Oil or gas lease or royalty payments? The taxman cometh


With only a few weeks left in the year, some landowners who have signed gas and oil leases need to give some thought to tax management on the payments received.

While I can describe the taxes landowners must pay and provide suggestions for minimizing your tax liability, you need to check with a qualified attorney and/or accountant to find out how you’re affected.

Lease payments

Oil and gas income is subject to both federal and state tax. Any lease bonus payments and royalty payments are considered “ordinary income” for federal tax reporting purposes and are subject to ordinary income taxes.

These payments are typically paid on a per acre basis and made either annually on the lease’s primary term or paid in a lump sum that combine all annual payments into one payment.

These payments are not subject to self-employment tax.

Some leases will refer to a “delay rental payment” the developer will pay to extend the primary term of the lease. These payments are also considered ordinary income and must be reported as such.

Royalty payments

For landowners who have a producing well, periodic payments will be received according to the terms of the lease. These payments are also considered ordinary income and must be reported.

Like the lease payments, the royalty payments are not subject to self-employment taxes.

Ohio and local income tax

Both lease bonus and royalty payments are subject to Ohio income tax. In addition, some landowners may be subject to local income tax. This may occur if your residence is within an incorporated area that has a local income tax. The tax applies even if the leased land is outside the incorporated area.

Tax management

Making management decisions to minimize taxes is wise; evading tax is not.

There are some strategies available to farmers that may help reduce your tax liability. Keep in mind that each individual situation will affect the usefulness of each strategy.

  • Depletion Deductions. The IRS recognizes that oil, gas, and other minerals are used up or depleted as they are extracted and allows for a reasonable deduction based on the depletion of the resources. To qualify, a landowner must have an ownership interest in the mineral property and a legal right to the income from oil and gas extraction.

    The depletion is allowed only when oil or gas is sold and income is reportable. Therefore this deduction is not allowed for a lease payment, but for a royalty payment only.

    The IRS requires landowners to compare two methods when calculating the deduction. These methods are known as cost depletion or percentage depletion. The IRS also requires that the method that provides the largest deduction be used.

  • Attorney Fees. In many cases, an attorney is hired to assist in negotiations, title searches, or lease review. If you are part of a landowner association, you may deduct only your actual share of the association’s attorney fees.

  • Retirement Planning. Contributions to an IRA or other qualified retirement plan may help lessen your tax burden, but there are limits. These limits are established annually by the IRS.

    A qualified financial planner can assist in determining the benefits and limitations.

  • Prepaid Taxes & Mortgage Interest. Prepayment of Ohio income tax, real estate taxes, and mortgage interest for the coming year allows these expenses to be minimized on Schedule A for federal tax purposes. However, doing so may affect the Alternative Minimum Tax (AMT).

    A qualified professional should be consulted before prepaying these expenses.

  • Charitable Giving. Many charities, including those with 501(C)(3) status, churches, and others qualified organizations, welcome contributions. Making these contributions can help lower your tax liability. However, it is suggested you meet with the organization prior to making a contribution, especially if it is very large, to determine how they want to receive the donation.

  • Minimizing Profit from Schedule F & Schedule C. It may be advantageous for some farmers to limit business profit in the year large payments are received. Farm expenses such as seed, fertilizer, fuel, and chemicals can reduce the overall tax burden.

    Keep in mind there are specific guidelines for making qualified pre-paid expenses.

  • Operating Expenses for Oil and Gas. If you have an operating or working interest in the production of oil and gas, there are certain expenses and costs that can be deducted.

    Other tax considerations

    Be aware that revenue from oil and gas production may raise other implications. Examples include Commercial Activity Tax (CAT), Current Agricultural Use Valuation (CAUV), and property, estate, and gift taxes.

    Capital gains taxes may be an issue if real property is sold.

    Many have asked if oil and gas revenue can be used to pay off debt as a way to minimize the tax liability. Unfortunately, doing so will not reduce the tax liability.

    How much will I owe?

    The table below provide a summary of federal and Ohio tax rates for 2012. A landowner who reserves 40 percent of the oil and gas revenue for income tax reporting should be able to meet the combined federal and state tax liabilities.

    For more information on this and other related gas and oil topics, visit http://shalegas.osu.edu.

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    1. Chris,

      Are you aware of any articles which discuss the subject of minimizing taxes on lease payments made to a trust? Our land in Pa. is part of a trust. Thank you.


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