United States v. Hill

Background

William F. and Lola E. Hill, a married couple in the oil-and-gas exploration and production business, claimed large percentage depletion deductions on their 1981 and 1982 tax returns ($439,884 and $371,636). To reduce the amount subject to the minimum tax, they included unrecovered costs of depreciable tangible items (machinery, tools, pipe, and similar equipment) in the "adjusted basis" of their mineral deposit interests. The IRS disallowed that treatment, assessed larger minimum taxes, the Hills paid deficiencies ($30,963 and $18,733) and sued for refunds. Lower courts sided with the Hills, and the Supreme Court took the case because of its importance to the federal fisc.

Reasoning

The core question was whether the phrase "adjusted basis," as used in the minimum-tax provision, includes the tangible drilling and development costs identified in Treasury regulation §1.612-4(c)(1). The Court explained that tax law treats minerals in place (the deposit) separately from improvements and equipment, and that depletion and depreciation are distinct methods of cost recovery. Under §1016 and related regulations, items that are properly subject to depreciation must be treated as separate depreciable property and not folded into the deposit’s basis. Allowing the Hills’ approach would let tangible items shelter many times their cost from the minimum tax. The Court therefore held these tangible costs are not part of the deposit’s adjusted basis and reversed the lower courts.

Real world impact

Producers cannot add unrecovered depreciable drilling equipment costs to mineral deposit bases to reduce the minimum-tax preference. This ruling raises minimum or alternative minimum tax exposure for oil-and-gas producers using percentage depletion and clarifies allocation rules between depletion and depreciation.