Oil and gas investments come with specific tax ramifications

 Peter G. Robbins, CPA, The Daily Record Newswire

Q: I have a friend who swears by his investments in oil and gas. He is trying to get me to invest also, but to be honest I really don’t understand this business. I’ve always heard I should not invest in something I don’t understand. What are your thoughts?

A: I think it was Warren Buffet who made the comment about not investing in what you don’t understand — or maybe someone just told me it was him!

Since I am not an investment adviser I won’t offer counsel on the wisdom of oil and gas investments. But having spent a number of years as a certified public accountant in Texas, and having clients with investments in natural resources in Texas, Oklahoma, Louisiana, North Dakota, Colorado and elsewhere, I can help educate you just a bit on the tax ramifications of your potential investment. Unfortunately my discussion of these investments, especially royalty and working interests, has to be quite limited in this article. But hopefully these general guidelines will help.

My clients have generally invested in the oil and gas industry in one of four ways. The first is simply by purchasing the stock of publicly traded companies, such as ExxonMobil or Chevron, or smaller private oil companies. As with any stock, you profit from these investments through receiving dividends or by the stock itself appreciating in value. Generally, both the dividends and gains from sale of the stock are taxed at the preferential capital gains rates, which makes this type of investment fairly tax efficient.

Many of my clients also have investments in publicly traded partnerships, sometimes referred to as master limited partnerships. PTPs are similar to the stocks I mentioned above, but because the company is formed as a partnership rather than as a corporation, the taxation is a bit different. As a partner in a PTP you will receive a Form K-1 each year, which reports your share of the various types and amounts of income attributable to your ownership in the PTP. Some of this income will be subject to ordinary tax rates and some eligible for capital gain rates. A number of very involved tax rules come into play with PTPs, and consequently, owning a PTP adds complexity to your tax return.

A more direct way to invest in oil and gas is by owning a royalty interest. Owning a royalty interest entitles you to a portion of the revenue produced, but you will not incur any of the cost of production. Each year you will receive a Form 1099-MISC and report the gross royalties, less any related expenses, on Schedule E in your tax return. You are also entitled to take a deduction for depletion, which represents the consumption of the resource. You can elect to deduct a portion of your investment cost, or you can deduct a percentage of the gross royalties reported to you, subject to a number of limitations.

The most direct investment is to own a “working interest.” This is just like owning any business, and the revenue from production and all the various expenses are reported on Schedule C as self-employment income. You are responsible for paying a portion of the exploration and operating expenses, and consequently, the production manager may periodically send a bill asking you to write a check to cover those expenses. While the net income from the investment is subject to your regular tax rate and also subject to self-employment taxes, there are some big tax advantages in writing off many of the exploration and drilling costs.

Some states are not blessed with huge oil and gas deposits. That doesn’t mean you can’t find these investment opportunities; it just means you may need to look beyond your own backyard. New discoveries and technologies have made some oil and gas investments very lucrative.

As with any investment, you will hear many opinions as to the worthiness of mineral interests and the best method to make the investment. Do your homework, ask a lot of questions, use your best judgment, and I hope you are as successful as Jed Clampett.

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Peter Robbins is a partner in the Boise office of CliftonLarsonAllen LLP, specializing in tax matters for small businesses, individuals, and trusts and estates.

To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. 

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