Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 73-80

1973-1 C.B. 308

Sec. 61
Sec. 611
Sec. 613
Sec. 631
Sec. 1231

IRS Headnote

Royalty payments received in exchange for an option to purchase coal land are not subject to capital gains treatment under section 631(c) of the Code but are taxable as ordinary income and subject to depletion deductions.

Full Text

Rev. Rul. 73-80

Advice has been requested, under the circumstances described below, whether payments received by a transferor of an option to purchase coal land are subject to "section 1231 capital gains treatment" under section 631(c) of the Internal Revenue Code of 1954, and whether such payments are subject to a depletion deduction within the meaning of sections 611 and 613 of the Code.

A taxpayer bought an option to purchase coal land. After holding the option primarily for sale in the ordinary course of his business for more than six months, the taxpayer transferred the option to a coal mining company. Concurrent with the transfer of the option, the coal mining company agreed to pay the taxpayer a stated royalty per ton for coal subsequently mined from the coal land.

The option to purchase the coal land was exercised by the coal mining company which mines coal from the land. The taxpayer receives royalty payments under the agreement with the coal mining company.

The taxpayer is not a co-adventurer, partner, or principal in the mining of the coal.

Section 631(c) of the Code allows certain amounts received from the disposal of coal to be considered as though they were a gain or loss on a sale under section 1231 of the Code. Section 631(c) of the Code requires, in part, that there be a disposal of coal, held for more than six months before such disposal by the owner thereof under any form of contract under which the owner retains an economic interest. The word "owner" means any person who owns an economic interest in coal in place, including a sublessor.

Section 1.631-3(b)(4)(i) of the Income Tax Regulations provides that the provisions of section 631(c) of the Code apply only to an owner of coal who has retained an economic interest and that a person who merely acquires an economic interest without disposing of coal under a contract retaining an economic interest does not qualify under section 631(c) of the Code. Such owner shall not be entitled to the allowance for percentage depletion provided in section 613 with respect to such coal. This treatment is not allowed where the owner of the coal is a co-adventurer, partner, or principal in the mining of such coal.

Section 1.61-8(a) and (b) of the regulations requires the recognition of rents and royalties from the exploitation of natural resources as gross income.

Section 611 of the Code provides, in part, that there shall be allowed as a deduction in computing taxable income in the case of mineral deposits, a reasonable allowance for depletion. Section 613 of the Code provides, in part, that in the case of certain mineral deposits, the allowance for depletion under section 611 shall be a percentage depletion allowance if such amount is greater than cost depletion.

Section 1.611-1(b) of the regulations provides, in part, that annual depletion deductions are allowed only to the owner of an economic interest in mineral deposits. Further, an economic interest is defined as any interest in minerals in place that has been acquired by investment in the mineral in place; and from which the taxpayer secures, by any form of legal relationship, income derived from the extraction of the mineral to which he must look for a return of his capital. E. G. Palmer v. Bender, 287 U.S. 551 (1933), Ct. D. 641, XII-1 C.B. 235 (1933); Commissioner v. Southwest Exploration Co., 350 U.S. 308 (1956), Ct. D. 1791, 1956-1 C.B. 614.

The taxpayer must have acquired by investment an interest in the coal in place and must look solely to the extraction of the coal for a return of his capital to have an economic interest in coal under section 611 and section 631(c) of the Code.

An option to purchase land is not an interest in land. For Federal income tax purposes, the land is "acquired" when the option to purchase is exercised and conveyance of the land is made. Commissioner v. San Joaquin Fruit & Investment Co., 297 U.S. 496 (1936), Ct. D. 1098, XV-1 C.B. 196 (1936).

An owner of an option to purchase coal land merely has the right to acquire the land with the coal in place. Such an option does not give its owner the right to extract coal and thus the owner of the option, while owning only the option, does not have an interest in the coal in place.

Since the taxpayer in the instant case was merely an owner of an option to purchase coal land, he did not own an economic interest in the coal in place when he transferred the option to the coal mining company.

Section 631(c) of the Code is applicable only where there is a disposal of coal by a person who owns an economic interest in the coal in place. The taxpayer in the instant case, as the owner of the option to purchase the coal land, was not an "owner" of coal who could make a disposal of it within the meaning of section 631(c) of the Code.

However, the taxpayer transferred his option in which he had a capital investment in exchange for the right to receive royalty payments upon the extraction of the coal by the transferee mining company. The taxpayer could look only to the extraction of the coal for a return of his capital investment. Thus, the taxpayer obtained an economic interest in the coal at the time the coal mining company exercised the option and purchased the coal land, but not before.

In respect of such royalty payments, there would be an allowable deduction for depletion under section 611 of the Code because the taxpayer was the owner of an economic interest in the coal produced at the time the payments were received. And, since the taxpayer would not be entitled to treatment under section 631(c) of the Code, such allowable deduction for depletion would be the greater of cost depletion or percentage depletion within the meaning of section 613 of the Code.

Accordingly, it is held that the royalty payments received by the transferor in return for an option to purchase coal land in the instant case are not subject to "section 1231 capital gains treatment" under section 631(c) of the Code because the taxpayer has not disposed of coal. The royalty payments are taxable as ordinary income under the provisions of section 61 of the Internal Revenue Code of 1954 subject to a depletion deduction under the provisions of section 611 or 613 of the Code.