2000 U.S. Tax Ct. LEXIS 22">*22 Decision will be entered for respondent.
Ps paid State nonresident income tax to nine States on net
royalty income derived from their interests in oil and gas wells
located within those States. Ps reported all their royalty
income on Schedules E, Supplemental Income and Loss, which they
attached to their Federal income tax returns. In calculating
their total net royalty income, petitioners deducted the State
income taxes they paid. Consequently, petitioners deducted the
State nonresident income taxes in computing their adjusted gross
income for the years at issue.
HELD, the addition of
Revenue Act of 1964, Pub. L. 88-272, sec. 207(a), 78 Stat. 19,
40, did not change the existing law with respect to the
deduction of State income taxes.
HELD, FURTHER, State nonresident income taxes are not
"attributable" to property held for the production of royalties
and, therefore, are not deductible under
in computing Ps' adjusted gross income.
2000 U.S. Tax Ct. LEXIS 22">*23 Held, further, State nonresident income taxes are not
deductible as a trade or business expense under
curiam
114 T.C. 206">*207 OPINION
PARR, JUDGE: Respondent determined deficiencies of $ 3,955, $ 5,379, and $ 3,983 in petitioners' Federal income taxes for the taxable years 1993, 1994, and 1995, respectively. The sole issue for decision is whether State nonresident income taxes paid on net royalty income are deductible for purposes of determining adjusted gross income. We hold they are not.
BACKGROUND
This case was submitted fully stipulated under Rule 122. 1 The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioners resided in Las Vegas, Nevada, at the time they filed their petition in this case.
2000 U.S. Tax Ct. LEXIS 22">*24 During the years at issue, petitioners owned interests in oil and gas wells (the properties) located in the States of Alabama, California, Colorado, Louisiana, Michigan, Mississippi, New Mexico, Oklahoma, and Utah (the nine States).
Each of the nine States imposed an income tax on nonresidents who derived income from an income-producing activity within that State. Petitioners received royalties from the properties and paid a nonresident income tax to each State on the net royalty income (gross royalty income minus production taxes, overhead and operating expenses, and allowances for depletion) derived from the properties located only within that State.
Petitioners reported all their royalty income on Schedule E, Supplemental Income and Loss, which they attached to their Federal income tax returns. In calculating their total net royalty income, petitioners deducted the State income taxes they paid in addition to the expenses that they deducted in calculating their State nonresident incomes. Consequently, petitioners deducted the State nonresident income taxes in computing their adjusted gross income for the years at issue. In computing their taxable income, petitioners 114 T.C. 206">*208 elected to2000 U.S. Tax Ct. LEXIS 22">*25 take the standard deduction allowed by section 63 instead of itemizing their deductions.
DISCUSSION
The general rule under the law before the Act was that State and local income taxes paid or accrued by an individual were deductible as itemized deductions for Federal income tax purposes. See H. Rept. 749, 88th Cong., 1st Sess. (1963), 1964-1 C.B. (Part 2) 125, 171-172.2000 U.S. Tax Ct. LEXIS 22">*26 The Act specifically provides for the continued deductibility of State and local income taxes in this manner, while, in the interest of tax equity and ease of compliance, denying the deduction of certain other taxes, devoting any revenue gain from the denial of those other deductions to further tax rate reductions. See id., 1964-1 C.B. (Part 2) at 173-174. Accordingly, the Act did not change the existing law with respect to the deduction of State income taxes.
The concept of adjusted gross income was first incorporated by Congress into the 1939 Code by adding subsection (n) to
2000 U.S. Tax Ct. LEXIS 22">*28 The proposed
the term "adjusted gross income" shall mean the gross
income computed under
following deductions: (1) Deductions allowed by
section 23 of the Code, which are attributable to a
trade or business carried on by the taxpayer not
consisting of services performed as an employee; * * *
(4) deductions allowed by section 23 which are attributable to
rents and royalties; * * *
* * * * * * *
The deductions described in clause (1) above are
limited to those which fall within the category of
expenses directly incurred in the carrying on of a
trade or business. THE CONNECTION CONTEMPLATED BY THE
STATUTE IS A DIRECT ONE RATHER THAN A REMOTE ONE. FOR
EXAMPLE, PROPERTY TAXES PAID OR INCURRED ON REAL
PROPERTY USED IN THE TRADE OR BUSINESS WILL BE
DEDUCTIBLE, WHEREAS STATE INCOME TAXES, INCURRED ON
BUSINESS PROFITS, WOULD CLEARLY NOT BE DEDUCTIBLE FOR
THE PURPOSE OF COMPUTING ADJUSTED GROSS INCOME.
2000 U.S. Tax Ct. LEXIS 22">*29 SIMILARLY, WITH RESPECT TO THE DEDUCTIONS DESCRIBED IN
CLAUSE (4), THE TERM "ATTRIBUTABLE" SHALL BE TAKEN IN
ITS RESTRICTED SENSE; ONLY SUCH DEDUCTIONS AS ARE, IN
THE ACCOUNTING SENSE, DEEMED TO BE EXPENSES DIRECTLY
INCURRED IN THE RENTAL OF PROPERTY OR IN THE PRODUCTION
OF ROYALTIES. * * * [S. REPT. 885, SUPRA, 1944 C.B.
AT 877-878; EMPHASIS ADDED.]
See also H. Rept. 1365, 78th Cong., 2d Sess. (1944),
The State nonresident income taxes were imposed upon petitioners' net royalty income, not upon property held for the production of royalties. Moreover, as the State income taxes were imposed on petitioners' net royalty income, the State income taxes were not an expense directly incurred in the production of that income. See, e.g., Bulloch, Accountants' 114 T.C. 206">*210 Cost Handbook 1.9 (3d ed. 1983) (expenses are expired costs that were used to produce revenue). Accordingly, we find that the State nonresident income taxes paid by petitioners are not attributable to property held for the production of royalties.
Furthermore, we find that the taxes are not otherwise deductible as a trade or business expense in2000 U.S. Tax Ct. LEXIS 22">*30 computing petitioners' adjusted gross income.
For example, taxes are deductible in arriving at
adjusted gross income only if they constitute
expenditures directly attributable to a trade or
business or to property from which rents or royalties
are derived. Thus, property taxes paid or incurred on
real property used in a trade or business are
deductible, but state taxes on net income are not
deductible even though the taxpayer's income is derived
from the conduct of a trade or business. [Id.]
The committee reports and the regulations specifically state that State taxes on net income are not deductible for the purpose of computing adjusted gross income. 3 Finally, in
2000 U.S. Tax Ct. LEXIS 22">*32 In the instant case, petitioners paid State nonresident income taxes on their net royalty income, which derived from their interests in oil and gas wells; the State income taxes were not expenses attributable to property held for the production of royalties or expenses directly incurred in the 114 T.C. 206">*211 production of royalties. Accordingly, we hold that the State nonresident income taxes paid by petitioners are not deductible for the purpose of computing adjusted gross income. 5
In reaching our holdings herein, we have considered each argument made by the parties and, to the extent not discussed above, find those arguments to be irrelevant or without merit.
To reflect the foregoing,
Decision will be entered for respondent.
1. Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code in effect for the taxable years at issue.↩
2. Par. (4) of
3. Following the enactment of
4. In
5. In this case, if petitioners had not elected to take the standard deduction, the State income taxes that petitioners paid would be deductible from their adjusted gross income as an itemized deduction, see secs. 63, 161, subject to the limitation imposed by sec. 68.↩