[author: Randy L. Varner]
On October 10, 2012, the Department of Revenue issued Informational Notice 2012-04, dealing with the Realty Transfer and Personal Income Tax treatment associated with the division and transfer of interests in oil and natural gas. While the Department does not break any new ground in the notice, the notice does provide a nice summary of the tax consequences surrounding these “Marcellus Shale” transactions.
Realty Transfer Tax
Initially, the notice tackles the Realty Transfer Tax (“RTT”) issues. The notice provides that the assignment of a lease for the production or extraction of coal, oil or gas is not subject to RTT. If the assignment covers the reserved real estate under the royalty clause of an oil or gas lease, then that assignment is subject to RTT. An assignment of royalty income is a personal property interest and therefore is not subject to RTT.
Personal Income Tax
The real meat of the notice addresses the Personal Income Tax (“PIT”) issues. The notice clarifies that if a mineral rights estate owner sells the mineral rights, the consideration less basis is taxable for PIT purposes and should be reported on Schedule D of the PA-40.
If both the surface rights and mineral rights are sold, the seller must allocate a portion of basis to the mineral rights estate. If this was not done when the seller originally acquired the property, an allocation must be made by taking the basis and multiplying by a fraction, the numerator of which is the FMV of the mineral rights estate and the denominator of which is the FMV of the entire real estate. The FMVs shall be determined as of the date the seller originally acquired the property. If an allocation cannot be made, a zero basis must be used.
A mineral rights owner who is the lessor under an oil or gas production lease may sell and assign his rights to income from future production payments under the lease. For PIT purposes, the sale and assignment are treated as anticipatory assignments of income. With respect to the assignor, he will be deemed to have received royalty income to the extent of the sales price. This income would be reported on Schedule E of the Pa-40 in the year in which the sale proceeds are received (no subsequent deduction will be permitted when the actual production payments are made to assignee).
With respect to the assignee, the tax treatment depends on whether the transaction is open (future production payments not readily ascertainable) or closed (amount readily ascertainable). The notice makes clear that open transactions will be very rare and will be handled on a case by case basis. There is a rebuttable presumption that all transactions are closed. For a closed transaction, each future payment is considered a partial non-taxable return of the assignee’s basis and the remainder is taxable royalty income to be reported on Schedule E of PA-40. The taxable and non-taxable amounts are prorated based upon the amount of anticipated future payments and the assignee’s basis.
Example: A lessor under a gas lease sells and assigns his right to future production payments for 10 years. The assignee agrees to pay $10,000 for the future payments. Therefore, the assignee will have a basis of $10,000 in the future payments. It is anticipated that that total amount of production payments over the 10 years will be 50,000 (1 yearly payment of $5,000 for 10 years). Therefore, by the time all future payments are made, the assignee will have recovered his basis plus an additional $40,000 of royalty income. The assignee’s basis accounts for 20% of the future production payments and the taxable royalty income accounts for the remaining 80%. Therefore, the assignee must account for 20% of each production payment as a return of basis ($1,000) and the remaining 80% as taxable royalty income ($4,000).
If there is an open transaction, the assignee is permitted to use the cost recovery method and apply the production payments to recover the entire basis first, then anything beyond basis is taxable royalty income reportable on Schedule E of PA-40.
Finally, donative transfers of production payments are treated as an anticipatory assignment of future income to the assignor. When a production payment is made, the assignor is deemed to have received the payment and in turn, transferred the payment to assignee. Therefore, the assignor has royalty income in the year the production payment is made, and the subsequent transfer is a gift and not subject to tax.
As noted above, there is no new treatment contained in the notice; however, it is a helpful resource for those involved in these transactions. Please feel free to contact any member of the McNees SALT team should you have questions relating to the points raised in this article. In addition, McNees has a Oil and Gas Group that can assist should you or your company require assistance with respect to Marcellus Shale issues.