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Working With Working Interests

With oil prices recently falling to post-recession lows, not many investors are looking for the best way to get into the energy sector, yet there are some interesting possibilities for those who want to go against the herd.

The simplest option, and the most common, is to buy shares of energy companies or of mutual funds that invest in them. Another approach is to lease mineral interests that you might already own, or which you acquire, to companies that want to explore and develop those resources. This is the avenue that has opened up for many landowners from the East Coast to the Rockies, where improved drilling technology has turned the United States into a leading energy producer.

But the approach that arguably offers the greatest tax advantages is to get directly into the energy business yourself. Most of us can’t do this on our own, but in some cases, there are opportunities to partner with an experienced and competent developer who is willing to share the risks and rewards of drilling with outside investors, who can provide capital. The investors take a minority interest - often just a few percentage points - in the prospects and wells that the driller develops. These so-called working interests are more complicated than many other investments, but they offer tax treatment that can make the extra complexity worthwhile.

Much of federal tax law related to energy resources rests on the concept of an “economic interest,” yet interestingly, the term is not clearly defined. For practical purposes, an economic interest is a clear and direct stake in a mineral property and the income from its production. This matters because a taxpayer must have an economic interest in order to take a depletion deduction (that is, a deduction designed to allow for the reduction in an oil or gas property’s reserves over time as the resources are extracted).

A working interest is a specific sort of economic interest - one in which the interest’s owner has a right to work on the leased premises to search, develop and produce oil and gas. The landowner usually assigns an interest in the property to an operator through a leasing arrangement; the operator’s property interest is thus a “working” interest or, in tax lingo, the “operating mineral interest.” Owning a working interest involves bearing all costs involved with finding the oil or gas and drawing the resources out of the reservoir. The interest expires when the lease is terminated.

Once an economic interest is established, working interest owners may want to establish a tax partnership, such as a limited liability company, as an instrument to hold their interests. A variety of reasons may motivate this choice. First, a partnership funded with mineral interests can create a framework for managing and maintaining the interest beyond the current owner’s lifetime. The partnership’s establishing documents may set up management and succession provisions in the case of the original transferor’s death, disability or resignation. A partnership can also create an opportunity for the owner to transfer indirect ownership interests to family members without subdividing the assets’ ownership. This can keep decision-making authority consolidated and help to preserve an existing investment strategy for the gas or oil interest.

Another important benefit of holding a working interest in a tax partnership is protection from liability. A working interest opens owners to greater liability than does a more passive investment, such as a royalty interest. As the name implies, an instrument such as a limited liability company offers a shield against such risks. Such protection flows both ways; the instrument can also protect the working interest from personal liabilities the owner may incur elsewhere.

Because oil and gas property receives unique income tax treatment, oil and gas tax partnerships are also unlike other instruments. For this reason, while they have many advantages, it is always prudent to hire a professional who is comfortable with oil and gas tax partnerships. That said, there are some major tax issues it is worth looking out for when dealing with these interests in the present and in the future (for example, when creating an estate plan), whether the interest is owned through an entity or outright.

Taxpayers who own working interests in oil or gas wells can either expense or capitalize intangible drilling and development costs (often abbreviated IDC). IDC can include a variety of items necessary for drilling besides drilling equipment, such as labor, grease and chemicals. The option to expense these costs is only available to the owner of a working interest (as opposed to, say, a royalty interest), because a working interest implies the owner bears the costs of production. When a working interest owner holds the interest through a tax partnership, it raises the question of whether tax rules limit the owner’s ability to deduct IDC because the activity has become “passive.” Internal Revenue Code Section 469 limits a taxpayer’s ability to deduct losses from passive activities; however, the section contains an exception for working interests in oil and gas property if the owner holds it directly or through an entity which does not limit the taxpayer’s liability.

As mentioned above, one of the reasons a working interest owner may want to hold the interest through a partnership is as a shield against potential liability. This creates a conflict between the potential for an immediate IDC deduction and the potential for increased liability exposure if the owner foregoes an LLC or limited partnership. Every taxpayer should carefully weigh the benefits and burdens of pursuing an IDC deduction. In some cases, liability insurance held directly by the working interest owner, or by a joint venture that does not extend liability protection, may be the better solution. However, such a decision should not be made lightly.

All partnerships have inside and outside basis. Inside basis is the basis of the individual assets owned by the partnership, and outside basis is the basis of your partnership interest. Holding a working interest in a partnership creates complications, due to certain deductions being calculated individually per partner. Basis allocations can be complicated, and require careful recordkeeping for all partners.

The depletion allowance is a tax deduction that is calculated in one of two ways. Cost depletion is usually calculated by dividing the cost of the mineral interest by the estimated recoverable reserves (which represents the cost per unit), multiplied by the units sold during the tax year. In contrast, percentage depletion relies on a percentage of the property’s gross income; taxpayers often prefer this method because it is not limited to their adjusted basis in the property, so the deduction amount is often greater than that calculated through cost depletion.

The tax law that allows eligible taxpayers to choose between cost depletion and percentage depletion was designed to allow independent producers to claim percentage depletion on a limited amount of domestic production, while denying this option to integrated producers - that is, producers who are engaged in refining or retailing oil and gas properties. Congress also denied outright any percentage depletion for foreign gas and oil production. Any producer that does not fit the definition of an integrated producer is, by default, an independent producer. It is also important to note that, to realize certain tax benefits, a producer must not only be independent, but a small producer; a producer’s size is generally determined by the quantity of barrels produced per day.

Working interest owners should also be aware of costs that are subject to recapture upon disposition. Both IDC and development costs are subject to recapture to the extent that these costs would have been included in the property’s adjusted basis if they had been capitalized instead of deducted in the year the costs were incurred. The idea behind the recapture rules is that taxpayers should not be able to deduct these costs against income taxed at ordinary rates when, in the absence of the rule that allows upfront write-off, these costs would otherwise produce a smaller benefit by reducing capital gains. Depletion recapture is limited to the lesser of either the amount of depletion deductions that actually reduced the property’s adjusted basis or the taxable gain on disposition. Again, percentage depletion will generally prove more favorable to the taxpayer than cost depletion, since any depletion deductions in excess of basis won’t be subject to recapture with the former method.

As you can see, the complicated rules for gas and oil interests can create a highly complex overall tax picture. On the other hand, these rules create unique opportunities, especially for owners of working interests, who have access to a variety of incentives the government has designed for small producers and investors to develop America’s natural resources.

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