Have you leased minerals, that is, oil and gas, and retained a royalty interest?

Usually, a landowner receives a bonus or an advance upon the execution of an oil and gas lease. This payment for the right to explore for oil and gas can be for a year or several years. As the landowner, this represents ordinary income.

Now, with reference to the royalty interest for oil and gas reserves, the landowner grants to the lessee, the driller, the right to ascertain whether a commercial quantity of oil and gas exists, and, if the lessee finds oil and gas in producing quantities, the lessee pays a royalty. Once the lessor, the landowner, receives royalties, it is considered ordinary income. As the owner of the property, you are entitled to a depletion deduction, which is a tax deduction against the royalties.

As the lessor, the deduction to you could be either on cost or percentage basis. Independent and royalty owners are entitled to deduct the greater of cost or percentage depletion.

Passing on the income to a family member

What happens if you have a family and you desire to pass the some this new found stream of income to other beneficiaries? Do you form a partnership? A corporation? A limited partnership? A limited liability company (LLC)? A trust? The tax consequences can be substantial both for income and estate tax purposes.

Limited partnership and limited liability company (LLC)

Let’s take a quick look at a limited partnership and a limited liability company. Generally, the landowner wants to manage and maintain so he would be considered the manager. The other owners, such as limited partnership interests or limited liability membership interests, do not control the management of the entity.

The operating agreement spells out the management, that is, who is the manager. What happens upon the death, disability, or resignation of the manager? The operating agreement also defines the interests of the partners in a limited partnership or members in a limited liability company.

The limited partnership or LLC can be arranged to limit who can receive an interest in the entity. That, in turn, creates an interest that can be transferred. Do the person or persons have the ability to transfer the ownership? Do you want non-family persons to acquire an interest? All of these questions should be addressed in a buy-sell agreement.

There are other decisions that result in whether to form a limited partnership or LLC, which are beyond the scope of this article, and should be discussed with a competent tax advisor. One factor, though, is liability. Holding your mineral interest in a limited liability entity is prudent for income and estate tax purposes, but also to protect the mineral interests from the personal liabilities of the landowner or other partners or members.

What are some of the key provisions of an operating agreement?

• Capital Contributions – Must the partners or members contribute if the company fails to produce sufficient cash? What happens if they fail to pay?

• Tax Distributions – Often you will find a provision that distribution of cash is required to be at least equal to the amount payable for income taxes.

• Management Succession – As already discussed, who will be the manager? What happens if the owners do not like the management?

• Buy-Sell Agreements – What happens in a divorce situation? Voluntary or involuntary transfer of an interest? Insurance on the partner’s or member’s interest?

There are numerous tax complexities surrounding oil and gas partnerships and limited liability companies. Please consult with your legal counsel and your accountant to determine your personal best course of action.

Contact an experienced Gas and Oil Lease attorney and CPA today

If you would like more information about Pennsylvania Elder Law, Business Law or Tax Law, please contact an experienced Pennsylvania Attorney who is also a Certified Public Accountant (CPA) via email or phone us at (724) 216.6551 at our Greensburg, Pennsylvania office.

The Iezzi Law Office serves clients in southwestern Pennsylvania, including Greensburg, Pittsburgh, Delmont, Monroeville, Murrysville, Latrobe, Irwin, Uniontown, Connellsville, Indiana, Somerset, and other towns located in Westmoreland County, Allegheny County, Fayette County, Indiana County, and Somerset County.

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IRS CIRCULAR 230 DISCLOSURE:

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.