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Permalink Reply by Arthur P Jensen, CPA on February 5, 2013 at 11:13am

Bob, I have pasted here the introduction section to a white paper I drafted on this topic that you might find informative. I am a professional CPA tax and financial advisor that works with families that have far greater financial opportunities than most people realize. Here's an informative section of my paper:   

Managing Landowner’s Mineral Rights Capital Asset

The gas company has come and knocked on your door offering a big up-front cash bonus to secure the gas leasing rights to drill your land, as well as some pretty rich royalty payments over time.   You are now faced with a great financial realization opportunity and with that come (1) significant new income, (2) new and higher income taxes and (3) potential estate taxes not heretofore existing.  

 Choice Matters

 Depending on how you choose to manage this opportunity at the outset will dictate how the future revenues will be taxed and when they will be taxed. Unfortunately, most landowners for years have not been informed very well of their choices, and they have taken in those revenues in such a way that taxes the cash receipt revenues at high ordinary income tax rates. While royalty income can currently be reduced by a 15% depletion deduction, the bonus payment for executing the leasing and drilling access rights is not eligible for depletion.  It’s taxed on just what it is – ordinary income and it doesn’t matter whether you’ve created a LLC, sub-S Corporation, a C-corporation, FLP or anything else.

 

In order to achieve the best tax treatment given these sets of facts, namely the sale of capital assets, the transaction on the part of the landowner with the gas company needs to be structured as a sale of the capital asset rights. The mere leasing approach, where the landowner retain the ownership of the sub-surface rights, leaves all future revenues as ordinary income as well.  Such income can be currently taxed up to the top ordinary Federal income tax rate of 35% or more in 2013, a rate that might very likely be raised in future years as the country deals with revenue deficits and high income taxpayers are the targeted revenue source for added taxes.

 

The gas company desiring to lease the mineral rights is not the ideal party to buy your mineral rights capital asset since they are not in the business of trying to maximize your capital gain.  Frankly, they don’t care much about your tax situation.  And they’re not in the real estate business; they’re in the gas and oil business. 

 

     Arthur P Jensen, CPA

     apjensen1@verizon.net

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Permalink Reply by jeff on February 5, 2013 at 11:28am

So, if you structure it as a sale of the rights, does that mean they have complete say as to what is done with the minerals and when and how? can you limit to certain formations, and is it not a permanent sale of rights?

What about a 501c3?

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Permalink Reply by Arthur P Jensen, CPA on February 5, 2013 at 11:51am

I generally consider using an SPE, Special Purpose Entity, such as a special trust or LLC, to buy the mineral rights under terms that the seller is willing to live with and is as restrictive as can be tolerated yet still qualify the sale to be a completed sale of capital assets for income tax purposes. Seller retains the landownership and retains unsold segregated mineral rights, such as different mineral rights to a separate lower zone, etc.

Capital assets can be split up for selling. Think of selling a condo, but not entire building.

If you rent, its ordinary income, if you sell, its capital gain, but watch the related party rules. Achieving capital gain treatment is perhaps cutting you tax burden in half, all the result of better structuring. The tax savings are not further taxable either, its net worth retained.

Different variations in planning are possible depending on the desires and interests of the selling family.

   Arthur P Jensen, CPA

   apjensen1@verizon.net 

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Permalink Reply by Angela Smith on February 5, 2013 at 10:43pm

Is the signing bonus reported on schedule E?  Is it considered passive income and can passive losses be used to offset the income?  I also came across the same language that Calla (post below) did and now not sure how to report the bonus.

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Permalink Reply by Arthur P Jensen, CPA on February 6, 2013 at 8:41am

I think schedule E is the most appropriate place to enter that income as schedule C makes it look like it's income subject to self employment tax, which this is not given no services are rendered.

You could choose to enter it on line 21, Other Income, on page one of the 1040.

This requires adding an explanatory description of the income, such as lease signing bonus or contractual inducement payment for lease rights. 

I think its passive, again given no services are rendered by the leasor. This is best type income in taxation, as passive investment losses could be secured as an offset to reduce tax burdens if so desired. These could come from say intangible drillng costs, etc.

Arthur P Jensen, CPA

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Permalink Reply by Arthur P Jensen, CPA on February 6, 2013 at 3:34am

Hi Calla, you have really done good homework but what I know from about 40 years study of tax law is you need to be ever vigilant in how you read materials, as they can be miss-read very easily. Unfortunately, I need to stand by my belief that the depletion allowance is NOT  available to the typical lease signing bonus and I support this with the following tax commentary from a professional tax service:

¶N-2132. Lease bonuses, advance royalties, or any other amount payable without regard to production from the property.

Income from oil or gas property eligible for the depletion deduction does not include any lease bonus, advance royalty, or any other amount payable without regard to production from the property. ¹³ Any advance royalty (to the extent that actual production during the taxable year is insufficient to earn that royalty), lease bonus, or other amount payable without regard to production isn't taken into account in computing the percentage depletion allowance, even though the amount may be taken into account for purposes of Code Sec. 61 and Code Sec. 612 (relating to gross income and cost depletion, respectively). ¹⁴

An identical rule applies to geothermal deposits. ^15
13

Code Sec. 613A(d)(5).
¹⁴

Reg § 1.613A-3(j)(1).
¹⁵

Code Sec. 613(e)(3).

Calla, you can see that confusion can occur given the lease signing cost or bonus cost of the producer company is available for THEIR cost depletion, BUT the recipient lessor is NOT eligible on that income received. 

Arthur P Jensen, CPA

apjensen1@verizon.net 

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Permalink Reply by Frank Walker on February 6, 2013 at 4:43am

Agreed, Arthur.  There is no serious discussion about this.  Depletion, for royalty owners, does not exist.  Period.

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Permalink Reply by Arthur P Jensen, CPA on February 6, 2013 at 8:20am

I didn't say that Frank, No depeltion on lease signing bonus BUT you do qualifty for 15% percentage depletion on gross royalty income payments.

Depletion does exist.

Arthur P Jensen, CPA

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Permalink Reply by Paul Martinelli on February 6, 2013 at 5:35am

Please give more details on this if you can.....I have not heard that.

How is the land cost determined? Does it matter when it was purchased.....etc.

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Permalink Reply by Olive Sue on February 6, 2013 at 1:00pm

Oh my be careful with that information.  I think you need to look beyond H & R Bloch.

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Permalink Reply by myles fetterhoff on February 6, 2013 at 4:57am

I set up family limit partnership and have CPA and estate attorney then work with northwest saving bank oil and gas division for royalties

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