Managing a Sudden Bonanza Oil and Gas Tax Considerations for the Landowner

Marcellus Shale gas drilling is the buzz in Washington County, with Southpointe serving as a vantage point for the tremendous amount of business activity driven by oil and gas producers, equipment manufacturers, and professional services stemming from oil and gas contracts. In fact, more than 50 oil- and gas-related companies have office locations in Southpointe, including Range Resources, which has begun construction on a large building near Morganza Road. All of the activity from this natural gas boom will likely create a large amount of income for landowners in our area who own mineral rights. Most landowners purchased their property for the surface rights, never dreaming that previously untapped underground resources could make them wealthy. For most people, managing sudden wealth will require a crash course in financial and tax planning. Specifically, while the tax laws pertaining to oil and gas leases and the resultant royalties are complex, understanding the rules may help you save taxes and avoid penalties. In this article we offer a brief overview of some of the general tax considerations. For more detailed information, however, please explore our website "Preparing for the 'NEW' Gold Rush" for free publications on gas leasing and related financial planning advice.

OIL AND GAS REVENUES. Oil and gas revenue is considered to be ordinary income and is subject to federal, state, and local income tax. Cash bonuses or upfront lease bonus payments are considered rent and, as such, are taxed as ordinary income, usually in the year received. The one-time payment may place you in the top income tax bracket for that year (35% in 2011). However, often possible is the deduction of expenses such as attorney’s fees, deed/title searches, surveys, some surface damage payments, and property taxes. Also, if the landowner has a working interest in the production of the gas, additional expenses such as intangible drilling costs, development costs (IDC), operational costs, equipment depreciation, and production tax credits might be deducted.

ROYALTIES. Most property owners will only have a royalty interest. Royalty payments are considered ordinary income for the landowner. However, because oil and gas is a natural resource and can be “used up” as it is produced and sold, most landowners will have the ability to deduct a “depletion” allowance. This is similar to depreciating a rental property or the purchase of capital equipment over time. For natural gas, 15% of the landowner’s gross income from the average daily production up to the total quantity of the gas is considered the depletion allowance. The depletion allowance is then limited to the smaller of either (1) 100% of the landowner’s taxable income from the property (without depletion allowance factored) or (2) 65% of the landowner’s taxable income from all sources (without depletion allowance factored). Selling mineral rights rather than leasing could offer the landowner significant tax advantages since selling can generate long-term capital gains. Long-term capital gains are taxed at 15% in 2011.

INCORPORATION. Landowners who anticipate receiving significant income from gas extraction may consider setting up family limited partnerships. Generally, the income generated via these entities is still subject to personal income tax, but it is possible to spread the taxable income over all of the owners who may individually qualify for a lower income tax bracket. Incorporation may also allow transfer to any number of beneficiaries and may provide the benefit of a reduced taxable estate.

ESTATE AND INHERITANCE ISSUES. Another tax consideration to take into account is the federal estate tax and the Pennsylvania inheritance tax. In 2011, $5 million of a landowner’s estate is exempt from federal estate tax ($10 million for husband and wife) while assets >$5 million are taxed at 35%. In addition, the Pennsylvania state inheritance tax is currently 4.5% on all assets. Although the federal estate tax rates may change in the future, many landowners will collect oil and gas revenues and still pass an estate less than the $5 million exclusion. Regardless of the estate size, there are opportunities to reduce the estate and inheritance tax burden if actions are taken prior to death. Despite the still recovering U.S. economy and lingering high national unemployment numbers, Marcellus Shale gas drilling holds the promise to invigorate our county. For the individual it could mean the guarantee of an ideal retirement, educational support for children’s college, or a legacy plan for heirs. While many landowners in the area will experience a windfall, some will take the first step to protecting their newfound wealth by calling a professional. Landowners who anticipate receiving lease bonus payments and royalties are advised to discuss the tax ramifications of their holdings with an accountant, an attorney, or a wealth manager.

Garrett S. Hoge, RFC, CFP®, MS of H Financial Management, is a private wealth manager based in Southpointe serving the ever-changing financial needs of his clients.

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Comment by Todd Charles on March 22, 2011 at 11:34am
Thank you, we will check into it - XTO to start drilling within 60 days now.
Comment by Garrett S. Hoge, RFC, CFP, MS on March 21, 2011 at 10:34pm
Southpointe is in Canonsburg, PA south of Pittsburgh. We have an office in Morgantown, WV. For more information go to our website, www.hfinancialmanagement.com.
Comment by Todd Charles on March 21, 2011 at 7:49pm

Thanks much.  Where is Southpointe and do you do business in West Virginia ?


Todd's mom, Kit

Comment by William Ladd on March 21, 2011 at 3:49pm

Thanks for the information. It will come in handy for many lucky landowners should they actually receive any monies from drilling companies.


Bill L.

aka Bummy

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