Oil and Gas Investor Subject to Self-Employment Tax for Fractional Working Interest Ownership

A recent court case, Methin v. Commissioner, T.C. Memo 2015-81, ruled that an investor’s small (at times 5% or less) share of a working interest in an oil and gas well constituted self-employment income under IRC §1402.

The taxpayer’s position in the case was clear –– his ownership in these working interest programs should not be considered self-employment income based on the following:

  • The taxpayer had no knowledge of the oil and gas industry.
  • The taxpayer had an agreement with the operator of his interest whereby the operator managed the operations of the various wells, which meant the taxpayer had no control over the operations and was merely an “investing” partner.
  • The taxpayer argued he was not subject to self-employment tax imposed on general partners of a partnership by IRC §1402(a), since the entity had elected out of Subchapter K; therefore, he was not a partner.

The court agreed that the taxpayer had no knowledge of the oil and gas industry and that the taxpayer did not actively participate in the management of the oil and gas wells in which he was invested. 

However, the tax court relied on Cokes v. Commissioner, 91 T.C. 222 (1988), which concluded that a partnership still exists even when an election out of Subchapter K is made.  Since there is still a partnership (although no requirement to file a Form 1065), the taxpayer’s distributive share of income allocated would be subject to self-employment tax under §1402(a).

Had the entity been formed under state law as a limited partnership and filed a Form 1065, the results could have been different.  The taxpayer would not be subject to self-employment tax under IRC §1402 due to a special exception granted to limited partners under IRC §1402(a)(13). 

The tax laws governing oil and gas investments are complex.  If you are contemplating one of these investments, please talk to your Schneider Downs tax advisor before making the investment to determine a strategy that will provide the most tax-efficient outcome.

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