Management of Oil and Gas Lease Payment Incomed Taxes
Oil and gas lease bonus and royalty payments received by Ohio landowners are considered taxable income for both federal and state income tax purposes.
### Federal and Ohio State Tax Impact:
Lease bonus payments, often a one-time payment for granting the lease, are taxable income in the year received and treated as ordinary income, subject to federal income tax. Ohio generally follows federal treatment, so the bonus will also be taxable on the Ohio state return.
Royalty payments, ongoing payments based on a percentage of the production, are also taxable as ordinary income federally and in Ohio each year they are received.
### Deductions and Expenses:
Expenses directly related to producing the oil and gas, such as post-production costs, may affect taxable income. However, recent Ohio federal court rulings have clarified that improper deductions by producers for post-production costs may be disallowed, protecting landowners’ royalty income.
### Strategies for Managing Income Taxes:
1. **Separate Reporting:** Landowners should report bonuses and royalties on Schedule E (Supplemental Income) or Schedule C if treated as a trade or business, but for most passive royalty income, Schedule E is typical on federal taxes.
2. **Cost Basis Allocation:** Allocate costs correctly between royalty interest and working interest if applicable to ensure appropriate deductions.
3. **Use of Tax Deferral Vehicles:** Consider entities like Limited Liability Companies (LLCs) or trusts to hold mineral rights, which might provide opportunities for tax planning or deferral depending on structure and income.
4. **Expense Tracking:** Maintain detailed records of any expenses related to mineral rights or lease income that can be deducted to reduce taxable income, including legal fees or leasing expenses.
5. **Depreciation and Depletion:** Landowners receiving royalties may qualify for a percentage depletion deduction on the royalty income under federal law, which can reduce taxable income.
6. **Consult a Tax Professional:** Because tax treatment can be complex and dependent on lease terms and ownership interest, consulting a tax advisor experienced in oil and gas taxation in Ohio is crucial.
### Additional Considerations:
- Operating expenses for landowners who hold an operating or working interest in the production of oil and gas can be deducted. - Contributions to an IRA or other retirement plan have limits as to how much can be contributed each year. - Delay rental payments, which extend the primary term and allow additional time to begin drilling activities, are also considered ordinary income and should be reported in the same way as lease bonus payments. - Both lease bonus and royalty payments are subject to Ohio income tax. - The highest Ohio income tax bracket is 4.79% for those with Ohio taxable income over $217,400. - The depletion deduction is allowed only when oil or gas is sold and income is reportable. - Section 179 Expensing limit for 2020 is $1,020,000 with a 2.55 million dollar phase out limit. - Landowners can utilize tax management strategies to help reduce the tax burden, but evading taxes is illegal.
The Tax Cuts and Job Act has changed the standard deduction amounts, which could decrease the ability to use the prepaid taxes and mortgage interest strategy. Landowners must compare two methods when calculating the depletion deduction and use the method that provides the largest deduction.
For more information about depletion deductions, refer to the IRS fact sheet "Using the Depletion Deduction to Minimize Oil and Gas Tax Liability." The IRS recognizes depletion deductions for oil, gas, and other minerals, based on reasonable deduction of the depleted resource.
Royalty payments are not subject to self-employment tax. Contributions made to qualified organizations, such as those with 501(C)(3) status, churches, and other qualified organizations, can help lower tax liability. Oil and gas payments may be subject to the Net Investment Tax, effective from January 1, 2013.
For donations of $250 or more, written confirmation is required. Lease bonus payments are typically made on a per acre basis, either annually or as a lump-sum payment. Professional guidance is suggested before prepaying taxes, Ohio income tax, real estate taxes, and mortgage interest.
The highest federal income tax bracket is 37% for those with an adjusted gross income (AGI) of $622,050 or higher. Royalty payments, received if drilling results in a producing well, are reported in Box 2 of Form 1099 MISC and considered ordinary income.
Examples of potential tax management strategies include deducting attorney fees, contributing to retirement and salary reduction plans, and prepaying taxes and mortgage interest. Payments of principal on a loan are NOT deductible, only the interest portion of a loan payment is tax deductible.
Lease bonus and royalty payments can be substantial and may require the landowner to make quarterly estimated tax payments. It is crucial for landowners to understand the tax implications of these payments and seek professional advice to manage their tax liabilities effectively.
In light of the taxable nature of lease bonus and royalty payments received from oil and gas leasing, it is advisable for landowners to consider strategies such as separate reporting on their federal taxes (Schedule E for most cases), cost basis allocation, use of tax deferral vehicles like LLCs or trusts, and expense tracking to reduce taxable income. Moreover, landowners may also be eligible for a percentage depletion deduction on their royalty income under federal law, which can help minimize their tax liability.
