Estate of Smith v. Commissioner

Algerine Smith leased land she owned to an oil company. The company was to pay Smith royalties equal to a set proportion of the price the oil company received for any oil or gas it extracted from the land. The royalty agreement further provided that the royalties would be adjusted if the government regulated the price of gas. The government did regulate the price of gas and later sued the oil company for setting prices above those permitted by regulations. A group of royalty owners, including Smith, began litigation concerning the effect of the government’s lawsuit on the oil company’s obligation under the royalty agreements. Shortly before Smith’s death, a judge in the pending litigation ruled that the oil company had a valid claim to sue the royalty owners for reimbursement of previously paid royalties based on oil sales prices in excess of those permitted by regulations. Smith died before these legal issues were fully resolved. At the time of Smith’s death, the oil company was seeking $2.48 million from Smith. Fifteen months after Smith’s death, her estate (plaintiff) and the oil company settled for approximately $680,000. The estate filed its estate tax return before the settlement was reached and included a deduction in the amount of $2.48 million. The Internal Revenue Service (IRS) (defendant) determined, after the settlement had been reached, that the estate was entitled to deduct only the $680,000 that the estate ultimately paid and issued a deficiency. The estate and the IRS jointly petitioned the tax court to resolve the dispute, and the tax court ruled in favor of the IRS. The estate appealed.