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Depletion Deductions for Landowners Receiving Gas Royalties

Natural-gasIt is filing season and landowners receiving natural gas royalty payments may be shocked by their tax liability if they have not been planning with their CPAs. Landowners who sign a lease with a gas company own a royalty interest. When royalty income is received, the landowner is entitled to depletion. Similar to depreciation, depletion is the cost recovery of a natural resource and, in the case of royalty owners, natural gas. It is provided for by IRC §611 and the rules governing it are IRC § 613 and 613A.

The Internal Revenue Service provides for two methods:

  1. Cost depletion - allows the taxpayer a deduction based on the ratio of units sold to the number of units available at the end of the year plus the units sold during the year. 
  2. Percentage depletion - allows the taxpayer a deduction based on the gross income of the gas producing property.
The IRS requires taxpayers to take the higher of cost depletion or percentage depletion. Percentage depletion is limited to royalty owners and independent producers who produce 1,000 barrels of average daily production of domestic crude oil or an equivalent amount of domestic natural gas.

Landowners, in a majority of situations, are going to be using percentage depletion on the royalty income. This normally entitles the royalty owner to a statutory amount of 15 percent depletion based on the property’s gross income.

The percentage depletion deduction is subject to two limitations:

  1. The 100 percent taxable income limitation on the property - the property’s taxable income is the gross income less allowable deductions such as severance taxes and other administrative expenses.
  2. The taxpayer’s 65 percent taxable income limitation - the taxpayer’s taxable income is computed without regard to any depletion on production, any IRC §199 deduction, net operating loss carryback to the taxable year or capital loss carryback to the taxable year. 

The 65 percent taxable income limitation could come into play if the taxpayer has a loss in another business that is offsetting the royalty income. Any amount that is disallowed may be carried forward and allowed as a deduction in the following year. Tax preparers should be sure their software tracks any disallowed percentage depletion carryover amounts.

Percentage depletion is also not available on lease bonus payments, advance royalty payments or any other amount payable without regard to production from the property. This prevents upfront bonus payment from being eligible for percentage depletion.

For partnerships, the depletion allowance is calculated separately by the partners and not at the partnership level. For S corporations, the depletion allowance is calculated at the shareholder level.

Gas royalty owners also benefit by not having the percentage depletion considered a tax preference item for Alternative Minimum Tax purposes.

There have been many proposals to remove percentage depletion since it was introduced in the early 1920s. It ended for big oil producers in 1975 when IRC §613A was enacted. In President Obama’s fiscal year 2012 proposed budget, the repeal of percentage depletion was proposed. Other proposals include the Sustainable Energy Act, introduced in the Senate on Feb. 14, 2013, and the American Jobs Act of 2013, introduced in the House on Jul. 31, 2013. It is important for CPAs to ensure that their clients take advantage of percentage depletion while it is still available.

Ed Kollar, CPA, Senior Manager, ParenteBeard. Ed has been a member of ParenteBeard's tax team for more than a decade, specializing in businesses in natural stone, natural gas and other extractive industries. He previously served as president of the Estate Planning Council of Northeastern Pennsylvania.

Natural gas image via Shutterstock

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