Oil and Gas Lease Bonus Payment Taxation
The negotiation process has been extensive and you are finally ready to sign the oil/gas lease agreement. All terms of the agreement have been settled upon and monies will begin to be received by you upon the execution of the agreement or shortly thereafter. One of the first payments you may receive upon the execution of the lease agreement is a "bonus" payment. This payment is normally received within ninety days of signing the lease. It could be paid in a lump sum amount or in installments over the term of the lease. This payment is not dependent on any extraction or production of any oil or gas. Understanding the proper tax treatment of this bonus payment is important because it may be one of the most significant payments that will be received in relation to the lease agreement.
Pursuant to a Supreme Court Ruling (Anderson vs. Commissioner), bonus payments are treated as advance royalties. Therefore, these payments are taxed as ordinary income to the landowner. These payments are generally taxed in the year received by the taxpayer. If there is separate cost basis in the oil and gas rights (usually not the case), the bonus payments may be eligible for cost depletion. However, percentage depletion is not available with respect to any lease bonus, advance royalty or other amount payable without regard to the production from any oil, gas or geothermal property.
Recent Tax Court Case
In the United States Tax Court Case (Michael H. and Brenda M. Dudek, Petitioners vs. Commissioner of Internal Revenue, Respondent) filed December 2, 2013, the Petitioners argued that a bonus payment they received as an inducement to enter into a lease agreement should be taxed as a long-term capital gain. The Internal Revenue Service (IRS) argued that the bonus payment constitutes ordinary income. The Petitioners attempted to argue that the Agreement was not a lease, but a sale of their rights to any oil and gas on the property. The Tax Court had to determine if the Agreement was a lease.
The Tax Court determined that the Petitioners retained a royalty interest in the natural resources because they were to receive royalty payments on a percentage of the income from any gas or oil extracted from the property. It was determined they still had an economic interest in the oil and gas in place. Thus the Agreement was regarded as a lease by the Tax Court.
The Tax Court also determined that the Agreement does not reflect the economic realities of a sale. A sale would be evidenced by an exchange of a determinable quantity of oil and gas for a determinable price. The Agreement provided for no definite quantities of transferrable oil and gas. Therefore it was determined this was not a sale.
The Tax Court found that the Agreement was a lease and that the bonus payment is taxable as ordinary income, not capital gain.
Non-Passive or Passive Activity
Although they are generally reported as "rent" by the payor, lease bonus payments received for an oil/gas lease agreement are not "passive" rent with regard to Internal Revenue Code Section 469. Rental activity under this Code Section is any activity for which payments are principally for the use of tangible property. These payments are not for the use of tangible property. They are for the acquisition of an economic interest in any oil/gas reserves that may exist. Also, the Section 469 Regulations provide that the rent of land or other non-depreciable property (where less than 30% of unadjusted basis is depreciable) is not treated as passive. Therefore, these lease bonus payments would not be passive income for purposes of Code Section 469.
If you have any questions about bonus payments, or any other payments to be received with regard to your oil/gas lease agreement, please contact us. At Herbein, our experienced professionals can provide you with the important advice you need.
For additional information please contact the author, David Cordier at [email protected].