More on Cost Depletion – Bonus Payments

Overview

Last week’s post on cost depletion generated an interesting question from a reader concerning whether a bonus payment that a landowner receives upon signing an oil and gas lease agreement entitles the landowner to a cost depletion deduction on the payment.   That’s an important question.  The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies, including bonus payments.

The taxation of bonus payments associated with oil and gas leases – that’s the topic of today’s post.

Bonus payment

Character of the gain.  The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor (landowner) when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411.  A bonus payment is generally categorized as ordinary income and not capital gain because it is not tied to production.  See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014). 

A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.  A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable.  Rev. Rul. 68-606, 1968-2 CB 42.  However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received.  See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5. 

Cost depletion?  Can a lessor claim cost depletion on a bonus payment?  This question came up in a Tax Court case in 2013.  In Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 558 Fed. Appx. 199 (3d Cir. 2014), the taxpayer owned a tract of land in Pennsylvania and entered into an oil and gas agreement with an oil and gas company.  The lease called for the taxpayer to receive a lease bonus payment upfront for entering into the lease agreement.  The taxpayer was also entitled to a royalty payment of 16 percent of the net profits of oil and gas extracted from the leased premises.  The bonus payment was not tied to extraction or production in any fashion.  It was purely an upfront payment made to induce the taxpayer to execute the lease agreement.  The taxpayer reported the bonus payment as long-term capital gain rather than ordinary income on the assertion that the transaction amounted to a sale of oil and gas.   On audit, the IRS disagreed, recharacterized the bonus payment as ordinary income and slapped a 20 percent accuracy-related penalty on top. 

The Tax Court agreed with the IRS, citing the classic U.S. Supreme Court case of Burnet v. Hamel, 287 U.S. 103 (1932).   On the sale/lease issue, the Tax Court taxpayer retained an economic interest in the oil and gas deposits that were the subject matter of the lease.  That was true, the Tax Court reasoned because under the lease the taxpayer was entitled to royalty payments computed as a percentage of net profits of oil and gas that were extracted from the property.  That meant that the taxpayer possessed an economic interest in the in-place minerals.  See, e.g., Kittle v. Comr., 21 T.C. 79 (1953).  Had the transaction been a sale, the Tax Court reasoned, there would have been an exchange of a set quantity of oil and gas for a particular price.   

The taxpayer also claimed that the bonus income was subject to percentage depletion.  Percentage depletion is a cost recovery method that provides a tax deduction for most natural resources.  Percentage depletion assigns a set percentage of depletion to the gross income derived from extracting fossil fuels, minerals, or other nonrenewable resources.   For oil and gas, the allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income. If net income is less than 15% of gross income, the deduction is limited to 100% of net income.  I.R.C. §613(b)(2).  The Tax Court disagreed with the taxpayer’s claim that percentage depletion applied.  I.R.C. §613A(d) bars percentage depletion from applying to lease bonus payments.  The payment must be tied to production for percentage depletion to apply.  See Treas. Reg. §1.613A-3(j). 

But the Tax Court did indicate that the taxpayer’s bonus payment could be eligible for cost depletion.  The Tax Court noted that cost depletion, in accordance with Treas. Reg. §1.612-3(a)(1), is tied to the taxpayer’s basis for depletion.  The amount of the deduction is dependent upon depletion basis, future expected royalties and the amount of the upfront bonus payment.  The taxpayer needed to establish all of these amounts to claim a deduction for cost depletion.  The taxpayer failed to do so.  The Tax Court also upheld the accuracy-related penalty.

Establishing Basis

The Dudek case makes it clear that the taxpayer must establish a basis in the minerals subject to an oil and gas lease agreement to be able to claim cost depletion.  That can be tricky when land is acquired that has an oil and gas deposit and purchase transaction combines both the land and the deposit together.  It is the position of the IRS that minerals do not have a separate cost basis unless the seller’s cost stipulated such an amount; or was the result of an estate tax valuation that contained the separate valuations; or the seller’s cost basis can be properly allocated in accordance with existing evidence at the time of the acquisition.  I.R.M. 4.41.1.2.1.2 (Dec. 3, 2013).  While the IRS has indicated that a taxpayer might be able to establish a separate value for the minerals based on the evidence, it clearly is the taxpayer’s burden to prove the basis allocated to the oil and gas (or other mineral) deposit.  See, e.g., Rev. Rul. 69-539, 1969-2 CB 141; Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979).  That allocation might even be 100 percent of the taxpayer’s basis in the lease if a zero estimate of future royalties is reasonable (such as in a wildcat area).  See, e.g., Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979); but see Tech. Adv. Memo. 8532011 (May 7, 1985). 

Conclusion

Cost depletion can be confusing.  The Dudek opinion reiterates the long-standing ordinary income treatment of bonus payments associated with oil and gas leases.  It also points out that cost depletion can apply to the payments.  But work must be done to be able to claim cost depletion, and that burden is on the taxpayer.