There is a new oil boom in rural Pennsylvania that is introducing tax complexity to a whole range of taxpayers. Natural gas embedded in a thick layer of rock known as the Marcellus Shale sits in a geographic area that ranges from Ohio and West Virginia to upstate New York, with rural Pennsylvania sitting dead center. Only recently has technology (as well as the high price of oil and gas) made it economical to extract this natural gas, potentially worth billions of dollars.
Landowners of all types have been approached by oil and gas companies with five-year lease and royalty agreements. The going rate for such lease agreements as of spring 2008 ranged from $2,000 to $2,500 per acre as an upfront payment for a five-year land lease plus a 15–18% royalty to the landowner from a producing well.
The players in this new oil boom are the oil and gas companies and landowners, including individuals, corporations, partnerships, homeowners’ associations, and nonprofit entities such as country clubs and hunting clubs. To enable individuals owning small parcels of land to negotiate more favorable leases and to provide for large enough tracts of land to allow drilling where state or local laws impose minimum acreage requirements for a drilling site, many individuals and associations are forming coalitions to negotiate a single lease. However, the relative business inexperience and organizational complexity of some of these taxpayers requires that tax advisers and attorneys thoroughly understand many disparate areas of taxation, including federal tax treatment of lease and royalty income, exempt entities and unrelated business taxable income (UBTI), federal classification of taxable entities, and state and local laws. This item provides an overview of some areas of taxation that taxpayers and their advisers must consider to ensure the most favorable terms if their clients are approached by an energy company seeking a land lease and royalty agreement.
Federal Tax Treatment of Lease and Royalty Income
Amounts received for the upfront land lease payments are treated as rental income. Generally, under Sec. 451(a), taxpayers must include advance rents in gross income in the year received. Cash-basis taxpayers include rent in gross income when actually or constructively received. Accrual-basis taxpayers include rent in income when all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (Regs. Sec. 1.451-1(a)). Taxpayers should also consult Sec. 467 for special rules that apply to stepped-rent arrangements that exceed $250,000. While taxpayers include in gross income the upfront payment for a five-year lease as rental income, the 15–18% received from the profits of a producing well is included as royalty income and taxed as ordinary income when received (Regs. Sec. 1.61-8).Depletion and other expenditures:To develop a producing gas well, a taxpayer may have expenditures for acquiring the natural resource (the gas deposit in place). While depletion cannot be taken on land, the owner of a purchased economic interest, including the purchase of royalty interests, mineral interests, working interests, net profits interests, and some production payments, may recover cost through depletion deductions (Sec. 611). Although there are two available methods of depletion, cost depletion and percentage depletion, generally oil and gas operations may use only the cost depletion method (Regs. Sec. 1.613-1(b)). The cost depletion method is similar to the units of production method for depreciation. While less likely, a lessor may also have intangible drilling costs, tangible asset costs, and other operating costs.
Social Clubs Exempt Under Sec. 501(c)(7)
Some of the actors in the new oil boom are entities exempt under Sec. 501(c)(7), including hunting clubs, country clubs, and similar social clubs. It is not unusual for hunting clubs to own hundreds or even thousands of acres of land. Sec. 501(c)(7) organizations generally begin as C corporations and later apply for tax-exempt status by submitting a completed Form 1024, Application for Recognition of Exemption Under Section 501(a), along with Form 8718, User Fee for Exempt Organization Determination Letter Request. It is important to note that many hunting clubs do not apply for federal exemption (nor are they required to do so).
UBTI: While a Sec. 501(c)(3) tax-exempt organization may exclude certain types of income from UBTI under Sec. 512(b)—including rents and royalties—Sec. 501(c)(7) organizations do not get the full benefits of the Sec. 512(b) modifications to UBTI. Rather, the UBTI of a Sec. 501(c)(7) social club includes all of its nonexempt function gross income, less deductions for expenses directly connected with the production of nonexempt function gross income (Sec. 512(a)(3)). Rental income from the gas leases and any royalty income from an active gas well would be UBTI.
In addition, if the social club has gross receipts from these “other than exempt function sources of income” in excess of 35% of gross receipts, exempt status is terminated, generally resulting in C corporation status (S. Rep. No. 94-1318, 94th Cong., 2d Sess. 4 (1976)). The change from a tax-exempt entity to a C corporation will qualify as a tax-free F reorganization (Sec. 368(a)(1)(F) and Letter Ruling 9548034).
As a C corporation, the entity would be subject to tax at the corporate level (Sec. 11) and any cash distributions would be dividends under Sec. 301. Where a C corporation accumulates earnings without making dividend distributions, there may be exposure to the accumulated earnings tax of Sec. 531 or the personal holding company tax under Sec. 541.
In addition, Sec. 501(c)(7) indicates that no part of a social club’s net earnings can inure to the benefit of private shareholders without the organization’s losing its tax-exempt status. Inurement will be deemed to have occurred if, among other events, members receive cash distributions, when income from nonmembers is used to subsidize club operations, or from failing to increase dues to cover increased services (Rev. Rul. 58-589).
For example, improving the hunting club’s facilities from the income generated from the gas leases or royalty income, without raising dues, could result in inurement to the club’s shareholders and the loss of exempt status (Coastal Club, Inc., 43 TC 786 (1965), aff’d 368 F2d 231 (5th Cir. 1966)). Inurement results in automatic and immediate loss of exempt status, whereas UBTI will terminate tax-exempt status only if the gross income from non-exempt activities routinely exceeds 35% of gross receipts from all sources.
Entity Status: C Corporation, Partnership, or S Corporation
C corporation status ultimately results in two levels of tax, one applied at the corporate level and a second at the shareholder level on dividend distributions. To avoid the corporate level of tax, an unincorporated entity or group of individuals may wish to be structured as an association taxable as a partnership or an S corporation. Converting a corporation to a partnership always involves a liquidation and will result in two levels of tax under Secs. 331 and 336. This creates a high toll charge for existing Sec. 528 homeowners’ associations or hunting clubs or other Sec. 501(c)(7) organizations that revert to C corporation status.
When the entity is already a C corporation, an S election may be a viable choice for single-level taxation. However, as an S corporation, the organization will want to exercise care in admitting new members so as not to dilute their ownership interest in the lease or royalty payments or to terminate S corporation status by inadvertently creating more than one class of stock. There are also a number of restrictions and implications to S corporation status that must be carefully considered (see generally Sec. 1361 and the regulations thereunder).
Making the S election and excess net passive income of an S corporation: While making the S election should not pose unusual difficulties for new entities, the tax consequences may be more complicated where a Sec. 501(c)(7) organization terminates and becomes a C corporation. If an S corporation has any accumulated earnings and profits (AE&P) from C corporation years, the S corporation may be subject to a corporate-level tax applied to excess net passive income (ENPI). If passive investment income (including income from rents and royalties) is in excess of 25% of total gross receipts for the year, a 35% penalty tax is imposed on the ENPI (Sec. 1375). In addition, if the S corporation has ENPI for three consecutive tax years, the S election is automatically terminated (Sec. 1362(d)(3)(A)(i)). Therefore, if the S corporation has any AE&P, one strategy to consider is making an accumulated adjustment account bypass election to purge AE&P under Sec. 1368(e)(3), thereby avoiding the tax on ENPI under Sec. 1375 and avoiding the threat of terminating the S election.
Built-in gains tax: While an S corporation normally does not pay federal income tax, an S corporation that was previously a C corporation may be required to pay a built-in gains (BIG) tax (Sec. 1374). However, there is no built-in gain related to the natural gas: The income generated from the natural gas is not recognized as a built-in gain under Sec. 1374 (Regs. Sec. 1.1374-4(a)(3), Example 1). To the extent the land is not disposed of during the 10-year recognition period, the BIG tax will not be triggered. The natural gas sold during the recognition period will not constitute separate assets held by the S corporation on the date of the S election, and thus its production and sale will not constitute a partial disposition of the land (Rev. Rul. 2001-50). Therefore, the S corporation’s income on the sale of any natural gas during the 10-year recognition period is not recognized built-in gain within the meaning of Sec. 1374(d)(3) and is not taxed under Sec. 1374.
Taxpayers must carefully weigh the goals for themselves, their families, associates, and use of the land when presented with a land lease and royalty agreement for natural gas exploration. For instance, many hunting clubs have a primary goal of preserving the land for recreational purposes. Taxpayers should rank their goals and determine what is most important to them. A client that owns land individually or through a business entity that is approached by an energy company with a land lease and royalty agreement should be advised not to sign the agreement before seeking the counsel of an attorney and a tax adviser to ensure that the goals for the use of the land, for obtaining cash distributions, and for tax minimization are achieved in the most efficient manner possible for the specific client situation.To develop a producing gas well, a taxpayer may have expenditures for acquiring the natural resource (the gas deposit in place). While depletion cannot be taken on land, the owner of a purchased economic interest, including the purchase of royalty interests, mineral interests, working interests, net profits interests, and some production payments, may recover cost through depletion deductions (Sec. 611). Although there are two available methods of depletion, cost depletion and percentage depletion, generally oil and gas operations may use only the cost depletion method (Regs. Sec. 1.613-1(b)). The cost depletion method is similar to the units of production method for depreciation. While less likely, a lessor may also have intangible drilling costs, tangible asset costs, and other operating costs.
Anthony S. Bakale is with Cohen & Company, Ltd. Baker Tilly International in Cleveland, OH
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
If you would like additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.