For those of us living in the Bakken, these are words we hear regularly. However, they are not specific to the region and many taxpayers routinely receive these types of payments. Our North Dakota office decided to give a brief description of these payments and the taxability of each. We will be a little more specific to pertain to Oil and Gas payments for this discussion.
The first (and easiest) are royalty payments. A “royalty interest” commonly consists of an interest in the underlying oil and gas reserves retained when the owner of land grants to another, the right to oil and gas that exists and to develop the property. A royalty bears no portion of the cost of exploration, development and production.
In return for assuming the risks involved in developing the property, the lessee is granted the right to the production, while a fraction of the production is set aside for royalties to the owner. The royalties are reported on IRS Schedule E and are allowed a depletion deduction of 15% of the gross royalties.
A common form of lease in the oil and gas industry is a “lease bonus”. A lease bonus is the term applied to the consideration received upon execution of an oil and gas lease. The bonus pays for the rights to enter upon the leased premises and explore for oil and gas for a set period of time. The Supreme Court has held that a bonus is not a sale of property, but payment in advance for oil and gas extracted and therefore would be reported on IRS Schedule E as rental income.
The final topic of damages is a little more difficult as a taxpayer must determine the nature of the damages. If the damage payment is for lost production (crops, hay etc.) those damages are to be reported as regular business income. This would be IRS Schedule F for farmers. If proof can be shown that a payment is made to the landowner specifically for damage done to the land during exploration, this payment is treated separately. The taxpayer can treat this damage payment as a nontaxable return of capital to the extent of his applicable basis in the land. To the extent that such payments exceed basis, the excess would be taxed as a gain. The taxpayer and tax preparer must be aware that often times long-time farmers’/ranchers’ basis in their land is very low. This often times creates a situation where most if not all of the damages are taxable income.
The above discussion is a general in nature and can quickly become complex. The professionals at Ketel Thorstenson are always available to help with your individual tax situation.