Oil & Gas Lease Taxation

During the initial discovery and subsequent tidal wave of leasing activity related to the Haynesville shale between 2008-2010, landowners in the Shreveport-Bossier area received record payments from granting the right to drill for minerals on their land (more commonly referred to as a “lease bonus”). Since this time, economic forces of the U.S. natural gas market have depressed the price of natural gas, causing a substantial slowdown in leasing activity and reduction in well count in the Shreveport-Bossier community.  Exacerbating the downward pressure, the global oil market has tumbled to less than one-third of the high-water mark set a few years prior.  But alas, history reflects volatile swings in energy prices as the norm more than the exception (not even John D. Rockefeller was immune to similar shifts).  Based on these trends, I expect the oil and gas industry to eventually recover and remain a prevailing force of economic activity in our community.  Below is a brief overview of select income tax and business planning issues related to this industry.

Oil & Gas

Lease Bonuses vs. Royalties:  In general, lease bonus income are payments from an energy company for the right to drill a well on property.  They are treated as rental income for federal income tax purposes subject to ordinary income tax rates.  By its very nature, rental income is considered passive that can only be offset by other passive losses (except from passive losses from publicly traded partnerships).  Passive income from lease bonus income cannot be offset by trade or business losses from non-passive losses.  However, lease bonus payments received from energy companies may be reduced by related expenses such as legal fees, property taxes, and title and survey costs.  This income may also be subject to the new Net Investment Income Tax (see explanation of this tax below) of 3.8% for certain high-income taxpayers.

Royalties, on the other hand, are payments made to landowners/interest owners based on the amount of oil/gas extracted from the property.  This income is treated as portfolio (investment) income subject to ordinary income tax bracket rates that may be offset by non-passive losses from a trade or business.  Again, this income may be subject to the new NIIT of 3.8% for certain high-income taxpayers.

Estimated Tax Issues:  Receipt of large lease bonuses and/or royalties can trigger the requirement of estimated tax payments on a quarterly basis.  This is especially true for salaried taxpayers who are used to having income tax withholdings (deposited with the IRS) cover their annual tax liability.  Upon receipt of these types of payments, it is important to consider making estimated tax payments during the year to avoid penalties and interest at year end (as well as a large tax obligation upon filing returns).

Form 1040-ES crop

Forming an Entity for Liability Protection:  Many taxpayers desire to establish an entity to receive the income from natural gas leases.  Limited Liability Companies (LLCs) and S Corporations provide liability protection for taxpayers receiving lease bonuses and royalty income.  These pass-through entities also provide estate planning opportunities for taxpayers wanting to pass out these future income streams to their heirs.  In general, LLCs offer greater flexibility than S Corporations and can potentially be filed along with a taxpayers individual income tax return without the need to file its own (separate) tax return.

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