Oil and Gas Leases
The parties to an oil and gas lease typically include the landowner and the energy company. The lease should state the rights and the obligations of both the landowner and the energy company.
The landowner is the Lessor and the energy company is the Lessee. When the landowner signs the lease he will be given an agreed upon bonus referred to as a “lease bonus”. This can be paid in a lump-sum or multi-year payments. The bonus can be substantial if there are producing wells near the land or it may be low if there is no drilling in the area.
Royalty payments are another part of the oil and gas lease. These payments are made to the landowner and are an agreed upon percentage of the revenue of the oil and gas based on the resources extracted from the property, net of the applicable severance taxes.
Delay rentals are paid if the term of the oil or gas lease extends past the time that the bonus was paid, and a well was not drilled. This is an agreed upon sum which is due on or around the anniversary of the lease. Failure to pay a delay rental timely cancels the lease.
Damages occur, and the lessee will become liable to the lessor, when the lessee goes beyond what is reasonably necessary, negligently injures the surface area or fails to accommodate existing uses on the surface. A lessor may want to place restrictions above and beyond those stated in the typical oil and gas lease regarding what the lessee can and cannot do on the surface as well as where the lessee may and may not go on the surface. The Environmental Protection Agency requires that the property be returned to a usable, environmentally safe condition when operations cease.
A working interest owner in an oil and gas property assumes the burden of developing and operating the property. The working interest owner bears its percentage of all costs involved in finding oil or gas and, if exploration is successful, the expenses incurred in lifting the minerals from the reservoir. If an individual owns the working interest directly, there is no liability protection from possible damages incurred during the drilling and operation of the well.
Tax Treatment and Reporting
The lease bonus is considered an advance rental. The lessee should provide the lessor with a Form 1099-MISC listing the amount of bonus payments as “Rent” in Box 1 or “Other Income” in Box 3 including an explanation that the income is lease bonus income. This income is considered ordinary portfolio income, not passive income to be used to offset passive losses.
The lessee of the mineral property should provide the lessor with a Form 1099-MISC reporting the payments as “Royalties” in Box 2. Royalties received should be included in the lessor’s gross income and are taxed as ordinary portfolio/investment income and are subject to the Medicare tax on net investment income over the threshold amount.
Income received from a working interest is ordinary income subject to self-employment taxes and is not subject to the Medicare net investment tax.
Depletion allows the owner of a producing well to recover their investment with tax deductions over the period in which oil/gas is produced. Working interest owners are entitled to a deduction for the greater of cost depletion or percentage depletion. Cost depletion is based on the leasehold cost of the property and is calculated using the mineral reserves and the number of units sold for the year. The percentage depletion deduction is 15% of gross income for the life of the well. Royalty interest owners are eligible for percentage depletion. Percentage depletion is limited to 65% of taxable income and 100% of net income from the well.
Cost depletion is allowable on a lease bonus as long as the basis in the mineral interest can be established. There is no limitation on cost depletion.
When damages are paid to the lessor by the lessee, a 1099-MISC should be provided to the lessor. The amount of damages paid should be reported in Box 3 “Other Income” and identified as payment of damages, or easement, if the case may be.
Generally, damages are excluded from gross income but treated as a return of capital, reducing the cost basis of the property. Income will arise if the damages received are in excess of the basis of the property.
The grant of a limited easement for a consideration is in effect a sale of a portion of the rights in the land and the proceeds should be applied to reduce the basis in that land. If only a portion of an entire tract of land is affected by the grant of an easement, only the basis properly allocable to that portion is reduced by the amount received, and any excess of the consideration is considered taxable gain. The lessor should be provided with a form 1099-S.
The grant of an easement, such as a perpetual easement, on a taxpayer’s land amounts to a sale of the land if it leaves the taxpayer with virtually nothing but the bare legal title to the land. This gain would be considered either long-term or short-term capital gain depending on the holding period of the property. If the taxpayer grants an easement for a finite term, following which the easement would revert to the taxpayer, the transaction is a lease and not a sale and is taxed as ordinary income, subject to the net investment income surtax.
Please call us at 281-759-1120 if you wish to discuss this area further or if we can assist you in any way.