The practice of extracting natural gas from shale through hydraulic fracturing, commonly referred to as “fracking,” is becoming more widespread throughout the country. It is essential for practitioners to understand the tax issues that could arise for clients who own property with shale gas deposits.
From 2001 to 2011, Americans signed more than a million leases to allow energy producers to drill for natural gas on their land. In some states, people have been receiving income from leases on their properties for a number of years, even though no drilling may have occurred. As more states permit fracking, many more landowners will be approached by energy companies to enter into leases.
In areas with economically viable and legal shale plays, energy companies typically send out “landsmen” (including women) to negotiate with landowners for leases to permit drilling wells and to pay royalties for any gas extracted. (A shale play refers to a geographic area that has been targeted for exploration because it contains an economically viable quantity of oil or natural gas.) Many landowners who entered into leases before anyone realized how valuable the shale gas deposits would become signed leases for as little as $3 an acre, but now leases can be much more lucrative. In 2012, the going rate for leases in Ohio was more than $5,000 an acre.
Many landowners are farmers or other individuals who may be unfamiliar with how their tax situation will change if they enter into a lease and receive income from the energy companies. In other cases, shale plays may be on land owned by tax-exempt organizations, such as hunting clubs, country clubs, or homeowners’ associations. This raises other unique tax issues. This article addresses the tax treatment of fracking for these two groups of taxpayers, but it does not address the loss limitation rules that apply to farmers.
An estimated 750 trillion cubic feet of technically recoverable natural gas is trapped in shale formations in the lower 48 U.S. states; 86% is located in the Northeast, Gulf Coast, and the Southwest. The largest shale play by geographic area, the Marcellus shale, which extends into parts of Maryland, New York, Ohio, Pennsylvania, Virginia, and West Virginia, holds 55% of the total technically recoverable gas. There are also active shale plays in Alabama, Arkansas, Colorado, Illinois, Indiana, Kentucky, Louisiana, Michigan, Mississippi, North Dakota, Tennessee, Texas, Wyoming, and elsewhere in the United States. Other areas have the potential for gas production. The Monterey shale in California, for example, has significant oil and natural gas deposits, but the state does not permit fracking.
MINERAL RIGHTS
One immediate issue to determine is whether the landowner also holds the land’s mineral rights. Land rights in the United States are sometimes split estates, meaning one person owns the surface rights and another owns the mineral rights. This can affect whether the surface owner receives compensation for drilling on the land. The answer is controlled by local law.
For example, in California, if the estate is split, the surface right owner is usually compensated for access to the land. However, in West Virginia, because of aggressive actions by companies to sever surface rights from mineral rights, many individuals do not own the mineral rights to their land, do not control fracking on their land, and are limited in their compensation from energy companies. New Mexico and Colorado, however, have enacted legislation requiring owners of surface rights to be compensated when drilling occurs on their land.
LEASE PAYMENTS VS. ROYALTIES
Payments the energy companies make to landowners for allowing them to drill on property are usually referred to as lease payments. Amounts paid based on the amount of gas extracted are royalties. The two types of income have different tax treatments.
Rent is a fixed amount, payable over a fixed period, that compensates the owner for the use of the property and does not vary based on the use of the property. Royalties, on the other hand, are based on the use of the property. Distinguishing between the two can be difficult if the contract is unclear—if the contract does not distinguish between payment of rent and royalties, a court may hold that all payments under the contract are royalties.
LAND LEASE PAYMENTS
Amounts received for upfront land leases that energy companies pay to permit drilling on the land are rental income for federal income tax purposes, which means the payments will be ordinary income. However, because the land is nondepreciable property, under Regs. Secs. 1.469-2T(f)(3) and 2(f)(10), the income is treated as portfolio income rather than passive income.
The lease payments are either made annually for the life of the lease or upfront at the beginning of the lease term. As cash-basis taxpayers, most individuals will have to pay tax on all upfront payments in the year received. Accrual-basis taxpayers will apply the all-events test, which may result in the income’s not all being immediately taxable. (For payments over $250,000, see Sec. 467, which requires accrual of rental payments in certain circumstances.)
Income from lease payments can be reduced by related expenses, such as attorneys’ fees, property taxes, surveying fees, and title costs.
Higher-income taxpayers are subject to Sec. 1411’s new 3.8% investment income tax on this income. The tax applies to the lesser of the taxpayer’s net investment income for the tax year or the excess (if any) of the individual’s modified adjusted gross income for the tax year over a threshold amount. The threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for other taxpayers.
ROYALTIES
Typically, agreements with energy companies provide for royalties of a certain percentage of the amount of revenue a well produces. (Pennsylvania sets a minimum of 12.5%; the average royalty nationwide is 18.75% (see “Pennsylvania Fracking Royalties Could Top $1 Billion as Private Landowners Rake in Cash,” Business Insider)). Royalties, like land lease payments, are ordinary income, and they are not treated as passive under Sec. 469; instead they are portfolio income and, as such, can offset losses from other business activities in which the individual participates. Similar to the land lease payments, royalty income will potentially subject higher-income taxpayers to the 3.8% net investment income tax.
DEPLETION
The amount of taxable royalties, but not land lease payments, may be reduced by a depletion deduction, calculated either under the percentage depletion method or the cost depletion method.
Landowners are more likely to qualify for percentage depletion. The amount of the percentage depletion deduction is 15% of the taxpayer’s gross income from the property, limited to the lesser of the taxpayer’s taxable income from the property or 65% of the taxpayer’s taxable income.
Cost depletion involves dividing a taxpayer’s cost for the investment in the property by the estimated value of the total recoverable amount of the natural gas. To use the cost depletion method, taxpayers must have a cost basis in the property they are depleting. In most cases, when individual taxpayers originally bought the land on which the shale gas deposits were later discovered, they did not establish a separate cost basis for their mineral rights because that was not the purpose of the land acquisition. Those taxpayers therefore do not have a basis to use to depreciate the mineral rights and must use the percentage depletion method.
ESTIMATED TAX
Many of the people who own large tracts of land with shale gas deposits are farmers. Often, the discovery of natural gas on a tract of land can help struggling farmers pay their bills and keep land in the family. However, these farmers may be unaware of how receiving income from these natural gas deposits may change their responsibility to pay estimated tax.
The Code has special estimated tax rules for qualified farmers. An individual is a qualified farmer if two-thirds of the individual’s gross income from all sources is from farming. A qualified farmer does not have to pay estimated tax if the qualified farmer files his or her return and pays his or her taxes in full by March 1. Gross income from farming is income from cultivating the soil or raising agricultural commodities, including income from operating a stock, dairy, poultry, bee, fruit, or truck farm (a farm that grows vegetables for market) and from a plantation, ranch, nursery, range, orchard, or oyster bed.
Income from land leases and natural gas royalties does not constitute gross income from farming, and if it exceeds one-third of the farmer’s gross income, the farmer is required to pay estimated taxes to avoid an underpayment penalty (Sec. 6654). In addition, landowners who are not farmers and who receive large amounts from leases and/or royalties may not realize that they are now subject to estimated tax. This is especially true for individuals who are salaried—all their income tax has been paid in the past by withholding, and the last thing they are thinking about is having to make quarterly estimated tax payments.
OTHER TAX ISSUES
Self-employment tax. The good news for landowners is that Self-Employment Contributions Act (SECA) tax generally does not apply to lease or royalty payments because the payments are not received in the course of a trade or business. The key is that the landowner must not have an “operating or working interest” in the lease and therefore is not engaged in a trade or business (Rev. Rul. 83-102).
State and local taxes. Generally, payments landowners receive also will be subject to state income taxes and, in some cases, local taxes, but this is beyond the scope of this article.
Estate planning. Because mineral rights are usually severable from the fee title on land, individuals who own land with shale gas deposits should consult tax and estate planning practitioners for the best way to leave these income streams to children, grandchildren, and later generations, including the best ways to minimize federal and state taxes. One method is to take advantage of the annual exclusion from the gift tax to make gifts to these family members or to trusts for their benefit.
SHOULD TAXPAYERS FORM AN ENTITY?
Before signing a lease, taxpayers may want to consider forming an entity to receive lease payments and royalties. To avoid C corporation double-taxation issues, taxpayers will generally want to form a passthrough entity, either a limited liability company (LLC) or an S corporation. S corporations can be good vehicles to hold these interests, but with their limitations on the number and types of shareholders and the requirement that distributions be pro rata to shareholders, they can present a “trap for the unwary.” In addition, taxpayers need to be aware that S corporations that have converted from C status and have accumulated earnings and profits from their C corporation years are subject to the Sec. 1375 tax on excess net passive investment income when their passive investment income exceeds 25% of gross receipts in a year. If the S corporation’s passive investment income exceeds 25% of gross receipts for three consecutive years, its S corporation election will terminate.
LLCs (which are disregarded as separate entities for federal tax purposes if they have only one member, and usually elect to be partnerships if they have two or more members) provide protection from liability while permitting business flexibility. For this reason, many individual taxpayers with shale gas interests choose this form to operate that part of their business activities.
LAND OWNED BY TAX-EXEMPT ORGANIZATIONS
Many landowners with large pieces of land that contain shale gas plays are tax-exempt organizations, such as country clubs, hunting clubs, or homeowners’ associations. A number of these organizations qualify under Sec. 501(c)(7) as clubs organized for pleasure, recreation, or other nonprofit purposes. For these organizations to qualify for tax-exempt status, substantially all of their activities must be for those purposes, and none of their earnings can inure to the benefit of private shareholders.
A few tax rules may cause problems for these types of organizations if they earn rental income or royalties from gas leases. First, Sec. 501(c)(7) organizations are subject to the rules on unrelated business taxable income. If a social club earns royalties and land lease rental payments, it is subject to tax on those amounts because the income is not from activities related to the organization’s exempt purpose. Under Sec. 512(a)(3), all of a Sec. 501(c)(7) organization’s income is taxable unless it is exempt-function income (generally dues and other money received from members for goods, facilities, or services provided in the furtherance of the organization’s exempt purpose). The taxable amount can be reduced by allocable expenses, such as survey or title expenses incurred in executing the lease.
A much bigger problem arises from the income itself. Social clubs must meet a gross receipts test, which prohibits them from earning more than 35% of their income from sources other than membership dues, fees, and assessments and revenue from members for the use of club facilities or in connection with club activities. Violating the 35% test can terminate an organization’s exemption. However, if the club violates this test, the IRS will take all facts and circumstances into account in determining whether the organization qualifies for exempt status.
In addition, if it is found that the income an organization earns inures to the benefit of any member, the organization will lose its tax-exempt status. If a Sec. 501(c)(7) organization uses its natural gas revenues to improve its facilities for its members without raising dues, this could be considered inurement.
A central case in the inurement area involved a duck-hunting club in Louisiana that lost its tax exemption after leasing part of its property for the exploration and production of oil and gas. The lease revenue was used to pay for the majority of the amounts required and expended by the club for operations, repairs, maintenance, and improvements or was invested in government bonds (Coastal Club, Inc., 43 T.C. 783 (1965), aff’d, 368 F.2d 231 (5th Cir. 1966)).
CONCLUSION
No matter what else happens in the development of energy in the United States, fracking is probably here to stay. And because the shale deposits are in so many places around the country, it may be possible to see fracking wells as frequently as oil wells appeared in Texas beginning in the early 20th century.
Farmers, homeowners, and almost anyone who lives in the vast areas in which shale gas can be found may want to get in on this new energy boom. In some cases, landowners may not hold the mineral rights, but they will still be compensated for drilling on their land. Taxpayers who own surface and mineral rights may want to split them so they can pass a steady income stream to their descendants. Because so many different types of taxpayers may be affected, CPAs and other tax advisers should be prepared to offer federal and state income tax advice and estate planning.
EXECUTIVE SUMMARY
Shale gas deposits have been discovered in many areas throughout the United States. Many taxpayers may find themselves owning land with these deposits.
Income from shale deposits may be rental income from leases or royalty income from the payments made for natural gas that is extracted.
The lease payments and royalty income are not passive—they may be used to offset losses from active sources, such as losses from farming.
Taxpayers may want to create a separate tax entity to receive the income from the property.
Farmers with shale gas deposits on their land who have not paid estimated tax may find that the income from the shale gas deposits is high enough that they will now be required to make estimated tax payments.
Tax-exempt entities that have shale gas deposits on their land face special tax issues, including unrelated business income taxes and the prohibition against inurement.
Sally P. Schreiber is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact her at sschreiber@aicpa.org or 919-402-4828.
AICPA RESOURCES
The Tax Adviser and Tax Section
The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies, and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.
PFP Member Section and PFS credential
Membership in the Personal Financial Planning (PFP) Section provides
access to specialized resources in the area of personal financial
planning, including complimentary access to Forefield Advisor. Visit
the PFP Center at aicpa.org/PFP.
Members with a specialization in personal financial planning may be
interested in applying for the Personal Financial Specialist (PFS)
credential. Information about the PFS credential is available at aicpa.org/PFS.
