                 106 T.C. No. 22



             UNITED STATES TAX COURT



  STEPHEN R. AND MARY K. HERBEL, Petitioners v.
   COMMISSIONER OF INTERNAL REVENUE, Respondent

  JERRY R. AND CAROLYN M. WEBB, Petitioners v.
  COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 22079-93, 22080-93.    Filed June 5, 1996.



     M, a subch. S corporation, purchased working
interests in various gas wells that were subject
to a gas purchase contract with A. To avoid
litigation over a so-called take or pay provision
in the contract, M and A entered into a Settle-
ment Agreement under which A paid $1,850,000 to
M in 1988 but reserved the right to recoup the
payment from future gas purchases under the
contract. The Settlement Agreement further
provided that M would pay any unrecouped amount
to A in cash in the event that it terminated the
contract or the wells became substantially
depleted. M did not report the payment as income
in 1988. R determined that A's payment to M was
an advance payment for gas, and is includable in
M's income in 1988, the year received. Sec.
1.451-1(a), Income Tax Regs.
     Ps, shareholders of M, filed a motion for
summary judgment in which they argue that, under
                            - 2 -

     general tax principles, the subject payment is
     a deposit in the nature of a loan and is not
     includable in income in 1988 under Commissioner
     v. Indianapolis Power & Light Co., 493 U.S. 203
     (1990). Ps further argue that A's right of
     recoupment is a production payment under sec.
     636(a), with the result that the transaction
     must be treated as a loan. In support thereof,
     Ps assert that sec. 1.636-3(a)(1), Income Tax
     Regs., is invalid to the extent it limits the
     definition of production payment to interests
     which are economic interests in the mineral in
     place.
          Held: A's payment is an advance payment
     for the purchase of gas under the gas purchase
     contract and is includable in M's income in
     the year received. Held, further, sec. 1.636-
     (a)(1), Income Tax Regs., is valid and, A's right
     of recoupment is not a production payment under
     sec. 636(a).



     Frederick R. Parker, Jr., and W. Deryl Medlin, for

petitioners.

     Martin M. Van Brauman and Josh O. Ungerman, for

respondent.



                           OPINION

     WHALEN, Judge:   These consolidated cases are before

the Court to decide petitioners' motion for summary

judgment.   The issue presented by petitioners' motion is

whether a payment received in settlement of a contractual

dispute involving a so-called take or pay contract for

the purchase and sale of natural gas is includable in

petitioners' income in the year received, as respondent
                             - 3 -

contends, or whether the payment is a deposit in the

nature of a loan, as petitioners contend.      In addition to

petitioners' motion for summary judgment and memorandum

in support thereof, respondent's notice of objection and

memorandum in support thereof, and petitioners' reply, the

parties have filed a stipulation of facts in each of the

consolidated cases, together with exhibits attached

thereto.   The stipulations and accompanying exhibits are

incorporated by this reference.      The facts set forth in

this opinion are taken from the pleadings and

the stipulations of facts.


                         Background

     Respondent issued a notice of deficiency to Stephen R.

and Mary K. Herbel, petitioners in the case at docket No.

22079-93, in which respondent determined the following

deficiency in, and additions to, their 1988 tax:


                             Additions to Tax
     Deficiency      Sec. 6653(a)(1)     Sec. 6661(a)

      $42,725            $2,136               $10,681


All section references are to the Internal Revenue Code as

in effect during 1988, unless stated otherwise.      Respondent

also issued a notice of deficiency to Jerry R. and Carolyn

M. Webb, petitioners in the case at docket No. 22080-93,
                              - 4 -

in which respondent determined the following deficiency in,

and additions to, their 1988 tax:

                               Additions to Tax
     Deficiency        Sec. 6653(a)(1)     Sec. 6661(a)

      $366,244            $18,312             $91,561


All petitioners resided in Shreveport, Louisiana, at the

time they filed their petitions with this Court.

     Petitioners owned all of the outstanding stock of

Malibu Petroleum, Inc. (Malibu).      Malibu had been

incorporated under Texas law on or about February 18, 1988,

to engage in the business of exploring for and producing

oil and natural gas.    During 1988, petitioners Stephen and

Mary Herbel owned 10 percent of Malibu's outstanding stock,

and petitioners Jerry and Carolyn Webb owned 90 percent of

Malibu's stock.   Mr. Herbel was Malibu's president.

     For Federal income tax purposes, Malibu was an S

corporation within the meaning of section 1361(a)(1).

Malibu and each petitioner reported income and deductions

for Federal income tax purposes using the cash receipts

and disbursements method of accounting.

     At various times during 1988, Malibu acquired the

interests of Regency Exploration, Inc. (Regency), and

others in certain gas wells located in Sebastian County,

Arkansas, that were covered by a gas purchase contract

dated January 2, 1981, between Revere Corp., an Arkansas
                              - 5 -

corporation, as seller, and Arkansas Louisiana Gas Co.

(Arkla) as buyer.    In this opinion, we refer to the gas

purchase contract as the Contract.    Section 9 of the

Contract provides as follows:


     Section 9.     QUANTITIES.

          (A)(1) The following phrases are used in
     this agreement with the following meanings:

                       (a) "Daily Deliverability,” with
                  respect to a particular well, refers
                  to the average daily rate at which the
                  well can lawfully deliver gas under
                  the conditions of this contract as
                  determined by a 5-day test, such 5-day
                  tests to be conducted by Buyer from
                  time to time as operations may indicate
                  to be necessary. The results of a
                  particular 5-day test shall be effec-
                  tive hereunder from the completion of
                  the test until the completion of the
                  next such test.

                       (b) “Average Daily Volume,” with
                  respect to a particular well, refers to
                  75% of the Daily Deliverability of that
                  well as in effect from time to time.

                       (c) "Contract Annual Volume,”
                  with respect to a particular well,
                  refers to an annual volume equal
                  to the cumulative total of the
                  Average Daily Volumes effective
                  hereunder from time to time for
                  that well during the particular
                  Contract Year.

          (2) Subject to the further provisions
     hereof, Buyer shall receive the Contract Annual
     Volume during each Contract Year from each
     Contract Well.

          (3) Buyer’s receipts of gas hereunder will
     fluctuate from time to time because of Buyer’s
                      - 6 -

fluctuating requirements for its system, and
Buyer shall balance its receipts hereunder from
each Contract Well over each Contract Year in
order to receive the Contract Annual Volume,
provided that to permit such balancing of
receipts, Buyer shall have the right to require
deliveries hereunder from the well at a daily
rate of at least the Daily Deliverability of that
well as in effect from time to time, and to the
extent that Seller is unable lawfully to deliver
gas at the required rate, Buyer shall be relieved
of its take obligations hereunder.

     (B) The provisions of this Section are
subject to all the other terms and conditions
of this contract and to the physical ability
of any given well or wells to lawfully deliver
the quantities of gas herein contemplated in
accordance with such other terms and conditions
and the rules and regulations of any regulatory
authority having jurisdiction.

     (C) Except as may otherwise appear in
context, this entire contract presupposes that
it covers 100% of the interests in all wells from
which gas is now or may hereafter be deliverable
hereunder, and accordingly, to the extent that
all the production from any particular well or
wells is not thus subject hereto and deliverable
hereunder during any particular accounting
period, or part thereof, then Buyer’s take
obligations hereunder in respect of such well or
wells shall be reduced proportionately. Reserves
attributable to an interest subject to a prior
call or other such right in a third party to
require delivery of production otherwise
deliverable hereunder, shall not be considered
for purposes of determining any obligations of
Buyer based on reserves until such time as the
interest is unconditionally dedicated to this
contract free and clear of any such prior rights
in third parties.

     (D) Buyer shall have the right to purchase
hereunder, in addition to the minimum volumes
provided to be received hereunder, such
additional volumes of gas as Buyer may in the
prudent operation of its business require from
the subject properties from time to time and
                      - 7 -

which Seller can lawfully deliver hereunder
consistently with prudent operation of Seller’s
wells and with all rules and regulations of any
regulatory authority having jurisdiction.

     (E) If any given subject well or wells be
connected to Buyer’s pipeline system and prepared
to deliver gas to Buyer hereunder during only
part of any given accounting period, then Buyer’s
take obligation in respect of such well or wells
for such accounting period shall be that propor-
tion of the take obligation otherwise applicable
which the number of days such well or wells are
connected to Buyer’s system and prepared to
deliver gas to Buyer hereunder during such period
bears to the total number of days in the period.

     (F) In order to avoid disproportionate
withdrawals of gas from any well or wells, it
is agreed that if gas from any particular well
or wells otherwise deliverable hereunder is not
delivered to Buyer, either because the gas is
delivered to Seller’s lessors or used by Seller
for operations in the area pursuant to other
provisions of this contract or for any other
reason, then Buyer’s take obligations hereunder
in respect of such well or wells may, at Buyer’s
option, be reduced by amounts equivalent to such
volumes produced but not delivered to Buyer.

     (G) Seller recognizes that the efficient
conduct of Buyer’s business requires the main-
tenance of accurate gas reserve records, and
Seller agrees to cooperate with Buyer to that end
and to make available to Buyer such information
as to subject wells as may be necessary or useful
to Buyer from time to time in its reserve
studies.

     (H) If Buyer does not receive the annual
minimum which Buyer is obligated to receive
hereunder during a particular Contract Year, and
the annual minimum was available and tendered by
Seller for delivery hereunder in accordance with
the provisions of this contract, Buyer shall pay
to Seller at the price per Mcf payable hereunder
on the last day of the particular Contract Year
for a volume (hereinafter for convenience
referred to as the "annual shortage") equal to
                      - 8 -

the difference between the volume actually
received during the Contract Year and the minimum
volume Buyer was obligated to receive during the
year. If Buyer thus pays for an annual shortage
not actually received, Buyer shall have the right
to recoup the volume thus paid for but not
received out of future production from any or all
wells delivering gas under this contract, without
further payment, and to that end, so long as
there is an unrecouped balance of annual
shortages paid for but not received:

          (1) 25% of all volumes of gas
     received from any or all wells under
     this contract will be credited toward
     recoupment whenever Buyer is requesting
     full deliverability of gas from such
     well or wells under this contract and
     receiving all gas delivered by Seller.
     As and when recoupment volumes are
     credited toward recoupment, such
     volumes shall be deemed currently
     purchased and received by Buyer for
     all other purposes of this contract,
     including satisfaction of current take
     or pay obligations.

          (2) In addition to volumes
     credited toward recoupment under the
     preceding paragraph, it is also agreed
     that all additional gas received by
     Buyer during each Contract Year in
     excess of the annual minimum Buyer is
     obligated hereunder to receive during
     that Contract Year will also be
     credited toward recoupment.

          (3) If recoupment gas can be credited
     hereunder to more than one prior Contract
     Year in which gas was paid for but not
     received, the recoupment gas shall be
     credited first to the oldest unrecouped
     annual shortage until the same has been
     recouped.

          (4) If Buyer has not recouped
     particular gas paid for but not
     received hereunder within 5 years after
     the close of the Contract Year in which
                            - 9 -

           the particular unrecouped annual
           shortage occurred, the right to recoup
           the remainder of that particular annual
           shortage will terminate.

                (5) Tax reimbursements, if any,
           due by Buyer to Seller hereunder will
           be payable as and when gas is actually
           received, without regard to whether the
           gas being received is recouped gas or
           gas currently being purchased and paid
           for.


                     (6) If the price
                payable under this contract
                when particular recoupment
                gas is received is higher
                than the price Buyer paid
                hereunder for the particular
                annual shortage against which
                that recoupment gas is
                credited, then Buyer will pay
                the difference at the time
                the recoupment gas is
                received.


     Shortly after Malibu acquired its interest in the

subject wells, Mr. Herbel wrote to Arkla and demanded

payment in the amount of $4,749,123 due to Arkla's failure

to take and pay for, or to pay for if not taken, a minimum

quantity of gas during the period April 1983 through April

1987, as required by section 9 of the Contract quoted

above.   In a letter dated March 9, 1988, Mr. Herbel reduced

Malibu's claim to $3,539,040 to account for the fact that

the original claim had overstated Malibu's working interest

in one of the wells.   He further reduced the claim to

$2,418,170, "After making certain adjustments because of
                          - 10 -

testing procedures" for one of the wells.   Arkla responded

to Malibu's claim by denying that it had a take or pay

obligation under the Contract.

     To settle this dispute without litigation, Arkla and

Malibu entered into a "Settlement Agreement" on April 25,

1988, and Arkla issued a check to Malibu dated April 28,

1988, in the amount of $1,850,000.   The Settlement

Agreement provides as follows:



                   SETTLEMENT AGREEMENT

          THIS AGREEMENT, executed as of this 25th
     day of April, 1988, by and between ARKLA ENERGY
     RESOURCES, a division of Arkla, Inc., a Delaware
     corporation (hereinafter referred to as "Buyer")
     (formerly known as Arkansas Louisiana Gas
     Company, a division of Arkla, Inc.), represented
     herein by James M. Monk, its duly authorized
     Vice President, and MALIBU PETROLEUM, INC., a
      Texas corporation, (hereinafter referred to
     as "Seller") represented herein by Stephen R.
     Herbel , its duly authorized agent .

                     WITNESSETH THAT:

          WHEREAS, by gas purchase contract identified
     on Exhibit A hereto, Seller agreed to sell and
     Buyer agreed to purchase production from certain
     natural gas properties, which contract, as the
     same may have heretofore been supplemented,
     modified and amended, is hereinafter referred to
     as the "Contract"; and

          WHEREAS, a controversy has arisen between
     Seller on the one hand and Buyer on the other
     hand concerning the obligations of Buyer under
     the Quantities provisions of the Contract; and

          WHEREAS, after balancing their hope of
     prevailing in, against the possibility of losing,
                     - 11 -

the aforesaid disputes, and in order to avoid
litigation, to limit the hazards and the uncer-
tainties of litigation and in order to buy their
peace, the parties have freely and voluntarily
agreed to settle and compromise all aspects of
the disputes upon the terms and conditions
hereinafter set forth;

     NOW, THEREFORE, for and in consideration
of the premises and the mutual covenants herein
contained, Seller and Buyer hereby contract and
agree as follows:

                      1.

     Seller and Buyer agree to execute
simultaneously with the execution of this
Settlement Agreement a gas purchase contract
amendment to the Contract in the form of that
attached hereto as Exhibit B, the provisions of
which shall govern the relations of the parties
as to the matters contained therein from its
effective date forward. Upon execution of the
amendment, the obligations imposed by this
paragraph of the Settlement Agreement shall be
completed and the Contract and this Settlement
Agreement shall be completed and the Contract and
this Settlement Agreement shall be treated as
separate and independent contracts so that
ongoing future performance under the Contract
shall not constitute performance under the
Settlement Agreement.

                      2.

     Buyer has this date made a lump sum
prepayment (hereinafter referred to as the
"Prepayment") to Seller in the total sum of
$1,850,000.00 which shall constitute a prepayment
in advance for natural gas to be delivered by
Seller to Buyer on and after May 1, 1988 from all
wells subject to the Contract (hereinafter the
"Subject Wells"). Buyer shall have the right to
receive and recoup out of all natural gas to the
extent specified below produced from the Subject
Wells, attributable to the Gross Working Interest
of Seller, a volume of natural gas which has a
value equal to the Prepayment, calculated by
applying the price per MMBtu in effect under the
terms of the Contract, as amended this date, at
                     - 12 -

the time such natural gas is requested for
delivery under the Contract. As used herein,
"Gross Working Interest" shall mean the share of
gas Seller has the right to sell, specifically
being prior to reduction for royalties, over-
riding royalties and other non-operating
interests. Such recoupment shall be accomplished
as follows:

    (a)   Fifty percent (50%) of the volumes
          of natural gas delivered from any
          Subject Well and sold to Buyer or
          to Buyer and Buyer's partial
          assignee under the Contract each
          month during the period May 1,
          1988 through the remaining term
          of the Contract, or until such
          time as the Prepayment is fully
          recouped or refunded, whichever
          first occurs (the "Recoupment
          Period"), shall be considered
          recoupment gas and received
          without further payment and,
          accordingly, all such natural gas
          purchased pursuant to the Contract
          from the Subject Wells will be
          retained by Buyer or by Buyer and
          Buyer's partial assignee and
          applied against the Prepayment
          until Buyer has thereby recouped
          the entire Prepayment.

    (b)   Buyer or Buyer and Buyer's partial
          assignee shall have the right to
          require deliveries and purchases
          from each Subject Well at a daily
          rate of up to the Daily Deliver-
          ability of that well in effect
          from time to time. In the event
          Seller fails or is unable for any
          reason to tender and deliver gas
          from any Subject Well at the rate
          requested, then Buyer, in addition
          to all other rights and remedies
          available to Buyer, shall be
          entitled to deduct an amount equal
          to fifty percent (50%) of the
          difference between the volume
          requested and the volume actually
          delivered, multiplied by the price
                      - 13 -

           in effect under the Contract at
           the time of the request for
           delivery, from any payment due
           Seller under the terms of the
           Contract and to credit the same
           against the Prepayment.

     (c)   Seller shall refund to Buyer
           the unrecouped balance of the
           Prepayment, if any, at the earlier
           of such time as (i) the Contract
           is cancelled or otherwise
           terminated by Seller, (ii) the
           Contract's primary term expires
           and the Contract is terminated by
           Seller or (iii) the wells subject
           to the Contract substantially
           deplete.

     (d)   In connection with the recoupment
           rights granted Buyer herein,
           Seller has this date executed an
           Assignment of Limited Term Over-
           riding Royalty (Production Pay-
           ment) in the form of that attached
           hereto as Exhibit C. It is agreed
           that the said Assignment of
           Production Payment shall have a
           term which equals the Recoupment
           Period. Upon the end of the term,
           Buyer shall furnish to Seller, in
           recordable form, a duly executed
           release of the said Assignment of
           Production Payment.

                       3.

     Buyer and Seller agree that, upon request of
Seller, they shall enter into a Release Agreement
in the form of that attached hereto as Exhibit D.
Arkla Energy Resources agrees that both prior to
and during the Release Period it shall continue
to make its requests ratably for the delivery of
gas for its system purchases in accordance with
the applicable rules, regulations and statutes of
any governmental body having jurisdiction.

                       4.
                     - 14 -

     Nothing contained herein is intended to
diminish Buyer's rights under the provisions of
Paragraph (K) of the General Terms and Conditions
of the Contract, it being specifically understood
that the said provisions shall be applicable to
the Prepayment and, accordingly, that Seller
shall bear the economic burdens, if any, of and
shall pay all royalties, overriding royalties,
production payments, taxes and other payments and
settlements of whatsoever kind and nature due in
respect of production prepaid for herein. Seller
further agrees to indemnify Buyer and save it
harmless from all claims, suits, actions, debts,
accounts, damages, costs, losses, attorneys' fees
and expenses arising out of adverse claims of any
and all persons or entities to or against said
production and said Prepayment.

                      5.

     In addition to the warranty provided for in
Paragraph (K) of the General Terms and Conditions
Supplement to the Contract, Seller hereby repre-
sents, warrants and guarantees that it is the
owner of the Gross Working Interest stipulated in
Exhibit E and has the right to sell and deliver
to Buyer that share of gas produced represented
by such Gross Working Interest without the
joinder of any other person whomsoever. Seller
further represents, warrants and guarantees that
it is the owner of all rights and claims
attributable to the said Gross Working Interest
arising out of the Quantities provisions of the
Contract for all periods commencing after the
Effective Date of the Contract. It is
acknowledged that the amount of the Prepayment
is predicated upon the foregoing representations.
Seller further represents, warrants and guaran-
tees that there exist no encumbrances or other
rights superior to the rights of Buyer to recoup
the said Prepayment. Seller agrees and covenants
that until such time as Buyer has fully recouped
the Prepayment, it shall not assign, transfer or
otherwise encumber its interests in the Subject
Well, in whole or in part, without the prior
written consent of Buyer, which consent shall not
be unreasonably withheld. No such transfer,
however, shall relieve Seller of its obligations
to Buyer hereunder.
                     - 15 -

                       6.

     Seller hereby waives any and all claims
relating to or arising out of the Contract,
including any failure to take gas or to pay for
gas not taken by Buyer, in respect of all natural
gas available for production from all properties
committed to the Contract from the Effective Date
of the Contract through June 30, 1990.

                       7.

     This Settlement Agreement and the exhibits
attached hereto represent the entire agreement
between the parties regarding the settlement of
their disputes and all previous negotiations and
representations are superseded.

                       8.

     It is understood and agreed that this is a
compromise of disputed claims and that Buyer
denies any liability whatsoever in the premises,
this compromise settlement being entered into
primarily for the purpose of avoiding litigation.

                       9.

     The parties to this Settlement Agreement
and their attorneys agree that, unless required
to do so by order of the court or regulatory
body asserting competent jurisdiction, they
will refrain from disclosing to any persons or
entities the terms of this Settlement Agreement
and any information or materials obtained in
connection with the settlement discussions
resulting in this Settlement Agreement.
Notwithstanding this restriction, Seller and
Buyer agree that this information may be
disclosed to financial institutions, lawyers or
other consulting personnel, as may be necessary
in the ordinary course of business, provided that
such financial institutions, lawyers or other
consulting personnel agree and covenant in
writing to all other parties to refrain from
disclosing the information to other persons or
entities, unless such institutions and profes-
sionals are already required by their normal
conduct of business to maintain client confi-
dentiality. The parties further agree that
                           - 16 -

     this restriction shall not be construed as
     prohibiting any party from reflecting the
     payments made herein in financial statements
     or in regulatory filings by Buyer.

                            10.

          It is the intent of the parties to include
     all gas sales and purchase agreements between
     Buyer and Seller within the definition of "Con-
     tract," whether or not specifically identified
     on Exhibit A. To the extent the same may be
     hereafter required, the parties agree to execute
     further instruments to evidence this intent.

                            11.

          This Settlement Agreement shall be binding
     upon and inure to the benefit of the parties
     hereto, their respective successors and assigns.

          IN WITNESS WHEREOF, the parties have
     executed this Settlement Agreement, in duplicate
     originals, as of the day and year first
     hereinabove written.


     Pursuant to paragraph 1 of the Settlement Agreement

quoted above, Arkla and Malibu also entered into the Gas

Purchase Contract Amendment (contract amendment) attached

thereto as an exhibit.   The purpose and effect of the

contract amendment was to change the mechanism for

determining the price of gas purchased by Arkla under the

Contract, effective May 1, 1988.

     Pursuant to paragraph 2(d) of the Settlement

Agreement, quoted above, Malibu executed an Assignment of

Limited Term Overriding Royalty (Production Payment),

granting Arkla the following interest in the subject wells:
                           - 17 -

    as a limited term overriding royalty interest,
    fifty percent (50%) of all of Assignor's
    [Malibu's] interest in all gas produced, saved,
    and sold to Assignee [Arkla], if as and when
    produced, saved, and sold to Assignee but not
    otherwise, on and after May 1, 1988 from those
    certain wells specified on Exhibit A attached
    hereto ("Subject Wells") and by this reference
    made a part hereof, under the gas purchase
    agreement between Assignor and Assignee applic-
    able to the Subject Wells. Assignor further does
    hereby grant bargain, sell, transfer, set over,
    convey and deliver unto Assignee an interest in
    the oil and gas leases and other mineral rights
    of Assignor within the drilling and spacing unit
    for each Subject Well sufficient to convey to
    Assignee the overriding royalty interest above
    described, the legal description of which unit is
    more fully described on Exhibit A.


The assignment was to last until:


     such time as the total production attributable
     to the interest assigned hereunder equals in
     value that certain total sum stipulated in the
     "Settlement Agreement" between Assignor and
     Assignee dated April 25 , 1988, at which time
     the interest assigned hereunder shall terminate
     and revert to Assignor. * * *

           Finally, paragraph 3 of the Settlement Agreement,

quoted above, provides that upon Malibu's request, the

parties will enter into a Release Agreement in the form

attached to the Settlement Agreement as an exhibit.    Under

the Release Agreement, Malibu and Arkla would agree as

follows:


     1.    Buyer [Arkla] and Seller [Malibu] hereby
           agree to release from commitment to the
           Contracts for a primary term commencing
           May 1, 1988, and extending through June 30,
           1990 and continuing on a month to month
                     - 18 -

     basis thereafter, unless and until
     terminated by either party upon 30 days
     written notice prior to the end of the
     primary term or any monthly extension
     (the "Release Period"), all gas otherwise
     deliverable by Seller each day from any well
     or wells committed to the performance of the
     Contracts which is (i) gas that is priced
     pursuant to the applicable Contract above
     the replacement cost of gas deliverability
     estimated by Buyer to be available on its
     system at the time of this release; (ii)
     gas that was not committed or dedicated to
     interstate commerce as of November 8, 1978
     (within the meaning of Section 2(18) of the
     Natural Gas Policy Act), or if so committed
     or dedicated gas that qualifies under Sec-
     tions 102(c), 103(c), or 107(c)(1-4) of
     the Natural Gas Policy Act; and (iii) gas
     deliverability that is in excess of the
     quantities of gas requested by Buyer, from
     time to time, from Seller's interest in such
     well or wells under the subject Contracts;
     and Seller shall have the right to sell such
     excess gas deliverability to third parties
     on such day during the Release Period.

2.   Buyer further agrees to release from
     commitment to the Contracts during the
     Release Period, subject to the prior receipt
     of any necessary governmental authorizations
     on terms and conditions acceptable to both
     parties, any other supplies of natural gas
     deliverable by Seller each day from any well
     or wells committed to the performance of the
     Contracts, provided that the gas released
     shall be limited to (i) gas from wells,
     priced at the lower of the contract price
     or maximum lawful price for such gas, which
     when combined with the deliverability and
     contract price of the gas released under
     Paragraph 1 hereof, exceeds the current
     replacement cost of gas deliverability
     estimated by Buyer to be available on its
     system; and (ii) deliverability from such
     wells which is in excess of the quantities
     of gas requested by Buyer, from time to
     time, during the Release Period from
     Seller's interest in such wells under the
     subject Contracts; and Seller shall have the
                           - 19 -

          right to sell such excess gas deliverability
          to third parties on such day during the
          Release Period.

     3.   Seller agrees that for each MMBtu of
          released gas nominated for purchase by any
          purchaser or sold by Seller (including any
          gas taken by Seller or an affiliate) in
          accordance with this agreement, Buyer shall
          be entitled to credit such quantities of gas
          against any obligations and liabilities it
          may have to take gas, or to pay for gas not
          taken, under any gas sales and purchase
          agreements between Buyer and Seller.

     4.   Seller further hereby agrees to waive and
          release Buyer from any and all obligations
          and liabilities Buyer has or may have
          arising out of any failure to take gas,
          or to pay for gas not taken, under the
          Contracts for all contract years commincing
          [sic] prior to the end of the Release
          Period.


     None of the documents executed in connection with the

settlement transaction placed any restriction on Malibu's

use of the $1,850,000 payment that it received from Arkla.

In fact, shortly after the settlement, Malibu lent

approximately one-half of the settlement payment to its

shareholders.   On April 28, 1988, and May 2, 1988,

respectively, Malibu lent $823,263.20 to Mr. Webb and

$112,000 to Mr. Herbel.   Each loan was authorized by a

corporate resolution and was evidenced by a promissory note

signed on the same day as the resolution.   The interest

rate on both loans was 8.6 percent.   For the first 3 years,

both loans called for the borrower to pay interest only,
                            - 20 -

compounded annually.   After that, principal was amortized

over 11 years and was payable annually with interest.

     At the time the Settlement Agreement was executed, the

total estimated recoverable reserves of natural gas from

the wells subject to the Contract exceeded the amount

necessary to recoup the $1,850,000 payment.    During 1988,

Arkla recouped $19,501.54 of the settlement payment from

deliveries of natural gas by Malibu, pursuant to paragraph

2 of the Settlement Agreement, resulting in an unrecouped

balance of the settlement payment of $1,830,498.46 as of

the end of 1988.    Malibu treated this amount as a liability

and reported it on the line designated "Mortgages, notes,

bonds payable in 1 year or more" on the balance sheet that

is attached as Schedule L to Malibu's 1988 income tax

return on Form 1120S, U.S. Income Tax Return for an S

Corporation.   As of June 1990, the unrecouped balance of

the settlement payment was $1,797,175.15, and as of

March 31, 1994, the unrecouped balance was $1,627,241.23.

     The amounts reported on Malibu's 1988 income tax

return are summarized as follows:


               Gross receipts or sales         $24,914
     Cost of goods sold
       and/or operations             2,945

     Gross profit                              $21,969

     Depreciation                      3,204
     Dryhole costs                    53,000
     Legal and professional            1,882
                                - 21 -

     Postage and delivery                        87
     Amortization-organization cap              135
     Bank charges                                55

        Total deductions                                 58,363

     Ordinary loss                                      (36,394)


Attached to Malibu's 1988 return are two Schedules K-1,

Shareholder's Share of Income, Credits, Deductions, Etc.

Mr. Herbel's Schedule K-1 reports $3,639 as his

distributive share of Malibu's loss, and Mr. Webb's

Schedule K-1 reports $32,755 as his share.

     Upon audit of Malibu’s return for 1988, respondent

determined that Malibu had understated its gross receipts

by $1,825,086.       Respondent's agent made the following

explanation of this adjustment:


     It is determined that payments made to you by
     Arkla, Inc. and Subsidiaries under a "take or
     pay" contract, in the amount of $1,825,086.00
     were not reported by you on your 1988 tax
     return. Therefore, taxable income is increased
     $1,825,086.00 for 1988.


     The following schedule summarizes the amounts reported

on Malibu's 1988 return, and the adjustments determined by

respondent:

     Malibu's
   1988 Return
  on Form 1120S         Per Return       Adjustments       Corrected

Gross receipts          $24,914.00    $1,825,086.00       $1,850,000.00
Cost of goods sold       (2,945.00)         --                (2,945.00)

 Total income            21,969.00       1,825,086.00     1,847,055.00
                               - 22 -
Depreciation            (3,204.00)         --               (3,204.00)
Other deductions       (55,159.00)         --              (55,159.00)

 Total deductions      (58,363.00)         --              (58,363.00)

Ordinary income (loss) (36,394.00)      1,825,086.00   1,788,692.00

Schedules K-1:

 Mr. Herbel (10%)       (3,639.40)        182,508.60     178,869.20
 Mr. Webb (90%)        (32,754.60)      1,642,577.40   1,609,822.80



     Based upon respondent's determination that Malibu's

gross receipts had been understated, respondent further

determined that the gross income of each of Malibu's

shareholders had been understated.         The notice of

deficiency issued to Mr. Herbel, who owned 10 percent

of Malibu's stock, states as follows:


     Due to the audit of Malibu Petroleum, Inc. and
     Subsidiaries, it is determined that your share of
     the corporation's taxable income is $178,869.00.
     Therefore, taxable income is increased
     $178,869.00 for 1988. * * *


The notice of deficiency issued to Mr. Webb, who owned 90

percent of Malibu's stock, states as follows:


     Due to the audit of Malibu Petroleum, Inc. and
     Subsidiaries, it is determined that your share of
     the corporation's taxable income is $1,609,823.00
     rather than the loss of $32,755.00 as reported on
     your 1988 tax return. Therefore, taxable income
     is increased $1,642,578.00 for 1988. * * *

                             Discussion

     The issue presented in these consolidated cases is

whether the payment of $1,850,000 received by Malibu during
                           - 23 -

1988 pursuant to the Settlement Agreement is includable

in Malibu’s gross income for 1988, as determined by

respondent.   The payment was made by Arkla to settle a

contractual dispute between Malibu and Arkla over the

so-called take or pay provisions set forth in section 9 of

the Contract.   Respondent determined in the subject notices

of deficiency that the settlement payment constituted

income to Malibu in 1988, and that each of Malibu’s

stockholders is required to include in income for 1988

his pro rata share of the payment, pursuant to the rules

applicable to S corporations.   Sec. 1366(a).

     Petitioners, Malibu’s stockholders, take the position

that the payment is in the nature of a deposit or loan

which will become income only as, and to the extent that,

Arkla chooses to recoup the payment by taking natural gas

produced from Malibu's interest in wells covered by the

Contract.   In support of that position, petitioners argue

that the Settlement Agreement imposes on Malibu a “fixed

and unconditional obligation” to repay the full amount of

the payment to Arkla, and, under certain circumstances, it

requires Malibu to repay the unrecouped balance of the

payment in cash.   Petitioners also argue that, while the

Settlement Agreement gives Arkla the right to recoup the

payment in kind from future production, it does not impose
                           - 24 -

an obligation on Arkla to purchase any minimum quantity of

gas from Malibu.

     According to petitioners, the effect of the Settlement

Agreement is to give “Arkla the option either to seek

repayment by delivery of gas in kind or to forego recoup-

ment and await repayment in cash upon depletion of the

Contract Wells.”   Petitioners argue that the Settlement

Agreement “effected the creation of a loan in its

traditional sense”.   In support of this argument,

petitioners cite the opinion of the Supreme Court in

Commissioner v. Indianapolis Power & Light Co., 493 U.S.

203 (1990), and the opinions of this Court and its

predecessor in Arlen v. Commissioner, 48 T.C. 640 (1967);

Veenstra & DeHaan Coal Co. v. Commissioner, 11 T.C. 964

(1948); and Summit Coal Co. v. Commissioner, 18 B.T.A.     983

(1930).   Petitioners also argue that the Settlement

Agreement is “a contingent and executory contract” and that

Malibu has no right to keep the settlement payment made

thereunder until the condition set forth therein is

satisfied; i.e., until, and to the extent, Arkla recoups

the advance payment by purchasing gas under the contract.

     Respondent argues that in form and in substance the

subject payment is not a loan but is a prepayment for

natural gas.   Respondent notes that the Settlement

Agreement itself describes the payment as a “prepayment in
                            - 25 -

advance for natural gas”, and that the other language used

in the Settlement Agreement is consistent with a sale of

gas, rather than a loan.   Respondent also notes that no

loan documents, such as promissory notes, were executed by

the parties, and no interest was charged on the unrecouped

balance of the payment.    Finally, respondent notes that the

treatment of the payment by the parties suggests that it

was an advance payment for the sale of gas and not a loan.

In this regard, respondent points out that Arkla booked the

payment to an account entitled “Gas Purchased In Advance of

Delivery”, an asset account and not a loan account, and

that minutes of a meeting of Malibu’s Board of Directors

state that the payment “constitutes prepayment in advance

for gas to be delivered by Malibu Petroleum, Inc.”

     Respondent argues that the payment does not constitute

a loan because “the maker of the payment, Arkla, has no

right to demand a refund of the payment in cash as long as

the recipient of the payment, Malibu, does not terminate

the Gas Contract and maintains certain levels of production

from the wells subject to the Gas Contract.”   Respondent

also argues that the cases cited by petitioners, such as

Commissioner v. Indianapolis Power & Light Co., supra, are

“completely inapplicable or clearly distinguishable.”

     Respondent notes that Malibu reports income under the

cash receipts and disbursements method of accounting, and
                              - 26 -

citing section 1.451-1(a), Income Tax Regs., argues that

Malibu is required under that method of accounting to

include the payment in income in the year of receipt.

Respondent acknowledges that section 1.451-5(g), Income Tax

Regs., provides an exception to the general rule in section

1.451-1(a), Income Tax Regs., for certain advance payments

treated as mortgage loans pursuant to section 636(a).

However, respondent argues that the subject payment is not

eligible for the exception for two reasons.     First, it is

not an “advance payment”, as defined by section 1.451-5(a),

Income Tax Regs., because Malibu is not a taxpayer using an

accrual method of accounting as required by that provision.

Second, it is not a “production payment” for purposes of

section 636(a) because "recoupment by Arkla can occur by

gas deliveries or by a cash repayment (but not by cash

payments from the sale of the minerals), the payment from

Malibu fails to satisfy the Treas. Reg. § 1.636-3(a)

criteria".

     Finally, respondent asserts that "there are genuine

issues as to material facts", and that summary judgment is

not proper.   See Rule 121.    All Rule references are to the

Tax Court Rules of Practice and Procedure.     In support of

that position, respondent relies on two affidavits attached

to respondent’s objection, one by an employee of Arkla's
                           - 27 -

successor corporation, NorAm Gas Transmission Co. (NorAm),

and one by an attorney for NorAm.

     The issues in this case involve the tax treatment

of the consideration paid by Arkla under the Settlement

Agreement, as opposed to Arkla's right of recoupment set

forth in paragraph 2 of the Settlement Agreement.   However,

the first issue presented by petitioners' motion for

summary judgment is whether Arkla's right of recoupment is

a carved-out production payment, as described by section

636(a), such that the settlement transaction must be

treated as a mortgage loan on the mineral property.

Section 636(a) provides as follows:


          SEC. 636(a). Carved-out Production Payment.
     --A production payment carved out of mineral
     property shall be treated, for purposes of this
     subtitle, as if it were a mortgage loan on the
     property, and shall not qualify as an economic
     interest in the mineral property. In the case of
     a production payment carved out for exploration
     or development of a mineral property, the pre-
     ceding sentence shall apply only if and to the
     extent gross income from the property (for
     purposes of section 613) would be realized, in
     the absence of the application of such sentence,
     by the person creating the production payment.


The regulations promulgated under section 636(a) define the

term “production payment” to mean "in general, a right to a

specified share of the production from mineral in place

(if, as, and when produced), or the proceeds from such

production.   Such right must be an economic interest in
                           - 28 -

such mineral in place."   Sec. 1.636-3(a)(1), Income Tax

Regs.

     Petitioners never explicitly argue that section 636

governs the settlement between Malibu and Arkla.   However,

they argue at length that the definition of production

payment set forth in section 1.636-3(a), Income Tax Regs.,

is "inconsistent with the express language of Section 636

* * * [and] with the legislative history" of section 636 to

the extent that it limits the definition to cases in which

the right to production is "an economic interest in such

mineral in place."   Sec. 1.636-3(a)(1), Income Tax Regs.

According to petitioners, no such limitation was intended

by Congress, and section 1.636-3(a), Income Tax Regs.,

"must be declared invalid."   In making this argument,

petitioners in effect concede that Arkla's right of

recoupment under the Settlement Agreement is not an

economic interest in the minerals in place, but they argue

that it should nevertheless be treated as a mortgage loan

pursuant to section 636(a).

     We agree with the proposition, implicit in

petitioners' argument, that Arkla's right of recoupment or

refund is not "an economic interest in such mineral in

place", as required by section 1.636-3(a)(1), Income Tax

Regs.   Generally, courts have applied a two-part test for

determining whether there is an economic interest.    See,
                             - 29 -

e.g., Freede v. Commissioner, 864 F.2d 671, 673-674 (10th

Cir. 1988), revg. 86 T.C. 340 (1986); Christie v. United

States, 436 F.2d 1216, 1218 (5th Cir. 1971).    In Freede v.

Commissioner, supra at 674, the court described the two-

part test 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."    In this case,

it is readily apparent that Arkla was not required to look

solely to the extraction of the minerals for a return of

its payment of $1,850,000.    To the contrary, the Settlement

Agreement provides that Arkla would receive "the unrecouped

balance of the Prepayment" in the event that the Contract

were terminated by Malibu or the wells became substantially

depleted.   Therefore, since Arkla is not required to look

solely to the extraction of the minerals for return of its

payment, Arkla's right of recoupment is not an economic

interest in minerals in place.    See, e.g., Anderson v.

Helvering, 310 U.S. 404 (1940); Christie v. United States,

supra at 1220-1221; Commissioner v. Estate of Donnell, 417

F.2d 106, 115 (5th Cir. 1969), affg. in part and revg. in

part 48 T.C. 552 (1967).   Accordingly, Arkla's right of

recoupment does not constitute a "production payment"

within the meaning of section 636.    Sec. 1.636-3(a)(1),

Income Tax Regs.
                             - 30 -

     Notwithstanding Arkla's lack of an economic interest

in the mineral in place, petitioners argue that Congress

intended to apply "Section 636 loan treatment in all cases

without regard to whether the 'purchaser' acquired an

interest in the minerals which would constitute an

'economic interest' within the traditional meaning of the

term."    Thus, petitioners take the position that Arkla's

right of recoupment under the Settlement Agreement is a

"production payment" within the meaning of section 636(a),

with the result that the consideration paid by Arkla under

the agreement is required to be treated as a mortgage loan.

We disagree.

     Section 636 was added to the Internal Revenue Code by

the Tax Reform Act of 1969, Pub. L. 91-172, sec. 503(a), 83

Stat. 487, 630.    In order to address petitioners' argument

that section 1.636-3(a)(1), Income Tax Regs., is invalid,

it is necessary to review the tax treatment of production

payments prior to the passage of section 636.

     Before section 636 became law, the owner of a mineral

property who sold, or carved out, a portion of his future

production was required to treat the consideration received

for the production payment as ordinary income, subject to

depletion, and to include such amount in income in the year

received.     Commissioner v. P.G. Lake, Inc., 356 U.S. 260

(1958).     The courts had adopted the Commissioner's view
                           - 31 -

that the transaction was essentially an assignment of

expected income for a fixed or determinable period of time,

and, thus, the consideration paid for such right should be

treated as ordinary income, rather than capital gain.     Id.

at 265 n.5; see I.T. 4003, 1950-1 C.B. 10, obs. Rev. Rul.

70-277, 1970-1 C.B. 280; I.T. 3935, 1949-1 C.B. 39, obs.

Rev. Rul. 67-123, 1967-1 C.B. 383; G.C.M. 24849, 1946-1

C.B. 66, obs. Rev. Rul. 70-277, 1970-1 C.B. 280.

     The owner of the mineral property was permitted to

exclude from income the amounts utilized during the payout

period to pay the production payment, and the owner was

permitted to deduct the expenses attributable to producing

the production payment in the year the expenses were

incurred.   Thomas v. Perkins, 301 U.S. 655 (1937); S. Rept.

91-552, at 182 (1969), 1969-3 C.B. 423, 539.   The holder of

the production payment, on the other hand, was required to

treat the payments received as income but was permitted to

deduct a reasonable allowance for depletion, pursuant to

section 611(a).   United States v. Witte, 306 F.2d 81, 87

n.12 (5th Cir. 1962); S. Rept. 91-552, supra at 182, 1969-3

C.B. at 539.

     The above tax treatment applied only if the trans-

action involved a "production payment" or "oil payment";

that is, "the right to a specified sum of money, payable

out of a specified percentage of the oil, or the proceeds
                            - 32 -

received from the sale of such oil, if, as and when

produced."   Commissioner v. P.G. Lake, Inc., supra at 261

n.1 (quoting Anderson v. Helvering, supra at 410).     To

qualify as a "production payment" or "oil payment", it was

necessary for the right to consist of an economic interest

in the mineral in place, as opposed to merely the right to

cash payments.   See Anderson v. Helvering, supra at 409-

411; Thomas v. Perkins, supra.    This is the same

requirement that must be met in order to be eligible to

deduct an allowance for depletion.   See Anderson v.

Helvering, supra at 407.

     If the transaction involved a right to cash payments,

as opposed to an economic interest in the mineral in place,

then the tax consequences of the transaction differed from

those summarized above.    In that case, the consideration

received by the owner of the mineral property constituted a

loan or something other than ordinary income.    See Lehigh

Portland Cement Co. v. United States, 433 F. Supp. 639

(E.D. Pa. 1977), affd. without published opinion 577 F.2d

727 (3d Cir. 1978).   Additionally, the amounts utilized to

make the cash payments during the payout period were

includable in the owner's income and not in the income of

the payee.   See, e.g., Anderson v. Helvering, supra at 413;

Holbrook v. Commissioner, 450 F.2d 134, 137 (5th Cir.

1971), revg. 54 T.C. 1617 (1970); Christie v. United
                           - 33 -

States, supra at 1219, 1221; Commissioner v. Estate of

Donnell, supra; Landreth v. Commissioner, 50 T.C. 803, 807

(1968).

     In reviewing the above law in connection with its

consideration of the Tax Reform Act of 1969, Congress noted

that taxpayers were able to use carved-out production

payments to artificially advance the time income is

reported for tax purposes, thereby avoiding limitations

based upon net or taxable income, such as the 50-percent

limitation on taxable income from the property for

depletion purposes, the foreign tax credit, and the

limitations on carryover of net operating losses and

investment credits.   S. Rept. 91-552, supra at 183,

1969-3 C.B. at 539; H. Rept. 91-413 (Part 1), at 139

(1969), 1969-3 C.B. 200, 287.   The report of the Senate

Finance Committee states as follows:



The committee agrees with the House that there is no reason
why a person who, in effect, is the borrower in a
production payment trans-action should be allowed to pay
off the loan with tax-free dollars while a borrower of
funds in any other industry must satisfy the loan out of
taxed dollars. In addition, the committee agrees with the
House that Congress did not intend to permit the avoidance
of the limitation on depletion deductions and the
mismatching of income and expenses which creates artificial
tax losses by the use of production payments. Moreover,
there is a substantial revenue loss which results from the
use of production payments. It is estimated that the
combined revenue loss from ABC trans-actions and carved-out
production payments is between $200 and $350 million
annually. An acceleration of the revenue loss can be
                            - 34 -

expected unless corrective action is taken.   [S. Rept. 91-
552, supra at 184, 1969-3 C.B. at 540.]


See also H. Rept. 91-413, supra at 140-141, 1969-3 C.B. at

288.    In order to remedy the above abuse, section 636(a)

treats a carved-out production payment as a mortgage loan.

The committee reports issued in connection with the Tax

Reform Act of 1969 describe the operation of section 636(a)

as follows:


            In the case of a carved-out production
       payment, the bill provides the payment is to
       be treated as a mortgage loan on the mineral
       property (rather than as an economic interest in
       the property). Thus, the proceeds received by
       the seller upon a sale of a production payment
       would not be taxable to him. However, as income
       is derived from the property subject to the carve
       out, that income would be taxable to the owner of
       the property, subject to the depletion allowance.
       The cost of producing minerals used to satisfy
       carved-out production payments would be deduct-
       ible when incurred. Thus, the use of a carved-
       out production payment would not cause income
       to be accelerated, and there would be, thus, no
       avoidance of the limitation on the percentage
       depletion deduction. [S. Rept. 91-552, supra
       at 185, 1969-3 C.B. at 540; H. Rept. 91-413,
       supra at 141, 1969-3 C.B. at 288.]


       It is readily apparent from the above discussion that

the abuse Congress sought to prevent by the passage of

section 636, namely the artificial acceleration of income

from the mineral property, could come about only through

the use of a right to payments which constituted an

economic interest in the mineral in place.    As described
                             - 35 -

above, if the transaction did not involve an economic

interest in the mineral in place, then the owner of the

mineral would not necessarily derive ordinary income in the

year of the transaction in the amount of the consideration

paid for the interest, but would continue to be taxed on

the income derived from the mineral property without regard

to the transaction.     Christie v. United States, 436 F.2d

1216 (5th Cir. 1971).

     Contrary to petitioners' argument, we find no basis

to conclude that Congress intended to apply section 636

"in all cases without regard to whether the 'purchaser'

acquired an interest in the minerals which would constitute

an 'economic interest' within the traditional meaning of

the term."   We conclude that Congress intended section

636 to apply only when the production payment qualifies as

an economic interest in the mineral in place.    Accordingly,

we reject petitioners' argument that section 1.636-3(a)(1),

Income Tax Regs., is not consistent with the congressional

purpose in enacting section 636 because it limits the

definition of the term "production payment" to a right to

production which is "an economic interest in such mineral

in place".

     The principal question presented by petitioners'

motion for summary judgment is whether, under general tax

principles, Arkla's payment is an advance payment for gas
                           - 36 -

to be purchased in the future or is a refundable deposit

in the nature of a loan.   The parties agree that an advance

payment is includable in income in the year received but

that a deposit in the nature of a loan is not income.    See

Oak Industries, Inc. v. Commissioner, 96 T.C. 559, 563-564

(1991).   The question presented by petitioners' motion for

summary judgment is whether the subject payment of

$1,850,000 is the latter and not the former.

     As the Supreme Court noted in the leading case on this

question:   "The distinction between a loan and an advance

payment is one of degree rather than of kind."     Commis-

sioner v. Indianapolis Power & Light Co., 493 U.S. at 208.

Both types of transactions confer economic benefits on the

recipient, but economic benefits qualify as income only

if they are "'undeniable accessions to wealth, clearly

realized, and over which the taxpayers have complete

dominion.'"   Id. at 209 (quoting Commissioner v. Glenshaw

Glass Co., 348 U.S. 426, 431 (1955)).   The key to

determining whether a taxpayer enjoys "complete dominion"

over a given sum is not whether the taxpayer has

unconstrained use of the funds during some period, but

whether the taxpayer "has some guarantee that he will be

allowed to keep the money."   Id. at 210.

     In the case of a loan, the recipient has no such

guaranty because the funds are acquired subject to an
                           - 37 -

express obligation to repay that does not require the payor

to purchase goods or services.   Therefore, if the payor

fulfills his legal obligations, then the loan will be

refunded to him.   Id. at 209.   In the case of an advance

payment, on the other hand, the payor retains no right to

insist upon return of the funds so long as the recipient

fulfills the terms of the bargain, and the recipient is

assured that so long as he fulfills his contractual

obligations, then he can keep the money.    Id. at 210-211.

     In distinguishing between loans and advance payments,

an important factor is whether the payor or the recipient

controls the conditions under which repayment or refund

of the amount at issue will be made.   See id. at 212.     In

Commissioner v. Indianapolis Power & Light Co., supra, the

payor, the utility customer, controlled the timing and the

method of the refund of his or her deposit.    Id. at 209.

Based upon that fact, the Court held that the recipient,

the utility company, did not have a guaranty that it would

be allowed to keep the money, and thus, it did not enjoy

complete dominion over the funds.    Id. at 211.   Therefore,

if the payor controls the conditions under which the money

will be repaid or refunded, generally, the payment is not

income to the recipient.   See Highland Farms, Inc. v.

Commissioner, 106 T.C. ____ (1996) (entrance fees paid to

retirement community to occupy apartments or lodges);
                            - 38 -

Kansas City S. Industries, Inc. v. Commissioner, 98 T.C.

242 (1992) (deposits charged by railroad to build    side

track); Oak Industries, Inc. v. Commissioner, supra

(security deposit collected by subscription TV company

upon installation of electronic decoder box); Houston

Industries, Inc. v. United States, 32 Fed. Cl. 202 (1994)

(fuel cost overrecoveries received by a public utility

company).

       On the other hand, if the recipient of the payment

controls the conditions under which the payment will be

repaid or refunded, we have held that the recipient has

some guaranty that it will be allowed to keep the money,

and hence, the recipient enjoys complete dominion over the

payment.    Milenbach v. Commissioner, 106 T.C. 184 (1996);

Michaelis Nursery, Inc. v. Commissioner, T.C. Memo. 1995-

143.   For example, Milenbach v. Commissioner, supra,

involved a payment of $6.7 million by the Los Angeles

Memorial Coliseum Commission to the Los Angeles Raiders.

The agreement under which the payment was made provided

that the money was to be repaid from revenues derived from

the operation of suites to be constructed by the Raiders at

the Los Angeles Coliseum.    In view of the fact that the

construction of the suites was within the sole control of

the Raiders, and the fact that there was no default or

alternative payment provision, we found that the Raiders
                            - 39 -

had the ability to control the repayment.    Id. at 197.

Accordingly, we held "the Raiders' dominion and control

over the funds at the time they received them was

sufficient to require their inclusion in the Raiders' gross

income."   Id.

     The distinction between a loan and an advance payment

turns upon the nature of the rights and obligations that

the payor and recipient assume when the payment is made.

Commissioner v. Indianapolis Power & Light Co., supra at

209; Highland Farms, Inc. v. Commissioner, supra at ___,

(slip op. at 24-25); Oak Industries, Inc. v. Commissioner,

supra at 568.    Accordingly, in this case we must analyze

the terms of the settlement under which Arkla made the

subject payment of $1,850,000 to Malibu.

     At the outset, we note that the parties to the

settlement did not terminate the Contract as part of the

settlement, nor did they amend section 9 of the Contract

which includes the so-called take or pay provisions under

which the dispute arose.    Therefore, Malibu's share of the

natural gas produced from "all Contract Wells" remained

committed for sale to Arkla under the Contract.    Similarly,

Arkla remained obligated under section 9 of the Contract to

take a minimum volume of gas on an annual basis or to pay

Malibu for a volume of gas "equal to the difference between

the volume actually received during the Contract Year and
                            - 40 -

the minimum volume Buyer [i.e., Arkla] was obligated to

receive during the year."

     The Settlement Agreement provides that Arkla's payment

of $1,850,000 "shall constitute a prepayment in advance for

natural gas to be delivered by Seller to Buyer on and after

May 1, 1988 from all wells subject to the Contract".    In

order to effectuate Arkla's receipt of a volume of natural

gas in an amount equal to the prepayment, the Settlement

Agreement further provides that 50 percent of the volume of

natural gas delivered to Arkla under the Contract during

the period May 1, 1988, through the remaining term of the

Contract or until the prepayment is fully recouped, shall

be considered recoupment gas and shall be received without

further payment.   The value of the gas delivered to Arkla

under the Contract is to be based upon "the price per MMBtu

in effect under the terms of the Contract, as amended this

date, at the time such natural gas is requested for

delivery under the Contract."

     While the Settlement Agreement does not disturb

Arkla's obligation of purchasing gas from Malibu, or

Malibu's obligation of selling gas to Arkla, the binding

nature of those obligations is alleviated somewhat under

the Settlement Agreement.   As to Arkla's take or pay

obligation, the Settlement Agreement provides that Malibu:
                           - 41 -

     waives any and all claims relating to or arising
     out of the Contract, including any failure to
     take gas or to pay for gas not taken by Buyer
     [Arkla], in respect of all natural gas available
     for production from all properties committed to
     the Contract from the Effective Date of the
     Contract through June 30, 1990.


     As to Malibu's obligation to sell gas produced from

the subject wells to Arkla, the Settlement Agreement

provides that, upon Malibu's request, the parties to the

settlement shall enter into a Release Agreement under which

gas committed to the performance of the Contract that is

in excess of the quantity requested by Arkla can be

released from the Contract and sold to third parties.

In consideration of the release of gas from the Contract,

Malibu would agree in the Release Agreement that Arkla

would be entitled to credit any gas released and sold to

third parties against "any obligations and liabilities

it may have to take gas, or to pay for gas not taken".

Furthermore, Malibu would also agree in the Release

Agreement to waive and release Arkla from any obligations

and liabilities for failure to take gas, or to pay for

gas not taken, during the time the Release Agreement is in

effect.   If Malibu requests it, the Release Agreement would

continue for a primary term beginning on May 1, 1988, and

extending through to June 30, 1990, and would continue on

a month-to-month basis thereafter, unless and until

terminated by either party upon 30 days' written notice.
                           - 42 -

There is insufficient evidence in the record to find

whether or not such Release Agreement was ever executed.

     The Settlement Agreement further provides that any

part of the prepayment which is not recouped from

deliveries of natural gas shall be refunded to Arkla upon

the happening of any one of three events.   The Settlement

Agreement provides as follows:


     Seller [Malibu] shall refund to Buyer [Arkla] the
     unrecouped balance of the Prepayment, if any, at
     the earlier of such time as (i) the Contract is
     cancelled or otherwise terminated by Seller, (ii)
     the Contract's primary term expires and the
     Contract is terminated by Seller or (iii) the
     wells subject to the Contract substantially
     deplete.


     In summary, the underlying premise of the settlement

is that Arkla would continue as the principal purchaser of

gas produced from Malibu's interest in the Contract wells.

Based upon the agreements forming the settlement, we agree

with respondent's contention that Arkla's payment of

$1,850,000 is a prepayment for the purchase of natural gas

under the Contract.   The agreements contemplate that Arkla

would recoup the prepayment from its purchases of natural

gas under the Contract.   The refund provision quoted above

is in the nature of a guaranty, to the effect that any

unrecouped balance of the settlement payment will be

returned to Arkla in the event that Malibu terminates the

Contract, or the wells became substantially depleted.    None
                            - 43 -

of the three events which trigger a cash refund is within

Arkla's control, such that Arkla is in control of the

timing and method of repayment.      See Commissioner v.

Indianapolis Power & Light Co., 493 U.S. at 209.      To the

contrary, Arkla retained no right to insist upon the return

of the payment so long as Malibu does not terminate the

Contract, and the wells do not become substantially

depleted.

     Petitioners argue that Malibu lacks complete dominion

over the settlement payment.    According to petitioners,

Arkla could refrain from ordering any natural gas under the

Contract, and could await the substantial depletion of the

wells.    In this way, petitioners argue, Arkla could force

Malibu to make a cash refund of the settlement payment.

Petitioners assert that this is possible because Arkla is

not obligated to purchase any gas under the Settlement

Agreement.

     We disagree with the premise of petitioners' argument.

In fact, Arkla is obligated to take a minimum volume of gas

per year under the Contract.    Under the Settlement Agree-

ment, however, Malibu has agreed to waive any claims

relating to or arising out of the Contract, including

Arkla's failure to take or pay for gas through June 30,

1990.    After that date, there will be no waiver of Arkla's
                           - 44 -

take or pay obligation, except through the Release Agree-

ment that Malibu must invoke.

     In any event, even if Arkla could refrain from taking

any gas under the Contract, the refund of any unrecouped

balance of the settlement payment requires that "the wells

subject to the Contract substantially deplete."    As

mentioned above, that event is not within Arkla's control.

Moreover, we agree with the court in Continental Ill. Corp.

v. Commissioner, 998 F.2d 513, 521 (7th Cir. 1993), affg.

in part and revg. in part T.C. Memo. 1991-66, T.C. Memo.

1989-636, and T.C. Memo. 1988-318, which observed in a

similar case that "income does not cease to be such because

there is some likelihood that the recipient may have to

give it back."   In these cases, the possibility that the

wells might become substantially depleted before the

settlement payment is fully recouped may reduce the

certainty of Malibu's income stream, but it does not

convert income into the equivalent of a deposit or a

bailment.   See id.

     In light of the foregoing,



                                    An appropriate order will

                             be issued denying petitioners'

                             motion for summary judgment.
