Suffering Through New Oil and Gas Wealth

For the last several years, areas of South Texas have experienced a huge surge in oil and gas drilling activity into the Eagle Ford shale which extends from the Mexican border into northeast Texas for several hundred miles. This deep shale formation has been vertically drilled for decades, but recent developments with hydraulic fracturing coupled with horizontal drilling capability are now being used to extract oil and gas deposits from this impermeable layer of shale, previously unattainable in economic terms. Several years ago, mineral leases in these areas were taken for a few hundred dollars an acre. These same leases are now commanding $10,000 or more an acre, and for some mineral owners, monthly royalty checks received are for amounts up to six figures.

Of course, there is usually a price to pay. Land and mineral owners who receive direct benefits from this oil and gas surge can face some considerable increases in their income tax bill in the year that payments are made, and later on, by the following April 15, when their income tax returns for the year are due.

Mineral lease payments, referred to as bonus, annual rental and extension payments, represent ordinary rental income, for income tax purposes, to the owner in the year received, subject to the prevailing income tax rates, presently capped at 35%. Owners can incur out-of-pocket expenses directly associated with these leases that are deductible against such income.

Land owners also benefit from the exploration activity by receiving damage payments that oil and gas companies pay to locate drilling and production sites, to build roads on the landowner’s property and for other consequential impacts to the property associated with their physical presence and activities. For income taxation, damage payments received which represent actual damages are treated as a nontaxable return of capital to the extent of the owner’s basis in the affected land and any excess is reported as ordinary income.

When wells have been completed, oil and gas companies often lay pipelines across certain landowners’ properties following the negotiation and payment of easement or right-of way payments to those owners. For income tax reporting, these easement and right-of-way payments received are treated as a nontaxable return of capital to the extent of the owner’s basis in the affected land and any excess is reported as ordinary income, except in the case of farm or ranching land where the excess is treated as a gain on sale, subject to long term capital gains rate, provided the property has been held for more than a year.

Once an oil or gas well is completed and put into production, periodic royalty payments are made by the oil and gas companies to the mineral owners representing their proportionate share of produced minerals sold during the period. These payments are normally reduced by production taxes and certain expenses, when provided for by contract. Shut-in royalty may sometimes be paid, during a non-producing period that is tied to predetermined amounts in the lease contract. All royalty payments are taxed as ordinary income in the year received.

Mineral owners may deduct, for income tax purposes, production taxes and certain expenses deducted from royalty payment according to the lease contract and various owner’s other direct out-of-pocket expenses. The mineral owner is also allowed to deduct depletion at a fixed percent of gross oil and gas income, presently 15%, subject to income limitations at the property level and at the owner’s total taxable income level. The amount deducted is applied against the owner’s remaining royalty basis. An alternative calculation of a unit-of-production depletion deduction is allowed but is not explained in this article.

Some families consider mineral ownership in Texas with an indefinite life as significant asset to be held for the benefit of current and future generations of the same family. Mineral trusts can be created that can maintain this ownership within the family members and their descendents for generations to come.

Income tax laws associated with mineral and land ownership interests have remained fairly unchanged since the early part of the 1990’s. But these laws are tied into the tax laws affecting oil and gas companies that are presently being eyed as a prime targets for revenue raising (i.e. tax increases) by various politicians. In both the 2010 and 2011 annual budget outlines, the Executive branch has proposed overhauling deductions available to the oil and gas companies that may impact mineral owners directly. Specifically, the 15% depletion deduction has been proposed to be eliminated although it is currently limited to non-integrated oil and gas companies only and then, further limited to the 1,000 barrels of oil equivalent per day. Elimination of this deduction would likely to extend to mineral owners as presently proposed.

For some mineral and land owners, tax rates will increase beginning in 2013 when a 3.8% Medicare tax will be imposed on investment income for individuals with adjusted gross income over $250,000 for joint filers, lesser amounts for other filers, under the 2010 Health Care Reconciliation Act. Investment income under this law includes royalty and rental income. At that time the highest prevailing income and Medicare combined rate will be increased to 38.8%.

If your family is one that is challenged by this new found wealth please contact Akin, Doherty, Klein and Feuge, PC.