If you've leased your land to an oil and gas company for energy production, it important to stat planning and preparing for the taxes you will owe on your lease bonus and royalty payments. Trying to understand the tax consequences on oil well and natural gas royalties and lease bonus payments can be overwhelming, but we're here to help with some advice!
What are Oil & Gas Royalties?
Knock knock!Who’s there?Big Oil Company.Big Oil Company who?The big oil company that’s about to make you rich!
Every land owner looks forward to getting that knock on the door from a friendly landman who informs them that an oil and gas company is interested in leasing their land for energy production. They may dig an oil well or extract natural gas on your land - an online royalty calculator will be a great help when establishing a fair sum.
How To Report Lease Bonuses & Royalty Payments on Your Taxes
Royalty owners typically receive lease bonus payments for leasing their land to the energy company. This bonus payment is usually reported as rental income on the royalty owner’s tax return.
What about the recurring royalty payments you receive as a royalty owner? What do you report these royalty payments as? These royalty payments are usually reported as royalty income on the owner’s tax return.
Your lease bonus and royalty income is combined with income from other sources, such as wages from your job and dividends from your investments, to determine your total taxable income.
Since your oil and gas related income is taxed as part of your overall income, it’s important to take advantage of any possible deductions against your oil and gas royalty income.
How To Avoid Tax Consequences of Oil & Gas Royalties & Lease Bonus Payments
The IRS communicates very clearly that leasing your land for oil and gas production creates tax consequences. The following quote is directly from the IRS:
Taxpayers who own land that contains valuable natural resources should be aware that arranging for the development of the resources by means of a lease creates tax consequences.
So to answer the landowners who ask “are oil and gas royalties taxable?” the answer yes, they are taxable. Let’s cover some important aspects of oil and gas royalty taxation, topic by topic.
When landowners recieve an offer for their mineral royalties, they start thinking about their newfound “mailbox money” and what they are going to do with their lease bonus and royalty payments. This optimism is natural, and it’s okay to take a few minutes and thank your lucky stars. But your second thought should be about planning and preparing for the value-added tax you will owe on your lease bonus and royalty payments.
Apply the Depletion Deduction
Fortunately, the IRS allows for taxpayers who own an economic interest in a mineral deposit (oil and gas minerals) to apply a depletion deduction to reduce their taxable income from oil and gas royalties. This depletion deduction reflects the economic reality that your oil and gas reserves are being reduced each time you receive a royalty check.
The depletion deduction is calculated either by a cost depletion method or a percentage depletion method. A royalty owner must use the method that produces the larger deduction. The percentage depletion rate depends on the mineral being taxed.
In addition to the depletion deduction, there are other state taxes which you can deduct against your royalty income. And some states’ depletion rate is larger than the federal depletion rate.
We have a lot of experience helping royalty owners make the most of the deductions they can take to lower the taxable income that comes from their oil and gas royalty income. Often our clients are surprised at the complexities and strategies available for them to take advantage of.
Make Estimated Tax Payments
Federal income tax is not usually withheld from oil and gas royalty payments. And sometimes royalty payments can be quite large. This combination can sometimes lead to a large and unexpected bill when it’s time to pay your taxes.
To avoid this financial surprise, we often help clients file quarterly estimated tax payments on their oil and gas royalty income.
Sell Oil & Gas Royalties
Sometimes, especially during the boom years, our clients get offers for their existing unclaimed oil and gas royalties. You can buy and sell oil and gas royalties just like any other capital asset.
Selling oil and gas royalties for a profit can lead to a capital gains tax; however, there are some interesting structural strategies we’ve helped clients take advantage of that allow them to defer any capital gains taxes that arise from the selling of their oil and gas royalties.
Make the Most of Your Oil & Gas Royalty Income
Here at Sean M. Hugo, CPA, PC we hope many of our land-owning Oklahoma clients get that knock on the door one day and find out that an oil and gas company wants to lease acreage from them and drill for oil and gas. If you are fortunate enough to get that knock, then you will no doubt be excited at the potential of your lease bonus and royalty income.
Take a few minutes to celebrate with your friends and family, and then give us a call so we can help you plan for the taxes you are going to owe and make the most of the deductions you can take against your oil and gas royalty income.
Let Us Worry About the Tax Preparation on Your Oil and Gas
We’ll worry about the tax consequences of your royalty income while you spend your time figuring out what to do with your newfound mailbox money and getting to know the relatives you never knew you had.
Contact us and we’ll discuss how our tax services can help you prepare for the tax consequences of your oil and gas royalty income. An an expert oil and gas cpa we can ensure that your oil and gas royalty income taxes are paid properly. We can also help you make the most of the allowable deductions against your royalty income and assist you with other tax related issues such as royalty trusts, tariffs, ad valorem tax, excise tax and more.