Estate of Reinke v. Commissioner (46 F.3d 760, 1995)

FRIEDMAN, Senior Circuit Judge.

This case involves the federal income tax treatment of payments received under coal lease agreements pursuant to which coal was removed from the land by strip mining. The dispute relates to payments that reflected only the surface rights the appellants had in the land. The appellants contend that the payments were for damages inflicted on the land by the mining, and therefore constituted a return of capital up to the amount of their basis in the land and capital gains thereafter. The Tax Court held, however, that the payments constituted ordinary income. It further held that the Commissioner of Internal Revenue properly imposed the 25 percent addition to tax that 26 U.S.C. § 6661(a) (1988) provides for substantial understatement of tax. We affirm both rulings.

I

A. The facts were stipulated. In 1961 Mr. Reinke, deceased, and his wife, who filed joint returns, entered into a coal lease agreement covering the southeast quarter of 480 acres in North Dakota. The lease authorized the lessees to remove any and all lignite coal from the land “by strip mining or otherwise.” The lessees agreed to pay the Reinkes

... As royalty for coal, the sum of ten cents (lOc) per ton * * * for all coal removed from said land, and as rental payments and damages for any surface used, occupied or destroyed in the mining and removal of any coal in and underlying lessor’s said lands.

The lease provided that if the Reinkes owned less than 100 percent of the coal under the land, then the “royalties and rents to be paid as herein provided” would be proportionately reduced.

In 1971 the Reinkes entered into a coal lease agreement with the assignee (Baukol-Noonan, Inc.) of the lessee of the first lease, covering two additional quarter sections. In those two sections the Reinkes owned only the surface, but not the mineral rights in the land. The 1971 lease provisions here involved are identical to those in the 1961 lease, except that there was added to the provision relating to less than one hundred percent ownership of the' coal the following statement: “Provided, However, that the royalty paid to the lessor herein shall never be less than 2