Incentive to Enter into Oil and Gas Lease Is Ordinary Income, Not Capital Gain.
(Parker Tax Publishing December 2013)

A payment received by landowners as an inducement to enter into an oil and gas agreement was taxable as ordinary income because the transaction was a lease; no depletion deduction was allowed. Dudek v. Comm'r., T.C. Memo. 2013-272 (12/2/13).

Michael Dudek was a CPA and attorney licensed to practice in Pennsylvania. From 1996 to 1998, Michael and his wife, Brenda, purchased acreage that was subject to oil and gas leases with Ohio Lease Development Co. After the leases expired in 2008, the Dudeks entered into an oil and gas lease agreement with EOG Resources, Inc., under which EOG could develop the couple's acreage and drill for, extract, and sell any gas and oil discovered on the property. Under the agreement, EOG bore the costs of exploration, development, and operation of the property regarding the production of oil and gas, and the couple would receive royalty payments equal to 16 percent of the net profits of any oil and gas extracted from the property. The agreement was for a term of five years, with an option to extend the term for an additional five years.

On behalf of EOG, T.S. Calkins & Associates (Calkins), a title search company, made a payment (bonus payment) of $883,250 to the Dudeks as an inducement to enter into the agreement. The payment was not dependent on any extraction or production of oil or gas. Calkins sent a Form 1099-MISC, Miscellaneous Income, to the IRS which reported the payment to the couple. The couple timely filed their joint 2008 federal income tax return and reported the bonus payment as long-term capital gain. The IRS said the payment was ordinary income and issued a notice of deficiency and determined an accuracy-related penalty. Michael and Brenda argued that the agreement was not a lease; rather, it was in substance a sale of their rights to any oil and gas on the property that generated capital gains.

Before the Tax Court, the Dudeks argued that if the court determined that the bonus payment was ordinary income, then they were entitled to a percentage depletion deduction of approximately $130,000. The IRS argued that they were not entitled to a deduction for percentage depletion or for cost depletion.

Code Sec. 611(a) states that a reasonable allowance for depletion is allowed in computing income derived from oil and gas wells. Code Sec. 613A(d)(5) provides that the percentage depletion for income from oil and gas wells does not apply to any lease bonus, advance royalty, or other amount payable without regard to production from the property.

The Tax Court held that the agreement between the Dudeks and EOG was a lease and the bonus payment to the couple was taxable as ordinary income. The court cited Laudenslager v. Comm'r, 305 F.2d. 686 (3d Cir. 1962), which found that where the owner of land received bonus payments for mineral deposits obtained from that land and retained an economic interest in the mineral deposits of the land, the transaction was regarded as a lease, and the proceeds were taxable as ordinary income. Under the agreement, the Dudeks were entitled to royalty payments equal to a percentage of the net profits of any oil or gas extracted from the property. Their royalty interest constituted an economic interest, the court stated, because they retained the right to share in the proceeds of any oil or gas extracted from the property. Moreover, the court noted that the agreement could not be a sale since it failed to reflect the economic realities of a sale as it did not provide for a determinable quantity of oil and gas to be transferred to the lessee.

Further, the bonus payment was not eligible for percentage depletion because the payment did not relate to the extraction or production of oil and gas. The court found that, although the bonus payment was eligible for cost depletion, the amount must be calculated from the taxpayer's basis for depletion, the amount of the bonus payment, and royalties that the taxpayer expected to receive. In this case, the Dudeks did not present any evidence as to the amount of royalties they expected to receive. Since it was not possible for the court to calculate the amount of the couple's cost depletion, no cost depletion deduction was allowed.

Finally, Michael and Brenda were liable for the accuracy-related penalty for substantial understatement of income tax. The couple failed to show that they acted reasonably and in good faith with respect to the underpayment of tax.

For a discussion of whether payments relating to mineral property are characterized as a sale versus a lease, see Parker Tax ¶117,545. (Staff Editor Parker Tax Publishing)

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