On August 28 and 29, I had the privilege of attending the 2013 Natural Gas Conference held at The Penn Stater Conference Center and Hotel in State College, Pennsylvania.
Among the many topics discussed, an area of particular relevance, especially to landowners, was the treatment of lease payments and the subtle distinction between easements, rents and royalties.
Easements - In order for a driller to cross private property with a road, pipeline, fencing or other structure, certain property interests must be obtained from the landowner. These interests are contained in a document called a grant of easement, which provides the driller with the necessary rights to the property and outlines the compensation to the landowner. Each easement is written with regard to the specific situation and should be reviewed by an experienced professional before execution to ensure that the structure of the agreement will provide the intended business and tax results.
The tax treatment of the compensation depends on the determination of the whether the easement is considered short term or long term. Although there are some bright-line tests, some easements are open to interpretation. In general, easements of 10 years or less are treated as short term, and 30 years or more are treated as long term. The distinction for easements falling between the bright-line terms is based on facts and circumstances of easement, using such considerations as the type of property, the amount of compensation involved and the beneficial interest in the property, if any, retained by the property owner.
Short-term easements are treated as rental income, while long-term easements are treated as a sale and are subject to capital gains treatment. The basis allocation for the gain calculation can include not only the acreage laid out in the grant of easement, but also parts of the property that are restricted or rendered unusable as a result of the easement. An example of property being deemed unusable would be if a farmer could not access a portion of otherwise farmable land due to an above-ground pipeline.
Lease and Royalty Payments - Natural gas trapped underground has little or no value to landowners; it only becomes valuable when companies with the technical ability are able to extract it and deliver it to the end-user. As a result, many landowners are realizing significant income by leasing their property to gas companies for exploration and drilling.
A typical gas lease is usually for a primary term of three to five years, and compensation to the lessor may include rents, royalties and, in many cases, a bonus payment.
Rents, sometimes referred to as delayed rentals, are paid periodically and like other rental payments, gas lease rental payments can be reduced by related expenses, such as property taxes and attorneys’ fees. Most leases are written to stop rental payments when royalty payments begin. However, the rent is not an advance payment for gas, but rather rent paid for the privilege of deferring development of the property. The proper determination will impact the tax reporting for the payment(s) and the income tax payable with respect to the income received.
Royalties are payments made to the landowner for the gas extracted and are based on the revenue a well generates. The landowners are permitted a deduction for the greater of cost or percentage depletion. Cost depletion is based on the tax basis of the gas rights. In many cases, however, the tax basis is not available due to lack of a purchase price allocation at the time the land was acquired. Even when cost depletion is not available, a percentage depletion deduction is permitted based on the taxpayer’s gross income from the property. The deduction, however, is limited to the lesser of the taxable income from the property or 65% of the taxpayer’s taxable income. Pennsylvania only allows a deduction for cost depletion.
In most cases, the bonus payment at the execution of a gas lease is considered an advanced royalty. However, because the payment is not based on production, it is not eligible for percentage depletion. In some cases, the lease language may be ambiguous as to whether certain compensation is a rental or royalty payment.
The distinction between rental and royalty may seem trivial, but does have tax consequences. Both are ordinary income; however, while rents are passive income, royalties are not considered passive under Internal Revenue Code Section 469 and are treated as portfolio income and can be used to offset losses from other business activities. These are very technical determinations that will require the advice of a knowledgeable oil and gas tax professional.
As indicated above, natural gas lease taxation can be a confusing area for both practitioners and land owners. Distinguishing between easements, rental payments and royalties can be a daunting task given the many grey areas and professional judgment required for proper distinction and income tax reporting. Accordingly, landowners presented with an opportunity to enter into an oil and/or gas lease should consult with a knowledgeable professional regarding the lease terms, terminology and tax impact thereof both during the initial lease signing and in subsequent years.
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