How to offset some of the federal income taxes associated with lease bonuses

I have recently signed a lease and will be receiving my bonus before the years end. It looks like uncle sam is going to hit me pretty hard. Does anyone have any plans to reduce the amount of taxes on the lease bonuses?

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Permalink Reply by Frank Walker on October 16, 2010 at 4:42am
Your tax accountant is the best person to consult on this. Tax planning is a very complicated matter and best left in the hands of professionals. In addition, the fact Congress has not yet acted regarding the 2011 tax structure and rates makes matters even more difficult and complex. Nobody can say for certain today what will happen in Congress during the lame duck session which will follow the general election early in November.

One common approach to saving on taxes, which might or might NOT be useful to you, is splitting of your bonus payment. You would collect a portion this year and the remainder next year. There is the potential to save thousands of dollars depending on your base income and the size of your bonus. Even if this would help you, the split must be structured thoughtfully and intelligently. There, once again, is where the assist from your tax accountant becomes pivotal.
Permalink Reply by Al Cramblett on October 18, 2010 at 6:21am
Jim, you have hit upon an issue that we all should be concerned about, but I find very few are even considering the impact of tax. First off, I must say that I am not a tax professional. During the recent NARO convention in Pittsburgh, a CPA told me there was a revenue ruling which precluded the apportionment of a signing bonus from one year to another. I do not know whether this is true or not but it certainly should be researched before you look into SPREADING payments from one year to the next. One thing that I know will work is to buy into an oil and gas drilling partnership. I have been doing this for years and recently purchased a partnership interest in an Atlas offering. I would suggest you talk to a financial planner regarding possible options to reduce your tax liability. Good luck to you.
Permalink Reply by Frank Walker on October 18, 2010 at 12:22pm
Thanks for an excellent post. I also have run into this with tax professionals claiming splits can be problematic. However, opinions on this matter appear to differ. Here is a reference:

http://en.allexperts.com/q/Tax-Law-Questions-932/2010/1/report-gas-...

Now most of us are cash basis taxpayers . . . . but perhaps not everyone. I know I am a cash basis taxpayer. That doesn't mean others necessarily are.

Oftentimes I think professionals (of all kinds) attempt to inject doubt on certain matters just to increase their business. You can't live with 'em . . . and you can't live without 'em!

I have searched the internet for a reference stating splits are problematic for cash basis taxpayers. So far no luck finding that reference. But it's a big internet. Just because I cannot find the reference does not mean it's not out there.
Permalink Reply by Al Cramblett on October 18, 2010 at 5:11pm
Frank, I don't want to appear to be argumentative but here is what I found this evening in an Internet search:

Cash Bonus
IRS Revenue Ruling 68-606
Some leases attempt to spread out the payment of bonus money.

Rev. Rul. 68-606 requires that:

If the lessee is unable to avoid such payments by production or by
terminating the lease, then the annual payments are regarded as
an installment lease bonus. Payments received from an obligation
that is not salable or freely transferable are income in the years the
payments are received. However, if the rights to the bonus
payments are freely transferable and readily salable, the total
amount of the lease bonus is includible in income at the time the
lease is executed even though the bonus is payable in installments

From my perspective, a Revenue Ruling trumps any CPA’s opinion.
Permalink Reply by Frank Walker on October 19, 2010 at 2:04am
Al, thanks. I don't think you're being argumentative at all. And I really appreciate the Revenue Ruling you posted. I had not seen it before. I think your post is very helpful, not just to me but also to others.

As for an explanation of the differences between the Revenue Ruling and the opinion of the CPA I posted, of course I have none. I'm not a CPA. My own accountant has given me the same opinion as the one I posted. Surely it is possible many accountants are unaware of the Revenue Ruling. I wish I knew the date of that ruling. If it is recent that would provide a possible explanation as to why some CPAs are unaware.

Thanks again.
Permalink Reply by Al Cramblett on October 19, 2010 at 3:22am
Frank, the irony here is that I had been planning on doing exactly what you suggested. However, during a bus ride associated with the NARO convention, the guy sitting next to me said that I would be making a mistake. The moral here is to associate with people that are educated. I had a question regarding 1031 exchanges that had plagued me for a couple of months. While at the convention professor Joel Bennett gave me the answer to my question in two minutes at which time I thought I had to bow down to him. In regard to the date on revenue ruling 68-606, I believe it was mid 2009. The bottom line of all this is that we as laypeople go to professionals for advice. I have found that many professionals will give that advice without the benefit of the necessary knowledge to back up what they just said. I would suggest the true value of this forum is really coming to the forefront!
Permalink Reply by Frank Walker on October 19, 2010 at 4:15am
Al, agreed. I have been working on this and trying to research the various aspects.

I have a feeling the lease can be structured so as to allow a split payment. Without question this is a matter best left to a professional, a lawyer, an accountant, or both!

But for example, and using your post, above:

If lease states the Lessee can sidestep (i.e., avoid) the second bonus payment by cancelling or terminating the lease, then possibly the split will work for tax purposes. Just a thought.

If not, and from what I am reading:

The second portion of the split payment is taxable at lease signing only as to its value at time of lease signing. That value might, indeed, be less than the nominal value of the second payment in future.

This is all very complex financial stuff which is, once again, why the right O&G professional is needed. Most of us, for all of our lives, never had enough money to where we needed such help. For people who always had money I guess this is no big deal. But for noobies it surely is.

It is a little worrying, though, when CPAs out there appear to have differing views on this. Gosh, what are we to do when even the pros disagree?
Permalink Reply by Frank Walker on October 19, 2010 at 5:45am
Al, that's good. Because answering your question is far beyond my knowledge.

The only thought I have is that any sale you make, or anyone else makes, to a family member must be an "arms length" sale. If it is not, then the difference between the amount you receive from the family member, and the larger amount you would have received from an arm's length sale, is considered (for tax purposes) a gift to the family member.

But this is highly complex financial stuff and your decision to consult with Professor Bennett is a wise one!
Permalink Reply by Al Cramblett on October 19, 2010 at 6:06am
You are correct in what you said above. However, we still have the $13,000 annual gift exclusion in place plus the $1 million life long exclusion. Yes, a gift tax return may need to be filed, but it would be an informational return laying in wait until my property becomes an estate issue.
Permalink Reply by Frank Walker on October 19, 2010 at 11:33am
Back on the topic of the split bonus. From what I can learn Al's statement (above) comes very much into play. Looking for simplicity at a single split where there are only two payments:

Al wrote that:


". . . . . if the rights to the bonus
payments are freely transferable and readily salable, the total
amount of the lease bonus is includible in income at the time the
lease is executed even though the bonus is payable in installments."

The notions of free transfer and straightforward saleability merit thought and exploration. Taking the second first, common stocks or bonds are readily salable. Those things trade every day on exchanges worldwide. An automobile is readily salable . . . a halfway decent one, anyway. At worst, you can take the car to an auto auction and sell it straightaway. The auction provides the needed marketplace and auto auctions are going concerns in many places in the USA. You can think of other things which meet the test of "readily salable".

I'm less certain the second portion of a bonus payment would be readily salable. I'm unaware of a going marketplace for such things. You most likely could find an investor, a risk taker, who would offer you money now in return for your signing over rights to your bonus money "next year". There would be a discount applied, of course. Leases I have seen specify that Lessee can decide not to pay second bonus payment at cost (to Lessee) of surrendering the lease. That's not likely to happen unless . . . .

Unless in the interim between payments Lessee discovers, through drilling, an unanticipated thrust fault, or some similar geological anomaly, which would render further drilling uneconomic. Likely to happen? Not at all. Could it happen? Well, anything could happen when you are drilling a mile down.

Point is there is enough uncertainty to impact the present value of the (hoped for) future payment. You still could find a buyer I'm pretty sure. Of what the price would be I am far less certain. It's not just the possible geological anomalies. If the price of natural gas continues to descend, as it is doing at present, the gas company might decide to write off their losses and just say "screw it" when time comes to pay the second bonus payment.

The "readily salable" concept carries with it the implication of easy price determination, as is the case (again) with the stock market, for example. Stock prices are published everywhere and easily ascertainable. That's not true with the value of the second portion of a Lessor's bonus payment.

I think a reason for the "readily salable" language comes about because you can only be taxed on the present value of the future bonus payment at the time of lease signing. You need to be able easily to set a present value on whatever will be taxed.

Concerning the "freely transferable" part of the test:

I think the second portion of a split bonus payment would be fairly freely transferable. Lessor would have to sign a legally binding agreement to surrender the money when paid . . or else Lessor might have to sign an authorization to Lessee to pay third party instead of Lessor. I don't know why something like this could not be accomplished. But setting the buyout price might be a glitch. It would be very situation specific, very unique. I don't think it would be all that straightforward finding a buyer and arriving at a price, where a great deal of subjectivity might be involved. Thus, I question the "ready saleability" of the second portion of a split bonus.

Maybe Craigslist? And some negotiating. But there is no marketplace I know of where such things are freely, openly and actively traded at well recognized and widely accepted prices.
Permalink Reply by Matt Henderson on October 20, 2010 at 8:35am
Since you are near the years end, I would suggest asking the company to hold off until after the new year. We were due a bonus payment and requested receiving it after the new year. If you get it early January, you will have almost 16 months to pay Uncle Sam and can make a few dollars on interest. As you stated, we are all mostly on a cash basis so have them date it after Jan 1 and deliver it then. Of course, everyone has different tax issues so consulting a professional tax advisor on your specifics would be best. We put the estimated tax due (state and federal) into an interest bearing account and just let it sit. A few thousand in interest is better than paying it right to Uncle Sam if you ask me.
Permalink Reply by Frank Walker on October 20, 2010 at 11:37am
Matt I don't disagree with you. But a few caveats are needed before pursuing your strategy:

You are relying on what's known as the "safe harbor" rules . . . and those rules are, indeed, reliable. But the rules must be read carefully, understood completely, and followed scrupulously. Otherwise the taxpayer will enter into a penalty situation. In particular, all taxpayers must be careful to pay quarterly in estimated tax an amount at least equal to one quarter of the previous year's tax obligation. There might be a slight wiggle on that in the rules, but I always pay at least a quarter just to be on the safe side. And all estimated tax payments must be paid timely, without exception.

Finally, anyone taking a chance with the split payment approach needs to be especially careful. The "safe harbor" technique will not work two years in a row!! What happens is that, for the second year, your safe harbor payments become very large.

So bottom line, folks need to understand the rules and proceed very, very carefully. For people unfamiliar with quarterly tax and the safe harbor rules, the counsel of a good tax advisor would be invaluable.

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