On Wednesday, April 26, President Trump submitted his tax reform proposal which is, for now, only about 100 words long.  It contemplates a number of sweeping changes to the tax code.  On the business side, these include a 15% business tax rate.  This lower rate could create broad planning opportunities for partnerships and other pass-throughs, including hydrocarbon related investors and operators.  Hydrocarbon investors and operators typically aggregate capital to conduct drilling operations through a contractual arrangement known as a “joint operating agreement”, or “JOA”, which, by virtue of Section 761(a)(2) of the Internal Revenue Code of 1986, as amended (the “Code”), can elect to not be treated as a partnership for U.S. federal income tax purpose.  After such an election is made, the parties are treated as tenants-in-common of the applicable working interests or royalty interests associated with the underlying minerals.  The parties pay their respective agreed shares of the drilling costs upfront in return for their agreed shares of production on the back-end.  Occasionally, one or more investors agree to bear the operator’s share of drilling costs as well (often referred to as a “carry”). 

If the parties fail to elect out, the JOA is classified as a general partnership for tax purposes (sometimes referred to as a “tax partnership”).  Whether or not an election out is made: (1) the investors’ drilling activities are excluded from certain “passive activity” loss restrictions under Section 469(c)(3)(A) of the Code that would otherwise generally prevent investors from deducting losses from the drilling activities against unrelated income of the investors; and (2) the investors may elect to currently deduct most associated investment expenditures against unrelated income under Section 263(c) of the Code.

If an investor in a tax partnership agrees to pay a carry, the investor can through a special allocation deduct not only its drilling costs against unrelated income, but also the costs it pays on behalf of the operator.  It is not uncommon for the parties in the early years to classify their JOAs as tax partnerships, then in later years elect to not be treated as tax partnerships after the oil and gas properties begin producing revenues in excess of costs, turning a profit.

So far so good.  Now the question becomes the purpose behind the proposed tax reform.  If the purpose is to lower the rates on pass-through entities, such as partnerships, S corporations, and limited liability companies, the industry can probably say goodbye to JOAs electing out of tax partnership status  and hello to a more ubiquitous use of JOA tax partnerships from their inception.  This would allow access to the lower 15% rate on the back-end.

The one down side to using a state law legal entity such as a limited partnership or a limited liability company would be the inability of individual investors to exclude their early-year losses in these deals against income from other sources due to the above mentioned passive activity loss restrictions.  However, if it is determined by Congress that the lower 15% rate should only apply to income earned through actual state-law legal entities (which generally excludes general partnerships), it could very well make sense for the parties to begin the deal using a general partnership, which is not subject to these passive activity loss restrictions, thus allowing early year losses from the deal to offset unrelated income of the investors (which, under the proposal, might be otherwise taxable at a rate as high as 35%, or, under current law, at a rate as high as 39.6%), then convert their general partnership into a state law limited partnership or limited liability company once the activity becomes profitable, taking advantage of the reduced 15% tax on back-end profits.   

None of the White House, the House or the Senate have yet communicated any further details regarding what the tax legislation might ultimately entail.  Nevertheless, it appears the final bill may have a big impact on the structures oil and gas operators and investors use to explore for and develop oil and gas interests domestically.