## Facts

- Ervin A. Reinke and Marion (Mary) Reinke owned surface and mineral rights in one parcel in Oliver County, North Dakota, and surface-only rights in adjacent parcels.
- The Reinkes entered into coal leasing arrangements covering the property, including a 1961 coal lease and a later coal lease.
- A separate surface-use agreement with the mining operator provided an additional payment of $0.10 per ton of coal as payment for “any damages” to the surface estate from mining operations.
- During 1985–1987, the Reinkes received (1) coal royalties of $0.10 per ton under the leases and (2) $0.10 per ton under the surface-use agreement.
- After Ervin’s death in 1985, Mary filed returns for 1986 and 1987 and treated the surface-related payments as non-taxable recovery of capital up to basis and capital gain thereafter, relying primarily on the return-of-capital approach associated with Inaja Land Co.
- The Commissioner determined income tax deficiencies and § 6661 additions for substantial understatement for 1985–1987, asserting the payments were ordinary income.
- The case was submitted fully stipulated under Tax Court Rule 122.

## Issues

1. Whether coal-lease royalties and per-ton “surface-use/damage” payments were ordinary income, recovery of capital, or proceeds from the sale or exchange of a capital asset.
2. Whether petitioners were liable for additions to tax under I.R.C. § 6661 for substantial understatement for 1985–1987.

## Decision

- The Tax Court held the coal-related payments, including the per-ton amounts labeled as surface damages, were taxable as ordinary income.
- The court rejected characterization of the payments as proceeds from a sale or exchange of a capital asset.
- The court rejected return-of-capital treatment because petitioners did not prove actual permanent damage or a measurable diminution in value tied to the payments, and the payment structure resembled royalties rather than a one-time disposition.
- The court sustained § 6661 additions to tax (subject to computation).

## Legal Principles

- Royalty-type payments under mineral leases are generally ordinary income, not capital gain from a sale of the underlying property interest.
- Labels in agreements (e.g., “damages”) do not control tax characterization; the court looks to the substance and economic reality of the payments.
- Return-of-capital treatment for payments related to property impairment is limited and typically requires proof of actual impairment and circumstances making basis allocation impracticable; production-based, ongoing payments ordinarily do not qualify.
- Taxpayers bear the burden to substantiate the factual predicate for capital recovery, including the existence and extent of permanent damage or diminution in value.
- § 6661 additions apply where there is a substantial understatement and the taxpayer does not establish a statutory defense such as substantial authority or adequate disclosure.

## Conclusion

The Tax Court treated both coal royalties and per-ton surface-use payments as ordinary income because they functioned as production-based consideration for mining rights rather than compensation proven to restore capital, and it upheld § 6661 additions due to substantial understatements without adequate authority or disclosure defenses.


Estate of Reinke v. Commissioner, 65 T.C.M. (CCH) 2570 (T.C. 1993)