CHAPTER 2 TAX CONSIDERATIONS IN OIL AND GAS PROMOTIONAL AGREEMENTS

• Jurisdiction: United States

Oil and Gas Agreements
(May 1983)
CHAPTER 2
TAX CONSIDERATIONS IN OIL AND GAS PROMOTIONAL AGREEMENTS
Harold R. Roth
Coopers & Lybrand
Denver, Colorado

TABLE OF CONTENTS

I. INTRODUCTION

II. INVESTMENT VEHICLES

A. Introduction

B. Corporations

C. S Corporations

D. Partnerships

E. Co-ownership

F. Tax Partnerships

III. ANALYSIS OF TAX ISSUES

A. Intangible Drilling Costs

1. Definition

a. Inflated Drilling Costs

b. Distinguishing Geological and Geophysical Exploration Costs

2. Limitations

a. "Operator"

b. "Incurred"

c. Payout Concept

3. Timing of the Deduction

a. Method of Accounting

b. Prepayment of IDC

4. Making the IDC Election

B. The Property Unit

1. General Rules

a. Separate Interests

b. Separate Mineral Deposits

c. Separate Tract or Parcel

2. Special Rules

a. Carryover Basis Transfer

b. Acquisition of Contiguous Leases

c. Election to Treat Operating Mineral Interests Separately or In Combination

d. Aggregation of Nonoperating Mineral Interests

e. Unitization

C. Depletion

1. Economic Interest

2. Cost Depletion vs. Percentage Depletion

a. Natural Gas

b. Domestic Crude Oil and Natural Gas

3. Limitations on Percentage Depletion

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D. Problems Associated With Property Transfers

1. Sharing Arrangements

2. Geological Scope of Pool of Capital Doctrine—Revenue Ruling 77-176

3. Proven Property Exception

a. Percentage Depletion

b. Windfall Profits Tax

4. Sale vs. Sublease

IV. CO-OWNERSHIP

A. Form

B. Requirements for Electing Out of Partnership Treatment

C. Mechanics of Election

1. Filing Partnership Return

2. Deemed Election

3. Election Subsequent to Formation

4. Revocation of Election

D. Effect of Election

E. Carried Interests

V. TAX PARTNERSHIPS

A. Purpose

1. Avoiding the IDC Limitation

2. Avoiding Revenue Ruling 77-176 Gain

B. Tax Partnerships—Private Letter Ruling Recognition

C. Special Allocations

1. Historical Development of Section 704(b)

2. Substantial Economic Effect

3. Case Law

4. Service's Position

5. Proposed Regulations

a. Substantial Economic Effect

b. Partner's Interest in the Partnership

c. Special Rules

d. Oil and Gas Examples

6. Tax Provisions in Joint Venture Agreements

D. At-Risk Considerations

E. Partnership vs. Association Considerations

1. Continuity of Life

2. Centralization of Management

3. Limited Personal Liability

4. Free Transferability of Interest

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F. Miscellaneous

1. Adoption of a Taxable Year

2. Adoption of an Accounting Method

3. Basis Adjustment to Section 38 Property

4. Election of Different Recovery Percentages

5. Subsequent Election out of Subchapter K

6. Alternative Minimum Tax and Tax Preference Items

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Corrections to

"Tax Considerations in Oil and Gas Promotional Agreements"

Page	Reference	Change
2-13	3.a. 3rd line	"expenses" should be "expenses"
2-19	C. last line of page	"interest" should be "interests"
2-29	2nd to last line in last full paragraph	"landowner" should be "landman"
2-30	2. 2nd line in 2nd paragraph	"farm-out" should be "farmor"
2-43	b) Heading	should be underlined
2-44	Heading of 2.	date: "3/8/83" should be "3/9/83"
2-49	5. 1st paragraph 2nd to last line	insert "effect" between "economic" and "test"
2-54	Heading at b.	"Partners" should be "Partner's"
2-55	C. 1) 1st paragraph:
• 6th line	insert "the" between "with" and "partner's"
•12th line	"Reg. §" should be "Regulations Section"
2-56	3) (i)
• 3rd line	"contain" should be "contained"
2-57	Heading at 4)	613A(C) should be 613A(c)
3rd line from bottom	"partnership" should be "partnerships"
2-63	Repeat of previous page at top	See substitute page
2-66	D. 7th line 1st paragraph	"tha" should be "that"
2-70	Heading of last paragraph	"Transferabiluty" should be "Transferability"
2-73	5. 1st paragraph 4th line	"burdents" should be "burdens"

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TAX CONSIDERATIONS IN OIL AND GAS PROMOTIONAL AGREEMENTS

Harold R. Roth

Coopers & Lybrand

Denver, Colorado

I. INTRODUCTION

This paper will discuss the principal Federal income tax concepts which should be considered by taxpayers who enter into promotional arrangements on oil and gas properties. These arrangements often are tax motivated and, therefore, require careful structuring of the tax consequences.

Co-ownership, whether by joint ownership or through partnerships, is extremely common in the oil and gas industry, primarily because of the large capital requirements involved and the desire of the partner to spread the risk of any unproductive properties. The achievement of the desired arrangement normally necessitates the transfer of a property interest. Typically, one party will own or control the property and the second party will provide the funds with which to drill and/or explore the property in question. In arriving at their final arrangement, one of the parties will more often than not insist on being promoted, i.e., receiving a greater percentage of the deal than his contribution would normally command. For example, a standard industry arrangement is to require the party contributing the funds to provide 1/3 of the necessary capital in exchange for 1/4 of the working interest. In this way, the property-owning party is "promoted." It is these promoted arrangements that require the most careful tax structuring to insure that the parties achieve the desired results.

The oil and gas industry has been provided certain incentives through the tax laws. Obviously, the allocation of these tax benefits can greatly influence the economics of a transaction.

The primary tax benefits of a typical oil and gas exploration transaction include:

. the ability to currently deduct intangible drilling costs (IDC);

The author would like to thank his following colleagues for their assistance on this paper: Francis Y. Grubb, Steven J. Revenig, Todd R. Mitchell, Janet L. Sandberg and Paul D. Timmer (Mr. Timmer is now with Schmidt, Elrod & Wills in Denver).

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. potential availability of percentage depletion;

. investment tax credits on, and rapid depreciation of, well and related equipment.

Depending on the investment structure chosen, it is possible for these tax benefits to flow through to the various parties and to make disproportionate allocations among the parties. This paper will examine in detail these tax benefits and the related rules governing their allocation.

The taxpayer must also avoid or at least minimize the recognition of income upon the transfer of property from one party to another. Additionally, close attention must be given to the "at-risk" rules to insure that the anticipated deductions are in fact recognized by the intended party.

However, before these tax rules can be examined in detail, it is necessary to review the types of tax entities in which an oil and gas investment can be made.

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II. THE INVESTMENT VEHICLE

A. Introduction:

The joint operation of a mineral property may be conducted in a number of different ways. Generally, the association will operate as either a corporation, partnership, or in co-ownership. Each method has its advantages and disadvantages which the participants must take into consideration in determining how their association will operate.

B. Corporations:

A corporation is a separate taxable entity that determines its own taxable income. Any distributions to shareholders are again potentially subject to tax at the shareholder level, thus resulting in what is commonly referred to as double taxation.

A corporation may adopt any taxable year, which may or may not correspond to the shareholders' own taxable year.¹

Additionally, a corporation can adopt its own accounting methods, and any other election allowed under the tax laws, such as the election to expense IDC.² If an association of persons is deemed to be taxable as a corporation (see discussion at V.E., infra), not only is the entity subject to corporate income tax,³ but the individuals may also be taxed on distributions to the extent of the corporation's earnings and profits.⁴ If the corporation incurs a net operating loss for the taxable year, the owners are not entitled to a loss deduction. This form of organization may be attractive to investors who wish to avoid personal liability, because creditors generally can only seek recourse against the corporation, not the individual shareholders.

A corporation may be subject to the personal holding company tax.⁵ A corporation will generally be considered a personal holding company if more than 50 percent of its stock is owned, directly or indirectly, by not more than 5 individuals and at least 60% of its adjusted ordinary gross income is personal holding company income.⁶ Oil and gas royalties are generally considered personal holding company income; however, see Section 543(a)(3) (all section references are to the Internal Revenue Code of 1954, as amended) for exceptions. To prevent personal holding company problems, the closely held corporation must avoid acquiring too much royalty income relative to other

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non-holding company types of income. The shareholders should also avoid incorporating overriding royalty or royalty production unless they also incorporate a greater amount of working interest production.

Additionally, the contribution of property to the corporation under Section 351 is subject to the transfer of proven property rules under Section 613A(c)(9). If these rules apply, neither the corporation nor its shareholders will be allowed percentage depletion with respect to such property. Section 613A(c)(10) provides for an exception if its conditions are met. In general, this rule requires that the stock of the corporation be issued solely in exchange for oil and gas properties and that the barrel per day limitation on percentage depletion be allocated between...