The percentage of income from a producing mineral property which one can claim as a deduction to account for depletion is currently 15% for oil and natural gas. For many royalty owners, the percentage depletion deduction is the only deduction they can take on their mineral royalty income. The purists involved in reforming the tax code want to lower the maximum corporate and individual rates to either 25% or 28% by ending numerous deductions. This would eliminate two vital deductions benefiting mineral and royalty owners.

In June of 2013 the Senate Committee on Finance Chairman Max Baucus and Ranking Member Orrin Hatch announced that they were determined to complete tax reform during the current session of Congress.  They planned to operate from an assumption that all exclusions, credits, and deductions were out unless there was clear evidence that they:  (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.

The deduction of Intangible Drilling Costs (IDCs) by oil and gas producers benefits mineral and royalty owners by promoting drilling activity.  IDCs permit a portion of the costs of drilling a well to be deducted fully in the year those costs are incurred, rather than being capitalized over several years. It has been estimated by industry experts that total drilling activity would decrease by thirty percent if current tax treatment of IDCs, percentage depletion, and the passive loss exception were ended.

In the face of this threat to royalty owners and producers, the National Association of Royalty Owners (NARO) and the Domestic Energy Producers Alliance (DEPA) joined forces to obtain a letter signed by four Senators and sent to the Senate Finance Committee.  Delivered on July 26, 2013, the letter strongly supported the retention of percentage depletion and IDCs, and disclosed the negative effects on the U.S. economy and energy security if they are eliminated.

In spite of the stated support of several Senators, the Senate Finance Committee issued their discussion draft on Nov. 21, 2013 proposing to eliminate percentage depletion and changing IDCs from a current year deduction to a five year amortization. The Senate Finance Committee discussion draft does great harm to domestic independent producers and royalty owners.

Fortunately for royalty owners and producers, Senator Max Baucus has been nominated as the next ambassador to China.  He is expected to be replaced as chairman of the Finance Committee by Senator Ron Wyden of Oregon.  Most observers believe that the tax reform issue will be put on the back burner until the new Congress convenes in January of 2015.

Royalty and mineral owners should not become complacent, but use the time wisely by contacting their Senators and Representatives to remind them that there are 8.5 million American private owners of oil and gas mineral and royalty interests.  Maintaining the percentage depletion deduction is a vital concern for all of them.

Mineral owners who also own the surface above their minerals have distinct advantages in negotiating an oil and gas lease to protect and advance their surface interests.

The owner of a fee simple, or unqualified, interest in land holds title to the surface of the land, the space above it, and the sub-surface minerals below it to the center of the earth. Most landowners who want to benefit from the production of their minerals enter into an oil and gas lease with a lessee who specializes in operating drilling programs.

By law the mineral estate is dominant to the surface estate. A mineral lessee (operator), unless restricted by the terms of the lease, may use any part of the surface reasonably necessary to conduct mineral operations – even drilling in irrigated fields. Since the surface rights of the parties to a mineral lease are expressly provided for by the terms of the lease, it is vital to include clauses which protect the land, water and existing use of the land.

Designating the locations of roads, drilling and production areas, and access points to the property are huge advantages for surface owners. The prevalence of horizontal drilling allows for greater flexibility in the location of drilling sites. This creates an opportunity for surface owners to prohibit activity in areas close to homes, pens, fields and other improvements.  Scenic and sensitive areas, such as mountains, streams, aquifers and prehistoric sites may also be designated as prohibited areas.

The lessee will need access to the land and the ability to build roads, pipelines, electric lines, compressor sites and central batteries. Experienced landowners require plat approval from their lessees before the lessee selects the locations for these facilities. For many surface and mineral owners, having your lessee build an expensive road that can be used in farm operations after the drilling is over is a big benefit.

Access points into the lease should be limited in order to prevent the land from becoming a staging point for other leases in the area. The locations for ingress and egress should be identified in the lease.  Access activity can be prohibited during certain hours, such as limiting trucking, gauging and pumping to daytime hours, except in emergency situations.

Water usage has become an important area for landowners to protect their interests.  The lease should specify which water sources are permitted for use and the quantity.  The quality of  water must be protected by strategic location of pits and storage, environmental protection, and reclamation of areas exposed to hydrocarbons and chemicals.

Lease surface maintenance includes road quality, which should be specific regarding width and material used, and the depth of pipelines. Anticipate damage from accidents which may occur during drilling and production by specifying penalties for spills, trash, and excessive use.

Another way to protect the land is to specify surface damage rates in the lease. Institutions that control large mineral lands establish a rate and damage schedule which is filed as public record. This is an excellent reference source for defining the prevailing rates at the time the lease is negotiated. And for adjusting the rates over time to not less than the prevailing rate.

Landowners who control both the surface and mineral interests have a tremendous benefit. They can take advantage of the fact that all terms in an oil and gas lease are negotiable to enjoy significant royalty income while preserving their land for future generations.

The world’s petroleum supplies could increase six-fold in the coming years to 10.2 trillion BBLS, according to a report by market research firm Lux Research.

Hydraulic fracturing, or fracking, is the most common new technique, in which chemical-laced water is injected to break up subterranean rock formations to extract oil and natural gas.  There are a host of exotic so-called Enhanced Oil recovery (EOR) technologies detailed in the report.  The technologies – from solar-powered steam injection to microorganisms – can be used to extend the life of old oil fields and gain access to unconventional petroleum reserves like oil sands.

If EOR technologies had not come online, the projected oil prices of $300 BBL during the peak oil hysteria, might have occurred.  Instead, unconventional reserves – which vastly exceed conventional ones – have become accessible.  However, the development of such technologies is predicated on oil prices of at least $100 BBL to offset the costs and induce a conservative industry to invest in and deploy new methods.

Thermal intervention injects steam into wells to extract heavy oils or oil sands.  It takes a lot of energy to generate the steam, so some companies are using solar energy instead of fossil fuels.  Solar fields built by BrightSource Energy and GlassPoint Solar have been deployed by Chevron at old oil fields in California to help recover heavy petroleum.

Chemical EOR injects polymers and alkaline compounds into oil fields to help loosen oil from rock formations and push it into production wells.  The leader in this method is the China National Petroleum Corporation, which is betting it will be 20% more efficient than flooding wells with water to bring oil to the surface.  In the U.S. there may be opposition to introducing large volumes of chemicals underground near water supplies. Also, Chemical EOR does not work well in oil reservoirs where temperatures are high and there’s a lot of salt and sulfur.

Microbial EOR uses environmentally benign microorganisms to break down heavier oils and produce methane, which can be pumped into wells to push out lighter oil.  Originally introduced in the 1950’s, it has only recently been put to limited use.  In Malaysia, an experiment with microbial EOR increased oil production by 47% over five months.

What tax deductions are available to oil and gas royalty owners?  The Federal Income Tax Code provides deductions that encourage exploration, development, and extraction of fuels from domestic oil and gas wells.  These deductions are available because our nation values the contributions made by oil and gas royalty owners to our national economy and energy security.

Most royalty owners are aware that oil and gas mineral royalties are treated as ordinary income and taxed at their marginal (highest) tax rate.  Let’s look at the three major deductions that benefit oil and gas royalty owners.

Percentage Depletion Allowance

Depletion is the using up of a natural resource by drilling, mining, quarrying or felling.  In the case of mineral owners, it is the reduction of reserves as the oil or gas is produced and sold.  The IRS code allows the mineral owner to use the depletion allowance of 15% as a deduction from their taxable income.

In addition to inherited mineral rights, the depletion allowance may also be claimed if you have purchased any interest in minerals and you have a legal right to income from the extraction of the minerals.

15% is subtracted from 100% of gross income from crude oil or natural gas, leaving 85% net taxable royalty income.

Example:

Annual gross royalty income:   $1,200

Percentage depletion:             X  .15

Deduction amount:                    180

Net taxable royalty income:     $1,020

Bonus and Royalty Deductions

Oil and gas lease bonuses are considered rental income, taxed at the same rate as ordinary income, and reported on a separate Schedule E.  An advantage of filing this Schedule is that you can deduct IRS approved costs you incurred while negotiating the lease, such as legal and professional fees.

Oil and gas royalty income deductions are also available.  All royalty owners pay a share of severance taxes, which are state taxes on production.  Under the terms of many oil and gas leases, royalty owners pay a percentage of transportation, compression, processing, and marketing costs to get their oil and gas produced and sold. By adding up all these taxes and fees on your royalty checks for the year, you can deduct them on your Schedule E.

Working Interest Deductions

There are also deductions available for oil companies and investors in oil wells. A working interest owner has an interest in oil or gas that includes responsibility for all drilling, developing, and operating costs.  Producing and operating companies are working interest owners.  Royalty owners are not responsible for any drilling and operating costs.

However, some mineral owners decide to take the risk to develop their own minerals and become both royalty and working interest owners.  The tax code specifically excepts working interest in an oil and gas well and states that it is not a passive activity.  If you invest in oil and gas wells you may deduct any losses created by those wells from your active income generated by stock trades, business income and salaries.

Summary

Mineral owners are allowed tax relief by the IRS for producing and depleting nonrenewable resources such as oil and gas.  By using the percentage depletion allowance and deductions available for bonus and royalty income, royalty owners get to keep more of their oil and gas royalty income.