royalties.   See also sec. 1.62-1T(c)(5),

Temporary Income Tax Regs., 53 Fed. Reg. 9873 (Mar. 28, 1988)

(same); sec. 1.62-1T(d), Temporary Income Tax Regs., 53 Fed. Reg.

9874 (Mar. 28, 1988) (taxes are deductible in arriving at

adjusted gross income only if they constitute expenditures

directly attributable to a trade or business or to property from

which rents or royalties are derived).   Petitioners contend that

the State nonresident income taxes they paid were "attributable

to" property held for the production of royalties and are,

therefore, deductible in computing adjusted gross income.    We

disagree.

     The concept of adjusted gross income was first incorporated

by Congress into the 1939 Code by adding subsection (n) to

section 22, I.R.C. 1939, in the Individual Income Tax Act of

1944, ch. 210, sec. 8(a), 58 Stat. 231, 235.2   See S. Rept. 885,


     2
      Par. (4) of sec. 22(n), I.R.C. 1939, provided that the term
"adjusted gross income" means gross income minus the deductions
                                                   (continued...)
                              - 6 -

78th Cong., 2d Sess. 24-25 (1944), 1944 C.B. 858, 877.   The

legislative history to section 22(n), I.R.C. 1939, states:

     The proposed section 22(n) of the Code provides that
     the term "adjusted gross income" shall mean the gross
     income computed under section 22 less the sum of the
     following deductions: (1) Deductions allowed by
     section 23 of the Code, which are attributable to a
     trade or business carried on by the taxpayer not
     consisting of services performed as an employee; * * *
     (4) deductions allowed by section 23 which are
     attributable to rents and royalties; * * *

               *    *    *    *       *   *   *

          The deductions described in clause (1) above are
     limited to those which fall within the category of
     expenses directly incurred in the carrying on of a
     trade or business. The connection contemplated by the
     statute is a direct one rather than a remote one. For
     example, property taxes paid or incurred on real
     property used in the trade or business will be
     deductible, whereas State income taxes, incurred on
     business profits, would clearly not be deductible for
     the purpose of computing adjusted gross income.
     Similarly, with respect to the deductions described in
     clause (4), the term "attributable" shall be taken in
     its restricted sense; only such deductions as are, in
     the accounting sense, deemed to be expenses directly
     incurred in the rental of property or in the production
     of royalties. * * * [S. Rept. 885, supra, 1944 C.B.
     at 877-878; emphasis added.]

See also H. Rept. 1365, 78th Cong., 2d Sess. (1944), 1944 C.B.

821, 839.

     The State nonresident income taxes were imposed upon


     2
      (...continued)
(other than those provided in pars. (1) for trade and business
deductions, (5) for certain deductions of life tenants and income
beneficiaries of property, or (6) for losses from sales or
exchange of property) allowed by sec. 23 which are attributable
to property held for the production of rents or royalties.
                               - 7 -

petitioners' net royalty income, not upon property held for the

production of royalties.   Moreover, as the State income taxes

were imposed on petitioners' net royalty income, the State income

taxes were not an expense directly incurred in the production of

that income.   See, e.g., Bulloch, Accountants' Cost Handbook 1.9

(3d ed. 1983) (expenses are expired costs that were used to

produce revenue).   Accordingly, we find that the State

nonresident income taxes paid by petitioners are not attributable

to property held for the production of royalties.

     Furthermore, we find that the taxes are not otherwise

deductible as a trade or business expense in computing

petitioners' adjusted gross income.    Section 1.62-1T(d),

Temporary Income Tax Regs., supra, provides that to be deductible

for the purposes of determining adjusted gross income, expenses

must be those directly, and not those merely remotely, connected

with the conduct of a trade or business.

     For example, taxes are deductible in arriving at
     adjusted gross income only if they constitute
     expenditures directly attributable to a trade or
     business or to property from which rents or royalties
     are derived. Thus, property taxes paid or incurred on
     real property used in a trade or business are
     deductible, but state taxes on net income are not
     deductible even though the taxpayer's income is derived
     from the conduct of a trade or business. [Id.]

     The committee reports and the regulations specifically state

that State taxes on net income are not deductible for the purpose
                               - 8 -

of computing adjusted gross income.3   Finally, in Tanner v.

Commissioner, 45 T.C. 145 (1965), affd. per curiam 363 F.2d 36

(4th Cir. 1966), we held that a taxpayer is not entitled to

deduct, in computing his adjusted gross income, the State income

tax he paid on income he received as his share of the net

business income derived from certain partnerships.4   See also

Lutts v. United States, 15 AFTR 2d 702, 65-1 USTC par. 9313

(S.D. Cal. 1965).

     In the instant case, petitioners paid State nonresident

income taxes on their net royalty income, which derived from

their interests in oil and gas wells; the State income taxes were

not expenses attributable to property held for the production of

royalties or expenses directly incurred in the production of

royalties.   Accordingly, we hold that the State nonresident

income taxes paid by petitioners are not deductible for the




     3
      Following the enactment of sec. 22(n), I.R.C. 1939, the
Commissioner amended Regulations 111 by adding sec. 29.22(n)-1,
which provided that State income taxes were not deductible in
determining adjusted gross income, even though the taxpayer's
income was derived from the conduct of a trade or business. See
T.D. 5425, 1945 C.B. 10, 16.
     4
      In Tanner v. Commissioner, 45 T.C. 145 (1965), affd. per
curiam 363 F.2d 36 (4th Cir. 1966), the issue was decided
pursuant to the provisions of sec. 62(1), I.R.C. 1954 (as
amended). The provisions of sec. 62 of the 1954 Code are
substantially the same as the provisions of sec. 22(n) of the
1939 Code. See id. at 147. Furthermore, sec. 62(a)(4), which is
in effect for the taxable years at issue, is the same as sec.
62(5), I.R.C. 1954 (as amended).
                                 - 9 -

purpose of computing adjusted gross income.5

     In reaching our holdings herein, we have considered each

argument made by the parties and, to the extent not discussed

above, find those arguments to be irrelevant or without merit.

     To reflect the foregoing,

                                         Decision will be entered for

                                   respondent.




     5
      In this case,   if petitioners had not elected to take the
standard deduction,   the State income taxes that petitioners paid
would be deductible   from their adjusted gross income as an
itemized deduction,   see secs. 63, 161, subject to the limitation
imposed by sec. 68.
