A Pennsylvania attorney/CPA and his wife were assessed a tax deficiency and an accuracy-related penalty for the reported treatment of a lease bonus payment on their 2008 federal return.
In a December 2, 2013 Tax Court Memorandum decision (106 T.C.M. 612), the Court held again that a lease bonus payment is ordinary income for federal tax purposes. The taxpayers had argued that the payment of $880,000 was received as an incentive to enter into a lease agreement and was, in substance, a sale of their rights to the oil and gas on the property. However, under the terms of the lease agreement, the taxpayers were entitled to a royalty payment of 16% of the net profits of any oil and gas ultimately extracted from the property. In cases where the landowner retains an economic interest in the deposits, as evidenced in this case by the retained royalty interest, the transaction is considered a lease. The Court further elaborated that the agreement did not reflect a sale of the oil and gas in place and did not transfer a determinable quantity of oil and gas at a determinable price and was therefore not a sale.
The taxpayers also argued that if the Court rejected the capital gain treatment, then they should be entitled to a 15% percentage depletion deduction on the proceeds. However, IRC Section 613A(d)(5) specifically excludes percentage depletion where an amount is payable without regard to the production of the property. A cost depletion deduction would have been allowed against the bonus lease payment; however, the taxpayers failed to provide any cost basis for depletion or the total amount of royalties expected to be received. When they purchased the property, the taxpayers apparently had not obtained a formal allocation of the purchase price between the surface area, timber, oil and gas, coal or other subsurface minerals. Therefore, they had no means of determining what portion of the original purchase price was attributable to the oil and gas in place.
Since the assessed tax deficiency exceeded 10% of the tax required to be shown on the return, the taxpayers had a “substantial understatement of income tax” for the 2008 tax year. The taxpayers were unable to show that they had reasonable cause for their position as reported in the return and that they had acted in good faith with respect thereto. Accordingly, the court confirmed the accuracy-related penalty of 20% of the tax underpayment.
As indicated above, oil and gas lease taxation can be a confusing area even to a licensed professional. Accordingly, landowners presented with an opportunity to enter into an oil and/or gas lease should consult a professional with specific oil and gas expertise regarding the lease terms, terminology and tax impact both at the time of the initial lease signing and in subsequent years.
Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) for promoting, marketing or recommending to another party any transaction or other matter addressed in this communication.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.