Tax on Oil Lease Revenue

[JPatrick]

We are pretty close to inking a deal to lease our mineral rights (farm land) to an oil company for a five year term. Involves the typical upfront lease payment and future profit sharing.
I've already taken care of step one--ice down champagne---but I'm wondering about the tax implications of this lump sum payment.
It will amount to low 6 figures paid in one payment.
If anyone has been through this drill with the IRS, I'd love to hear about the experience, specifically, what type of income this is considered and whether there is any magic to soften the blow. I think I have a plan to deal with future profits (if any) but I'm concerned about the lease payment.

Any thoughts/guidance appreciated.

 

[REWahoo]

Heh. The concept of moving from TX to MO and 'striking oil' is a hoot! Congrats on winning the mini-lottery.

 

[JPatrick]

Heh. The concept of moving from TX to MO and 'striking oil' is a hoot! Congrats on winning the mini-lottery.

Actually the land is in ND.
However, if you need more snakes, chiggers, and armadillos MO can help you.

 

[dex]

You definitely need to go to a tax accountant specializing in that type of transaction. You probably should have gone to one prior to signing the deal so as to use the most beneficial wording and payment structure for you.

You might be able to amortize the up front payment and depreciate the properly against the income.

 

[JPatrick]

You definitely need to go to a tax accountant specializing in that type of transaction. You probably should have gone to one prior to signing the deal so as to use the most beneficial wording and payment structure for you.

You might be able to amortize the up front payment and depreciate the properly against the income.

Had a lawyer look at the lease deal and it appears to be pretty much what passes for standard practice. The prices offered are slightly above market. However, he wasn't a tax guy.
This parcel is not owned by us...only the mineral rights.
Apparently splitting this payment comes under the heading of slightly risky business. Sort of a bird in hand/two in bush.

 

[haha]

Apparently splitting this payment comes under the heading of slightly risky business. Sort of a bird in hand/two in bush.

+1 on that. Unless the counterparty is Exxon or some such, take the money and run.

Ha

 

[MasterBlaster]

Is the lump sum payment some sort of incentive or does it cover some (or all) of the lease payments. If the latter is the case then almost certainly the lump sum taxation could be distributed over the term of the lease.

But as other have said you need an oil and gas accountant for the finer details.

 

[JPatrick]

. If the latter is the case then almost certainly the lump sum taxation could be distributed over the term of the lease.

.

The payment covers five years.
The distribution thing is something I'll look into.
I don't mind front loading it so much, as I expect my income to rise over the next five years, and all my capital losses that I've worked to hard to harvest will be gone soon.
Mainly hoping for some way to score a more favorable tax rate.
I suspect there is no possibility of avoiding a trip to the green eye shade dudes.

 

[JPatrick]

+1 on that. Unless the counterparty is Exxon or some such, take the money and run.

Ha

My thought exactly ...

 

[Texas Proud]

Is the lump sum payment some sort of incentive or does it cover some (or all) of the lease payments. If the latter is the case then almost certainly the lump sum taxation could be distributed over the term of the lease.

But as other have said you need an oil and gas accountant for the finer details.

My guess... (I have not done this kind of tax work in decades).... it will all be taxable... you are a cash basis taxpayer... you can not spread it over the 5 years...

You also can not depreciate land or mineral rights... you can deplete them when and if production starts... but that means you will be getting more money anyhow....

 

[HFWR]

Hey, we (the government of the people...) are broke, so whip out that check book!

 

[EO 11110]

It sounds like an even trade to me. Where's the gain to be taxed? You are trading something of value for something of equal value.

This is just my logic. I'm sure the IRS has their own logic

 

[Texas Proud]

It sounds like an even trade to me. Where's the gain to be taxed? You are trading something of value for something of equal value.

This is just my logic. I'm sure the IRS has their own logic

OR.... you have mineral rights... someone pays you to 'rent' those rights.... and after the rental is up (assuming they did nothing to find any).... wait for it.... wait for it.... you still have your mineral rights... just like you did before receiving that check.... so you did not trade anything when said and done...

The only difference is you got MONEY for that time period when you rented them... hmmmm, rental income is taxable last I checked...

 

[earlyspot]

Any good tax advice on mineral rights lease?

I saw your thread while searching for an answer to the same question. Do you have any advice or any information you can share? I am wondering what IRS form the one time mineral lease payment should be reported on and if this can be treated as capital income since the mineral rights are an investment. Also, tax treatment and reporting of profit sharing (hoping I will need to know)?

 

[JPatrick]

I saw your thread while searching for an answer to the same question. Do you have any advice or any information you can share? I am wondering what IRS form the one time mineral lease payment should be reported on and if this can be treated as capital income since the mineral rights are an investment. Also, tax treatment and reporting of profit sharing (hoping I will need to know)?

I don't know if I can be of much help tax wise, except to note that (as some above have advised,) the whole enchilada is indeed taxable and not as capital income. My first step was to determine if any form of prepayment was necessary. YMMV, but in my case, the only prepayment necessary was to my home state. If you are talking large dollars, I'd get an IRS opinion on that one even though the regs are pretty straight forward.
From what I have gathered, the actual filing ought to be easy aside from the pain involved in writing the check.
You don't say if you have already sealed your deal, but if not, let me know if you need any websites regarding leases. Getting the right lease is critical.

 

[ronocnikral]

off topic question: are you guys sure you own the mineral rights? typically, land owners don't own the mineral rights. you can't stop the oil company (or companies) who has the rights from drilling on your land, but they must compensate you for it. those who own the mineral rights have typically had the land in the family for generations. otherwise, the mineral right have already been purchased or are too expensive.

just curious...it would certainly help your negotiating position.

 

[JPatrick]

off topic question: are you guys sure you own the mineral rights? typically, land owners don't own the mineral rights. you can't stop the oil company (or companies) who has the rights from drilling on your land, but they must compensate you for it. those who own the mineral rights have typically had the land in the family for generations. otherwise, the mineral right have already been purchased or are too expensive.

just curious...it would certainly help your negotiating position.

In an area where the action is hot, you normally will not get that knock on the door/offer unless the landman has determined (at the courthouse) who the owner is. Even then, they may request that "you" warrant the ownership as part of the lease, which is a clause to be avoided if possible.
You are certainly right about it being a generational thing, but even so, weird things happen on the way to 2011. During the depression the guvment acquired rights to some farm land (sometimes a big surprise to the current generation) and over the years many little side deals have been done that cloud the issue. In those cases a specialist is needed ($$$$$$$$$$$$$) to sort things out.

 

[earlyspot]

thank you

JPatrick - thank you for your reply. The deal is sealed and I think we did alright and did have a lawyer. I will be making an estimated payment for the taxes owed at ordinary rate when payment is received(will have the cash but still a painful check to write). It looks like schedule E is the form to report the income.

ronocnikral - yes, the land has been in the family for generations and we own the mineral rights. The top land was sold to another family years ago but our family retained the mineral rights and with the passing down of the mineral rights over generations there are several cousins/siblings sharing the rights.

 

[JPatrick]

JPatrick - thank you for your reply. The deal is sealed and I think we did alright and did have a lawyer. I will be making an estimated payment for the taxes owed at ordinary rate when payment is received(will have the cash but still a painful check to write). It looks like schedule E is the form to report the income.

ronocnikral - yes, the land has been in the family for generations and we own the mineral rights. The top land was sold to another family years ago but our family retained the mineral rights and with the passing down of the mineral rights over generations there are several cousins/siblings sharing the rights.

Congrats on your deal.
Considering the real bucks are in the ground, I wish you happy check writing for many years in the future..