According to a recent article in Forbes Magazine, oil and gas production has more than doubled in Texas alone in the last two years and Texas recently surpassed Venezuela in total oil production. All of this activity depends on investors willing to pony up the capital to fund this expansion, and that can lead to some complicated tax issues.
Every tax season, we prepare tax returns for many partnerships that own oil and gas interests and have hundreds of investors. Inevitably, after preparing and mailing the K1s to the investors, we receive phone calls from all across the nation because the investors had been told by investment advisors or other investment professionals - who might have the best intentions, but lack the appropriate tax knowledge - that they can deduct the Intangible Drilling Costs (IDCs) passed through to them by the partnership even though they are a passive investor. The phone call leads to the question, “Where is that in the Internal Revenue Code?” After responding to so many of these calls, we have prepared a brief overview that outlines some of the key points for the average oil and gas investor.
First, let’s take a very high-level look at how a typical investment in an oil and gas partnership works. The income from an oil and gas property is usually divided between the mineral interest owner (the royalty owner) and the operator (the working interest owner). In a typical lease arrangement, this usually results in the royalty owner retaining 12.5% and the working interest owner owning an 87.5% interest. In general, the normal working interest consists of the remaining share of production or income after the royalty interest's share is satisfied. The working interest is subject to all of the costs of exploring for, developing, and producing minerals. The holder of the working interest can retain ownership throughout the life of the lease or assign all or part of the interest during the term of the lease.
The royalty owner incurs none of the cost to explore, develop, or operate the mineral production. These costs are borne by the working interest owner. This is where the investor comes into play. In order to fund the exploration, development, or operations, the working interest owner transfers various interests in the property to the investor in exchange for their capital.
As the operator begins the exploration and development of the property, these costs are allocated to the investor. In the beginning, these are geological survey costs, well equipment (also called tangible costs), and intangible drilling (IDC) costs which, for tax purposes, are allowed to be deducted rather than capitalized. The partnership passes these IDCs through separately to the investors on the K1. In the early years, these investments create large losses. Normally these passive activity losses would only be deductible to the extent that the investor has passive income. Most investors find themselves with large passive losses that they cannot deduct. But if you own a working interest in any oil or gas property, either directly or through an entity that doesn't limit the taxpayer's liability with respect to the interest, it is non-passive activity, regardless of the taxpayer's participation. What a great deal for the taxpayer! For you CPAs looking for the specific reference to this, see Reg § 1.469-1T(e)(4)(i) and watch this short video about the benefits of this investment here.
Under Reg § 1.469-1(e)(4)(iv), for these purposes, working interest in oil or gas property is defined by reference to the depletion rules. These rules cover "minerals in place," including ores of metals, coal, oil, gas, and all other natural metallic and nonmetallic deposits. So, where taxpayer's activity is the production of fuel from landfill, a man-made non-conventional source, it doesn't qualify as a working interest in oil and gas property. Landfill gas is derived from the biodegradation of municipal solid waste, i.e., not from minerals (oil and gas).
This one is fairly easy. For the purposes of this rule, an entity limits the liability of the taxpayer for purposes of this rule if the interest in the entity is in the form of:
An important note is that there are arrangements that can be put into place that do not violate this rule. Some of these arrangements are:
For example, let’s say that Joe owns a 20% interest as a general partner in the capital and profits of Top Oil and Gas, LP, a partnership which owns oil or gas working interests. The other partners of Top Oil have agreed to indemnify Joe against liability in excess of Joe’s capital contribution for any of Top Oil's costs and expenses with respect to Joe's working interests. As a general partner, however, Joe is jointly and severally liable for all of Top Oil's liabilities. The indemnification agreement isn't taken into account in determining whether Joe holds the working interest through an entity that limits his liability. As a result, the partnership doesn't limit Joe's liability with respect to the drilling or operation of wells under the working interests; Joe is therefore considered non-passive with respect to his investment in Top Oil and can deduct IDCs passed through to him against his other non-passive (or earned) income. This video explains how to set your investment up correctly.
This is great for you also. If you are both a general and a limited partner in a partnership that owns a working interest, your entire interest in each well drilled under the working interest is treated as an interest in a non-passive activity, whether or not you materially participate.
So, assuming from the example above that Joe and his wife Amy each owned a 1% general partnership interest and a 5% limited partnership interest in a partnership and were jointly and severally liable for the partnership's activities, the partnership's oil and gas working interests will be non-passive activities.
However, let’s take the same facts from the example above, except that Joe owns a 20% limited partnership interest in Top Oil. As a limited partner, Joe’s liability with respect to his investment in Top Oil is limited and, therefore, he is considered a passive investor. As such, any losses passed through to him by the partnership could only be deducted to the extent of other passive income he might have. Here is the important part – if he has no other passive income to offset his passive losses, the passive losses are suspended and carry forward to future tax years until he has passive income to offset or he disposes of his investment in the partnership.
There are several important issues to consider when contemplating an investment in an oil and gas partnership that promises big tax deductions upfront. The tax rules in this area can be very complex, and you should always seek the advice of a competent tax professional before putting your money on the table.