A mineral rights lessee decides that the timing is right to flip his lease portfolio of undeveloped leases to a large oil and gas company, which in turn will develop the land for production. He isn’t in the business of E&P, but wants to retain an overriding royalty interest in the future oil or minerals produced. He negotiates a deal with the E&P company which will receive a 100% working interest (but receives only 80% of the revenue). In exchange, the mineral rights lessee will receive cash and carves out a 5% overriding royalty interest for himself (the remaining 15% of revenue will cover royalties owned by the original lessor).
In this scenario, the lessee/flipper carves out an ongoing interest in the property. Because the carved out interest has differing characteristics than the transferred interest, this transaction does not qualify for sale treatment. He does not get to deduct the cost of acquiring the mineral rights against the cash he receives from the E&P company. The cash payment is taxed as ordinary income and any royalties he receives in the future will be taxed as ordinary income. Essentially the transaction is treated as a sublease and taxed the same way as the original leasing transaction.
If, however, the lessee/flipper doesn’t retain any economic interest in the property, the transaction will essentially be treated as a property sale and he can offset proceeds by deducting his cost in acquiring the mineral rights. The net gain will be taxed as a capital gain.
Finally, assume the lessee/flipper decides to retain a fractional working interest rather than an override. He sells a 95% working interest to the E&P company and retains a 5% working interest. On the face of it, this transaction looks nearly identical to the transaction described above. However, since the retained interest has the same characteristics as the sold interest, the transaction qualifies as a sale. The proceeds the lessee/flipper receives will be offset by the proportionate share of the cost of acquiring the lease and the resulting gain will be taxed as a capital gain.
As you can see, there is a higher tax cost to retaining a piece of the action through a carve out — the royalties — because the lessee/flipper is gambling that the royalties from production will far outweigh his costs for retaining that 5%.
As for the E&P company, the cost of acquiring the leases are capitalized and will be recovered through depletion once the property begins production.
Conclusion: Retaining an overriding royalty interest after selling a working interest is a gamble that production will more than compensate for foregoing sale treatment.
To view other scenarios and learn more about this topic, visit: Oil & Gas Update: Tax Implications of Buying and Selling Mineral Rights
The oil and gas industry has experienced booms and busts of varying lengths since the dawn of mineral exploration. The current climate for O&G suggests continued consolidation, however forecasts by industry experts anticipate the boom may be back by 2018. For any owners or buyers of mineral interests, the market may be ripe for making deals now — with a careful eye toward the tax implications of buying and selling mineral rights. No two deals are alike, and it’s important to learn the potential tax impact and the types of taxes you may be paying.
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients. Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.