Oil and gas working interests for investors

The following are some of the most commonly asked questions by oil and gas investors and those looking to start an entity to attract oil and gas investors.

Oil and Gas Working Interest FAQs

If I won my oil and gas working interest in an LLC, is it passive? 

Generally, the answer to this question is yes, it does make the investment passive. But if you own a working interest in any oil or gas property, either directly or through an entity that doesn't limit your liability with respect to the interest, it is not a passive activity, regardless of your participation (Reg § 1.469-1T(e)(4)(i)). The applicable state law governs how the entity limits your liability, and this generally includes an LLC. 

Are royalty losses for oil wells deductible? 

This depends on the types of losses we are talking about. When we are asked this question, the investor typically is trying to determine if they can write off the intangible drilling costs and other expenses related to the investment in an oil and gas property that will eventually pay them a royalty or some form of income. If you hold the investment directly or through an entity that does not limit your liability, the answer is yes, they generally are deductible. 

 Is an investment in an oil and gas limited partnership a passive activity? 

If you only hold a limited partnership investment, yes, it is a passive activity. If you hold a general partnership unit, generally your liability is not limited and the activity would not be passive, regardless of your participation. What we see most often is that when these investments begin, the investor will own both a general partnership unit(s) and a limited partnership unit(s). 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. 

How should I set up a working interest in an oil and gas investment?

If you are an investor looking to take advantage of IDC deductions during the drilling phase, you will want to make sure that you own it directly or through an entity that does not limit your liability with respect to the oil and gas property. This will allow you to treat the investment as active rather than passive, regardless of your participation. 

If you do plan on being active in the entity that owns the investment, you will want to consult with your legal counsel to make sure you have afforded yourself liability protection. By being an active participant, you will not need the exclusion provided by Reg § 1.469-1T(e)(4)(i). 

If you intend to raise capital from investors, you will want to make sure that you allow the investor the opportunity to take advantage of the deductions during the drilling phase. In our experience, we most often see this done through a limited partnership that has both limited and general partnership units. Law firms that are familiar with oil and gas partnerships will know exactly how to set these up. Typically an LLC would not be the entity of choice if you have investors.

I have a basis in my working interest investment, doesn't this alone allow me to deduct the IDCs?

This was an interesting question that came up while discussing the ability of the investor to deduct IDCs with a client. The client I was speaking with thought that the basis trumped all of the other rules and that the only issue was his basis in the working interest. Unfortunately, this is not the case. Basis alone does not allow you to deduct the IDCs. While basis will come into play at some point, it is not the first hurdle to cross. The first test you will have as an oil and gas investor is the passive/active test. If you are a passive investor, basis alone will not allow you to take the deduction. In order to avoid the passive test, you will want to make sure that you own the working interest directly or through an entity that does not limit your liability with respect to the working interest (as mentioned above). Once you have cleared that hurdle, we can then talk about basis.