                        T.C. Memo. 2002-128



                      UNITED STATES TAX COURT



       JAMES S. & DENISE D. GOODFELLOW, DANIEL R. & CLAUDIA
     GOODFELLOW, JAMES B. & NANCY B. GOODFELLOW, Petitioners
         v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8469-00.                Filed May 28, 2002.




     Lowell V. Ruen, for petitioners.

     Robert S. Scarbrough, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   This case is before the Court for decision

without trial.   See Rule 122.   Petitioners petitioned the Court

to redetermine deficiencies in their 1995 and 1996 Federal income

taxes.   Respondent determined the following deficiencies, all of
                                  -2-

which stem from respondent’s disallowance of depletion deductions

claimed by an S corporation named Goodfellow Bros. Inc. (GBI):

                                                1995      1996

     James S. and Denise D. Goodfellow        $69,594   $28,546
     Daniel R. and Claudia Goodfellow          57,887    23,729
     James B. and Nancy B. Goodfellow             —0–     2,858

     We decide herein whether GBI had the requisite economic

interest in certain unusable materials to deduct depletion under

section 611.   We hold it did not.      Unless otherwise indicated,

section references are to the Internal Revenue Code in effect for

the subject years.   Rule references are to the Tax Court Rules of

Practice and Procedure.

                          FINDINGS OF FACT

     All facts were stipulated.    We incorporate herein by this

reference the parties’ stipulation of facts and the accompanying

exhibits.   Petitioners resided in Wenatchee, Washington, when

their petition was filed.

     James S. Goodfellow, Daniel R. Goodfellow, and James B.

Goodfellow (collectively, shareholders) own all of GBI’s stock.

Their respective ownership interests are 53.5 percent, 44.5

percent, and 2 percent.   GBI’s primary business activity is

excavating and grading land.   GBI works primarily as a general

contractor but works sometimes, including on all occasions

relevant herein, as a subcontractor.
                                -3-

     In 1995 and 1996, GBI performed services for subdivisions of

the State of Hawaii and others (collectively, landowners) under

which it excavated and graded the landowners’ land for future

construction.   GBI performed these services directly for general

contractors, who, in turn, had contracted with the landowners.

GBI’s contracts with the general contractors generally required

it to excavate materials from specified job sites (sites) and to

grade the sites in accordance with certain specifications.     GBI’s

grading services included using “fill”.    GBI was required by the

contracts to use as fill any “usable” materials which were

present on the site.   When not enough usable materials were

present on the site, the contracts required GBI to supply

additional fill at its own expense.

     Materials were considered usable if they met certain

specifications.   An engineer employed by the landowners examined

the materials after their excavation and ascertained whether the

materials met the specifications.     Materials which the engineer

rejected as not meeting the specifications were characterized as

“unusable” and had to be removed from the site at GBI’s expense.

When GBI agreed to perform the relevant services at a site, it

did not know (either actually or by estimate) the amount of

materials at the site which would be considered usable or

unusable.
                                -4-

     Materials on the site which the engineer characterized as

unusable became the property of GBI at or after the time of that

characterization.   GBI removed the unusable materials from the

sites at its own expense and crushed and sold the removed

materials to third parties as crushed rock.    GBI crushed the

unusable materials using equipment that it owned and maintained

at a rock quarry (quarry) that was located on land owned by GBI.

GBI used that equipment primarily to crush rock obtained from the

quarry.   For Federal income tax purposes, GBI depreciated the

equipment in the subject years as well as in prior years.

     GBI calculated and claimed percentage depletion deductions

of $330,082 and $140,660 for 1995 and 1996, respectively, which

passed through and were reported by the shareholders on their

individual Federal income tax returns.    GBI’s deductions

reflected its sale of both the unusable materials and the

materials obtained from the quarry.     Respondent disallowed GBI’s

deductions to the extent that they were attributable to the

unusable materials.   Respondent determined with respect to the

unusable materials that GBI lacked an economic interest in a

mineral in place.

                              OPINION

     Respondent determined that petitioners are not entitled to

the depletion deductions which GBI claimed as to the unusable

materials.   Petitioners argue that GBI is entitled to those
                                  -5-

deductions because it had an economic interest in the unusable

materials.1   Petitioners rely on the 7-factor test set forth in

Parsons v. Smith, 359 U.S. 215 (1959).     Respondent argues that

petitioners lacked an economic interest in the unusable

materials.    Respondent asserts that the Parsons test supports his

argument.

     We agree with respondent that GBI is not (and thus

petitioners are not) entitled to deduct depletion with respect to

the unusable materials.     Petitioners, as shareholders of GBI, an

S corporation, are permitted to take into account their pro rata

shares of GBI’s “items of income * * *, deduction, or credit the

separate treatment of which could affect the liability for tax of

any shareholder, and * * * nonseparately computed income or

loss.”   Sec. 1366(a)(1).   GBI claimed the depletion deductions as

to its excavation activities, and petitioners, in turn, claimed

the depletion deductions through the passthrough provision of

section 1366(a)(1).    A deduction for depletion is a matter of

legislative grace, Parsons v. Smith, supra at 219, and

petitioners bear the burden of proving that they are entitled to

such a deduction.2    Rule 142(a)(1); INDOPCO, Inc. v.

     1
       Petitioners make no assertion that GBI also had an
economic interest in the usable materials.
     2
       The parties agree that sec. 7491(a), which places the
burden of proof on respondent in certain cases, does not apply
here. Sec. 7491 applies only to court proceedings arising from
                                                   (continued...)
                                -6-

Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934).   The fact that the parties

submitted this case to the Court fully stipulated does not change

or otherwise lessen petitioners’ burden in this case.   Rule

122(b); Kitch v. Commissioner, 104 T.C. 1, 8 (1995), affd. 103

F.3d 104 (10th Cir. 1996).

     Section 611(a) provides that a taxpayer may deduct a

reasonable allowance for depletion as to “mines, oil and gas

wells, other natural deposits, and timber”, such allowance being

ascertained under regulations prescribed by the Secretary.     As

relevant herein, the applicable regulations, the relevant portion

of which we set forth in the appendix to this opinion, clarify

that a depletion deduction may be claimed only by the taxpayer

with an economic interest in the depleted mineral deposit.     Sec.

1.611-1(b)(1), Income Tax Regs.; see also Parsons v. Smith, supra

at 226; Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 603

(1946); Helvering v. Bankline Oil Co., 303 U.S. 362, 368 (1938).

The regulations explain that an economic interest is present when

the taxpayer has:   (1) Acquired by investment an interest in

mineral deposits embedded within the earth (i.e., minerals in

place) and (2) secured, by any form of legal relationship, income


     2
      (...continued)
examinations commencing after July 22, 1998. Internal Revenue
Service Restructuring and Reform Act of 1998, Pub. L. 105-206,
sec. 3001(c), 112 Stat. 727.
                                 -7-

derived from the extraction of the minerals to which the taxpayer

must look for a return of capital.     Sec. 1.611-1(b)(1), (d)(4),

Income Tax Regs.; see also Commissioner v. Southwest Exploration

Co., 350 U.S. 308, 313-314 (1956); Palmer v. Bender, 287 U.S. 551

(1933).   Depletion deductions serve to compensate a taxpayer for

minerals consumed in the production of income resulting from

extraction, Anderson v. Helvering, 310 U.S. 404, 408 (1940), so

that when the minerals are exhausted, the taxpayer’s investment

in the mineral deposit remains unimpaired, Paragon Jewel Coal Co.

v. Commissioner, 380 U.S. 624 (1965).     Commissioner v. Southwest

Exploration Co., supra; Mo. River Sand Co. v. Commissioner, 83

T.C. 193, 198 (1984), affd. 774 F.2d 334 (8th Cir. 1985).

Whether the taxpayer has the requisite economic interest in a

depletable asset is a factual determination.     Ramey v.

Commissioner, 398 F.2d 478, 479 (6th Cir. 1968), affg. 47 T.C.

363 (1967).

     The regulations recognize two methods for computing an

allowance for depletion as to mineral deposits.    Sec. 1.611-1(a),

Income Tax Regs.   The first method, cost depletion under section

612, focuses on the property’s adjusted basis.     Id.   The second

method, percentage depletion under section 613, focuses on the

property’s gross income.   Id.   Percentage depletion, the method

at issue here, “is not computed with reference to the [taxpayer]

operator's investment” and does not limit the taxpayer’s
                                -8-

deduction to the amount of any investment.   United States v.

Swank, 451 U.S. 571, 576 (1981).   Percentage depletion deductions

continue as long as minerals are extracted from the property, and

even where a taxpayer has invested no money in the deposit.      Id.

at 576-577.   Nor must the taxpayer claiming percentage depletion

as to a mineral deposit have legal title over the deposit.       Kirby

Petroleum Co. v. Commissioner, supra; Lynch v. Alworth-Stephens

Co., 267 U.S. 364 (1925).   The linchpin of a percentage depletion

deduction is that the taxpayer has an economic interest in the

mineral deposit for which the deduction is claimed.   Commissioner

v. Southwest Exploration Co., supra; Kirby Petroleum Co. v.

Commissioner, supra at 603.

     Here, we find that GBI never had the requisite economic

interest in the minerals (unusable materials) in place.    GBI

neither purchased by investment, nor contracted for, any interest

in those materials as they sat embedded in the ground.    GBI

received the materials only after they were rejected by the

landowners’ engineer following the materials’ excavation from the

ground.   GBI’s receipt of the unusable materials at that time

resulted from its contractual obligation to dispose of minerals

once owned and now abandoned by the landowners, rather than from

its purchase of minerals from the landowners.3

     3
       We express no opinion as to whether we would have decided
this case differently had the landowners agreed to sell to GBI an
                                                   (continued...)
                                  -9-

     Nor did GBI secure through a legal relationship income

derived from the extraction of the unusable materials to which it

looked for a return of capital.    The Supreme Court has repeatedly

stated as to this requirement that it is met only where a

taxpayer looks solely to recover capital invested in a mineral

deposit through an extraction of that deposit.    Paragon Jewel

Coal Co. v. Commissioner, supra at 635, 638; Commissioner v.

Southwest Exploration Co., supra at 314; Kirby Petroleum Co. v.

Commissioner, supra at 603-604.    GBI failed this requirement in

that it received from the landowners substantial remuneration for

the excavation and grading services it performed under the

contracts and did not look solely to recover any capital invested

in the unusable materials from an extraction of those materials.

Nor under the contracts did GBI receive the unusable materials as

compensation for services.   Although GBI did in fact realize

income on its sale of the unusable materials, that income was

independent of and merely incidental to GBI’s performance of

services under the contracts.   Such an economic advantage

obtained from the contracts does not constitute an economic

     3
      (...continued)
ascertainable amount of the embedded materials as part of the
excavation project. The facts of this case establish clearly
that GBI had no understanding of the amount, if any, of the
unusable materials that it would acquire as part of its contracts
with the landowners. Nor do the facts persuade us that GBI had
agreed to buy any of the unusable materials or that it had
depended on its sale of the unusable materials to recover any of
its capital expended on the excavation project.
                               -10-

interest in the unusable materials.   Paragon Jewel Coal Co. v.

Commissioner, supra at 634-635; Parsons v. Smith, 359 U.S. at

224; Helvering v. O’Donnell, 303 U.S. 370, 372 (1938); Helvering

v. Bankline Oil Co., 303 U.S. at 367-368.   As the regulations

provide as to this matter, a taxpayer who has no capital

investment in a mineral deposit does not possess an economic

interest in the deposit merely because, through a contractual

relation, the taxpayer obtains an economic or pecuniary advantage

through the production of the deposit.   Sec. 1.611-1(b)(1),

Income Tax Regs.; see also Helvering v. Bankline Oil Co., supra

at 367 (“the phrase ‘economic interest’ is not to be taken as

embracing a mere economic advantage derived from production,

through a contractual relation to the owner, by one who has no

capital investment in the mineral deposit.”); cf. Holbrook v.

Commissioner, 65 T.C. 415, 419 (1975) (presence of an economic

interest does not necessarily require a monetary investment in

the mineral deposit in place but requires an element of ownership

in the minerals in place and a right to share in the income from

their production).

     Petitioners argue that GBI possessed an economic interest in

the unusable materials under the rationale set forth by the

Supreme Court in Parsons v. Smith, 359 U.S. 215 (1959).    We

disagree.   In Parsons, the taxpayers were paid by the owners of

coal-bearing land (owners) to strip mine the land and to deliver
                                -11-

the coal to the owners.   The taxpayers argued that they were

entitled to deduct depletion in connection with these payments

because they had a capital investment in minerals (coal) in

place.   The taxpayers argued that their capital investment was in

the equipment, facilities, and labor which they expended to mine

the coal.    The Supreme Court disagreed.   The Court held that the

taxpayers lacked an economic interest in the coal.    The Court

noted first that the taxpayers lacked any interest or investment

in the coal apart from any interest held under the mining

contracts.    The Court then stated that the contracts gave the

taxpayers merely an economic advantage from the strip mining

operation.    The Court viewed the following seven factors as

relevant to its decision:    (1) The taxpayers’ investment was in

their equipment, all of which was movable, and they lacked an

investment in the coal in place; (2) the taxpayers recovered

their investment in the equipment through depreciation; (3) the

taxpayers’ contracts with the owners were terminable without

cause on short notice; (4) the owners never agreed to surrender,

nor did they ever surrender, to the taxpayers an interest in the

coal in place; (5) title to the coal always vested in the owners,

and the taxpayers were not allowed to sell or keep any of the

coal but had to deliver it to the owners; (6) the taxpayers

received none of the proceeds from the coal’s sale but were paid

for their services a set amount for each ton of coal mined and
                                  -12-

delivered; and (7) the taxpayers agreed to look solely to the

owners for all amounts due under the contracts.    Accord Paragon

Jewel Coal Co. v. Commissioner, 380 U.S. 624 (1965) (where the

Court applied these seven factors to decide that certain coal

mining contracts did not give the contract miners an economic

interest in the coal in place).

     Our analysis of these factors in the light of the setting at

hand leads to a conclusion contrary to that desired by

petitioners.   As to the first two factors, petitioners observe

that GBI incurred costs to remove, transport, store, and crush

the unusable materials.   Petitioners argue that the costs which

GBI incurred to remove the unusable materials constituted an

investment in those materials that was more proprietary and

meaningful than the investment made by the taxpayers in Parsons

v. Smith, supra.   We disagree.    As was true in Parsons, GBI’s

sole tangible investment was in movable equipment, and GBI

recovered that investment through depreciation.    Whereas

petitioners focus primarily on GBI’s labor and other nontangible

property costs in arguing that GBI’s investment was more

proprietary and meaningful than the investment made by the

taxpayers in Parsons, the fact of the matter is that the

taxpayers in Parsons incurred similar nontangible property

(labor) costs.   The Supreme Court did not find that those labor

costs in Parsons constituted an economic interest in the coal,
                                 -13-

and we do not consider the similar costs here to give GBI an

economic interest in the unusable materials.       These two factors

favor respondent.

     The third factor favors petitioners.       Unlike the contracts

in Parsons, GBI’s contracts were not terminable at will.        GBI’s

contracts required GBI to perform its services within a set

period of time and provided that GBI was liable for liquidated

damages in the event of a breach.       Under the facts at hand,

however, the probative value of this third factor is minimal

given our conclusion supra that the first two factors favor

respondent and our conclusion infra that the remaining four

factors also favor respondent.

     As to the fourth factor, petitioners focus on the fact that

the owners in Parsons never surrendered to the taxpayers an

interest in the minerals at issue there.       Here, petitioners

observe, GBI obtained title over the unusable materials when they

were declared as such by the engineer.       Petitioners assert that

the fact that GBI had to dispose of the unusable materials also

evidences its economic interest in those materials.         Petitioners

conclude that this factor favors them.       We disagree.    Under the

applicable regulations, petitioners’ focus should properly be

placed on any interest that GBI had in the unusable materials

when the materials were embedded in the ground.       Sec.

1.611-1(b)(1), Income Tax Regs.    Contrary to petitioners’
                               -14-

assertion, the mere fact that GBI had to remove and dispose of

the unusable materials does not necessarily mean that the

landowners surrendered an interest in those materials when they

were in place.   In fact, given that the materials were only

characterized as unusable after they were inspected by the

engineer following excavation, we conclude to the contrary that

all interests in the unusable materials which the landowners

surrendered to GBI were in materials not in place.    This factor

favors respondent.

     As to the fifth factor, petitioners observe that the

taxpayers in Parsons could not keep or sell any of the coal but

were required to deliver it all to the owners.    Petitioners

conclude that this factor favors them because, they claim, GBI

never delivered the unusable materials to the landowners.     We

disagree with petitioners’ conclusion.    Contrary to their

assertion, GBI was required to and did in fact deliver the

unusable materials to the landowners by way of their engineer.

Only after the materials had been excavated and declared unusable

by the engineer did GBI’s interest in the unusable materials

arise.   This factor favors respondent.

     As to the sixth factor, petitioners observe that the

taxpayers in Parsons received only a set price for each ton of

coal mined and delivered.   Petitioners conclude that this factor

favors them because GBI received the set amount in the contracts
                                 -15-

plus an additional amount paid by the third party/purchasers of

crushed rock.   We disagree with petitioners’ conclusion.     GBI was

paid solely by the landowners under the contracts for excavation

and grading services, and those services included removing the

unusable materials from the sites.      The ultimate sale of the

unusable materials was a mere economic advantage that GBI derived

by virtue of the contracts, rather than a dispositive factor in

determining depletion deduction eligibility.      See Helvering v.

Bankline Oil Co., 303 U.S. at 367-368; Helvering v. O’Donnell,

303 U.S. at 372; Paragon Jewel Coal Co. v. Commissioner, 380 U.S.

at 634-635; Parsons v. Smith, 359 U.S. at 224.      We conclude that

this factor favors respondent.

     As to the seventh factor, petitioners observe that the

taxpayers in Parsons were able to look only to the owners for all

sums due under the contracts.    Petitioners conclude that this

factor favors them because GBI’s receipt of payment was not

solely from the landowners.   Petitioners assert that the costs

which GBI incurred to process the unusable materials into crushed

rock for sale to the third parties were recoverable only from

their sale of the crushed rock.    We disagree with petitioners’

conclusion.   GBI agreed to excavate and grade the landowners’

land, and those services required GBI to remove all unusable

materials from the sites and to secure any necessary fill.     GBI

was able to look only to the landowners for payment for these
                               -16-

services.   Given that the contracts did not address any sale by

GBI of the unusable materials, we conclude that any proceeds

which GBI received from such a sale were incidental to the

underlying contracts and merely an economic advantage derived

from the contract.   This factor favors respondent.

     For the foregoing reasons, we sustain respondent’s

determination.   We have considered all arguments made by the

parties and have rejected those arguments not discussed herein as

irrelevant or without merit.   Accordingly,


                                           Decision will be entered

                                      for respondent.
                           -17-

                         APPENDIX

Sec. 1.611-1.   Allowance of deduction for depletion.--

     (a) Depletion of mines, oil and gas wells, other
natural deposits, and timber--(1) In general. Section
611 provides that there shall be allowed as a deduction
in computing taxable income in the case of mines, oil
and gas wells, other natural deposits, and timber, a
reasonable allowance for depletion. * * * In the case
of other [than standing timber] exhaustible natural
resources the allowance for depletion shall be computed
upon either the adjusted depletion basis of the
property (see section 612, relating to cost depletion)
or upon a percentage of gross income from the property
(see section 613, relating to percentage depletion),
whichever results in the greater allowance for
depletion for any taxable year. In no case will
depletion based upon discovery value be allowed.

                *    *    *       *   *   *   *

     (b) Economic interest.--(1) Annual depletion
deductions are allowed only to the owner of an economic
interest in mineral deposits or standing timber. An
economic interest is possessed in every case in which
the taxpayer has acquired by investment any interest in
mineral in place or standing timber and secures, by any
form of legal relationship, income derived from the
extraction of the mineral or severance of the timber,
to which he must look for a return of his capital. * *
* A person who has no capital investment in the
mineral deposit or standing timber does not possess an
economic interest merely because through a contractual
relation he possesses a mere economic or pecuniary
advantage derived from production. For example, an
agreement between the owner of an economic interest and
another entitling the latter to purchase or process the
product upon production or entitling the latter to
compensation for extraction or cutting does not convey
a depletable economic interest. * * *

          *     *    *    *       *   *   *

     (d) Definitions. As used in this part, and the
regulations thereunder, the term--

          *     *    *    *       *   *   *
                    -18-

     (3) “Mineral enterprise” is the mineral
deposit or deposits and improvements, if any,
used in mining or in the production of oil
and gas and only so much of the surface of
the land as is necessary for purposes of
mineral extraction. The value of the mineral
enterprise is the combined value of its
component parts.

     (4) “Mineral deposit” refers to minerals
in place. When a mineral enterprise is
acquired as a unit, the cost of any interest
in the mineral deposit or deposits is that
proportion of the total cost of the mineral
enterprise which the value of the interest in
the deposit bears to the value of the entire
enterprise at the time of its acquisition.

     (5) “Minerals” includes ores of the
metals, coal, oil, gas, and all other natural
metallic and nonmetallic deposits, except
minerals derived from sea water, the air, or
from similar inexhaustible sources. It
includes but is not limited to all of the
minerals and other natural deposits subject
to depletion based upon a percentage of gross
income from the property under section 613
and the regulations thereunder.
