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Tenth Circuit Affirms Tax Court; Passive Participation in Oil and Gas Ventures Is Subject to Self-Employment Tax

(Parker Tax Publishing July 2016)

Despite the fact that a provision in an operating agreement that governed a taxpayer's working interest in several oil and gas ventures explicitly elected out of partnership treatment, the taxpayer was found to be a partner in the ventures and was subject to self-employment tax on the income from those ventures. In affirming the Tax Court, the Tenth Circuit noted differences in taxpayer's circumstances compared to the taxpayer in the case relied on by the Tax Court, but found that the Tax Court did not clearly err by characterizing the arrangement as a partnership. Methvin v. Comm'r, 2016 PTC 231 (10th Cir. 2016).

In the early 1970s, David Methvin acquired working interests in several oil and gas ventures. These interests were no more than about 2 percent to 3 percent in any single venture and were not part of a business organization (such as a partnership, a limited partnership, a limited liability company, or a corporation) registered under the laws of any state. Rather, Methvin's working interests were governed by an operating agreement entered into by Methvin and Stewart Varn, with Varn serving as the operator of the interests. Varn's interest in the operating agreement was then transferred to Egan Resources, Inc. (Egan) and Egan was the operator of the interests during 2011.

Under the agreement, Egan managed the operations of the ventures and allocated income and expenses from the working interests to Methvin and other owners. Methvin had no right of involvement in the management or operation of the ventures. Under the agreement, the parties elected under Code Sec. 761(a) to be excluded from the application of subchapter K of the Code. Each year, Egan provided Methvin with a year-end accounting indicating both the revenues and expenses allocated to Methvin's working interests. In 2011, Methvin reported $6,760 of net income from his working interests as "other income" on Line 21 of his Form 1040. Methvin did not pay any self-employment tax on this net income.

The IRS determined that Methvin's net profits from his oil and gas working interests were subject to self-employment tax as income from a trade or business carried on by a partnership or a joint venture taxable as a partnership. Before the Tax Court, Methvin argued that he was not engaged in a trade or business, was not a partner in a partnership, and that his minority working interests were merely investments and his activity in connection with them did not rise to the level of a trade or business.

The Tax Court concluded that the working interest owners and the well operator created a pool or joint venture for operation of the wells. The court concluded that Methvin's income from the working interests was income from a partnership of which he was a member under the broad definition of "partnership" found in Code Sec. 7701(a)(2), and determined that Methvin was thus liable for self-employment tax. According to the Tax Court, while the record supported Methvin's contention that his personal involvement in the day-to-day operation of the wells was minimal, a taxpayer who is not personally active in the management or operation of a trade or business may be liable for self-employment tax if the trade or business is carried out on his behalf through his agents or employees or constitutes his distributive share of income from a partnership in which he was a member.

In reaching its decision, the Tax Court cited Cokes v. Comm'r, 91 T.C. 222 (1988), where it held that making an election under Code Sec. 761(a) does not operate to change the nature of an entity. A partnership remains a partnership, the court said, and the Code Sec. 761(a) exclusion simply prevents the application of subchapter K. The partnership remains intact and other sections of the Code apply as if no exclusion existed. Thus, the Tax Court held, an election under Code Sec. 761(a) does not prevent a finding that the operating agreements at issue created a partnership.

Methvin appealed to the Tenth Circuit, arguing that his circumstances differed from many of the circumstances in Cokes. For example, he said, the working-interest owner in Cokes enjoyed some decision-making rights that he did not have.

The Tenth Circuit affirmed the Tax Court's decision. The court noted that, similar to Methvin's arguments, the working owner in Cokes had argued that she owned only a minority interest and that her income involved only passive participation as an investment. The Tax Court, however, concluded that the arrangement between the operator and the working-interest owners established a partnership because the working-interest owners shared costs and proceeds, had a formal written agreement, and carried on a business together. The Tenth Circuit found the Cokes decision to be persuasive. With respect to the differences pointed out by Methvin, the Tenth Circuit noted that such differences might have led the Tax Court to arrive at a different factual finding since each case rests on its own facts. But, the Tenth Circuit said, the Tax Court did not clearly err by characterizing Methvin's arrangement with Egan as a partnership. In the absence of clear error, the Tenth Circuit upheld the Tax Court's finding that the arrangement constituted a partnership.

For a discussion of what constitutes a partnership, see Parker Tax ¶20,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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