Depletion tax allowance on inherited royalties

Accounting and Taxes
1

I inherited royalties in 2009, which have since been produced. I use TurboTax to do my federal return, and the program always fills in the blank for taking depletion. However, according to IRS publication 535 it states you can take depletion if you have an “economic interest” in the mineral property. It further defines that for “economic interest” to be valid, you must have “acquired by investment any interest in mineral deposits or standing timber.” Since we inherited our mineral acres, we did not acquire them by investment.

My issue is that some of my royalty co-owners take depletion while some of us do not. I’ve searched and searched the Internet for an answer as to whether to take depletion, and come up more confused. I also called the IRS and was transferred to three different people before getting a person who then proceeded to read the text of publication 535 to me.

Any advice will be greatly appreciated.

2

Here are my 2 cents…

After reading a lot of information online…I came to the conclusion that I could take this depletion allowance even as a royalty owner (in my case a non-participating royalty interest owner).

http://www.mineralweb.com/owners-guide/leased-and-producing/royalty-taxes/depletion-allowance/

3

Bill, did you inherit your royalties? I went to the link and, alas, it points me back to IRS publication 535 for more information, and under the section about who can claim depletion it states you can only take the allowance if “You have acquired by investment any interest in mineral deposits or standing timber”. Since I am a royalty owner only through inheritance, I did not acquire through investment, and thus it seems I am not eligible for the depletion allowance. Somehow this doesn’t seem right, though.

4

Connie,

I believe there is more than one type of depletion allowance. You may be looking only at cost depletion. There is also percent depletion which allows for the loss of a proven asset through its depletion. It is different for each mineral depleted. For oil, I think it is 15% of income but you should consult an accountant familiar with oil and gas. It will probably be worth your while. I have many types of royalties and from time to time both depletion allowances have been used. Unlike you, I’m not clever enough to do my own mineral business return. Before you give up on depletion, contact a minerals savvy accountant. If you need a name, let me know.

Connie Allen said:

Bill, did you inherit your royalties? I went to the link and, alas, it points me back to IRS publication 535 for more information, and under the section about who can claim depletion it states you can only take the allowance if “You have acquired by investment any interest in mineral deposits or standing timber”. Since I am a royalty owner only through inheritance, I did not acquire through investment, and thus it seems I am not eligible for the depletion allowance. Somehow this doesn’t seem right, though.

5

Connie, I believe that Gary is correct. On those minerals I inherited, I take the 15% depletion. I’m not a tax professional but the man who prepares my taxes is. I believe that the other depletion that Gary is talking about would require a report on the proven reserves in place, and probably beyond our needs and may not put you ahead of the 15% depletion.

6

If the property was in production you would have had a valuation done and a value at time of inheritance. With the determination of the estimated reserves and the current price per barrel and mcf of gas. Generally the valuation would be for boe (barrel oil equivalent) and gas would have been converted to bbls at 6000 mcf (sometimes 5,800 mcf) gas = 1 barrel of oil. So you would take the valuation (well by well) and had a value placed of the estimated reserves left. So let’s just say the valuation at your interest estimated to have 100,000 bbls left in the ground. And at that time the price of oil was $100 a bbl. Therefore your value of the well would be at $100 a barrel or $10,000,000.00. In the event that the price drops to $80 bbl you are still using the cost depletion allowance at $100 bbl. Once you reach $0.00 you then convert to the standard percentage depletion (15%). Without getting too complicated, how many wells and what kind of money are we talking about?

7

Below is a link to an IRS chapter on oil & gas. It appears to be an IRS agent training manual. Below the link is an excerpt from this chapter that describes “economic interest.” Looks like based on this info…In my opinion inherited mineral interests (passive royalty income) would be an “economic interest” and not an “economic advantage” as described below. However I am not an oil and gas accountant or lawyer. I hope this answers your question…or at least sends you down a more fruitful road.

  • Bill (I’m not sure why it is in all CAPS, but I promise I’m not yelling)

http://www.irs.gov/irm/part4/irm_04-041-001-cont01.html

4.41.1.3.9.1.1 (12-03-2013) Economic Interest

  1. An economic interest in an oil and gas property is possessed in every case where a taxpayer has acquired, by investment, any interest in minerals in place and secures, by any form of legal relationship, income from the extraction of the oil and/or gas for which the taxpayers seeks a return on capital investment. Refer to Treas. Reg. 1.611–1(b).

  2. In many foreign countries, a corporation cannot acquire legal title to any of the lands, or to any petroleum or other hydrocarbons contained therein or produced therefrom. Rev. Rul. 73-470, 1973-2 CB 88 illustrates the rights and obligations that would permit a corporation to have an economic interest for purposes of depletion and intangible drilling costs with respect to United States federal income taxes.

  3. Depletion deductions are allowable only to the owner of an economic interest in the mineral deposit. Although a production payment is by definition an economic interest, IRC 636 provides that the payee will not be treated as the owner of an economic interest.

  4. The agent must distinguish between an economic interest and an economic advantage. The contractual right to purchase oil or gas after it has been produced is an economic advantage. See Rev. Rul. 68–330, 1968–1 CB 291. Court cases turning on the “economic interest” concept are Tidewater Oil Co. v. United States, 339 F.2d 633 (Ct. Cl. 1964); 14 AFTR 2d 6043; 65–1 USTC Para. 901A; CBN Corp. v. United States, 364 F.2d 393 (Ct. Cl. 1966); 18 AFTR 2d 5143; 66–2 USTC 86,703; cert. denied, 386 U.S. 981; Southwest Exploration Co. v. Commissioner, 350 U.S. 380 (1956); 48 AFTR 683; 56–1 U.S. 54,691; and Estate of Donnell v. Commissioner, 48 TC 552 (1967) AFF’D 417 F.2d 106 (5th Cir. 1969).

  5. The agent should be able to determine the “economic interest” status of an asset by obtaining from the taxpayer’s property acquisition files or from any other sources the documents, letter agreements, assignments, unitization agreements, and operating agreements. The division order is the legal abstract of mineral interest in a specific property and indicates each party’s percentage of ownership. These documents should be studied carefully for the nature of the interest owned by the taxpayer.

  6. The agent should not be concerned about the economic interest status unless the taxpayer has claimed depletion deductions or IDC deductions. These are the only types of deductions which are affected.

  7. If the taxpayer claims cost depletion deductions, the agent should be primarily concerned with basis, reserves of oil and/or gas, current tax period production, and the computation of the deduction.

8

May I suggest that you inquire with Tax CPAs and Tax Attorneys as to what is the best way to proceed. Just phone and inquire what their services will cost you. I do not think IRS would ever compare the tax returns of the royalty co-owners. Good Luck!!!

9

Gary, lest you think I really am clever, please know I am a tiny, tiny fish in this pond and don’t make enough in royalties to much matter. I just want to do the right thing, because even though it isn’t much money now, who knows what the future will bring. That said, I would much appreciate the contact information for a knowledgeable tax accountant, as I would be willing to pay to have this one question answered so it doesn’t come up every year. I live in Washington state and nobody here knows anything about it.

Thank you everyone who responded. You have given me awesome information, and I’m so glad I stumbled across this forum.

10

First time taxpayer of Royalties. HELP! (ok now that I got that out of the way…) Sch C, E or ???

Like Connie, I’m a tiny fish in the pond. Doing taxes for the first time involving royalties is daunting at best. You might see a portion of the below on a different page I found when looking just for tax info. Content and concern remains the same and ANY help or suggestions will be appreciated.

2 siblings and myself began receiving royalties in 2013. Prior to 2013, my investments and income have been simplified. Adding royalties has seen a mind-boggling change for in 40 years of filing taxes I will be paying a huge/whopping amount back to the IRS.

Depletion: having inherited mineral rights, I read about the 15% depletion. Through 2013 I did not automatically set aside a monthly amount to prepare for a penalty.

Without knowing different, I bought a simplified software program for not having a 2nd business, rental income or other investments to deal.

Basic allows the intro of the 1099-Misc amount but WHERE does one file the Depletion? The volume/s of info provided by the IRS is taxing (pardon the pun) and the head is swimming at this time. Schedule E has been identified. So has Schedule C for Profit/Loss but I am receiving income… not selling or losing to warrant capital gains, etc.

If I have to step up to a business form of the software I’ll do that as it appears Schedule C or E is not accessible.

As it is I took a trip to a local H&R office, pointing out ahead of time I wanted to talk solely to a person who had dealt with royalties or depletion in the past only to sit there for 1.5 hours while the 40 year veteran fumbled through IRS info that I could have done at home. The agent was making a big deal about my having to know ahead of time the “basis for the rights received by the siblings” that I interpret to be the size of the pool of oil being drilled for I do not recall having gotten anything stating the overall size as in 100k barrels or a million etc. to take depletion against.

My understanding of the depletion is that a 15% can be taken against the GROSS value of the yearly take between gas and oil in my/our case. That amount could be inputted where? Schedule C? Schedule E? just on the 1040?

Any help I gain will be passed to my siblings. Hate to come across as ignorant but truly am at this moment and hope nothing else changes to add to confusion in 2014 moving forward.

Thanks in advance!

Appreciating as would anyone looking at this site helpful suggestions!

11

Hello T. Starkweather, this is the other tiny fish Connie. I did get my question answered by a paid tax expert and did get my taxes done. I use TurboTax Premier (business version) because lesser versions don’t deal well with royalties. If you are just getting royalties and not doing something fancy (by my standard) where there are other expenses involved and other revenues, the 1099MISC with royalties show up on Schedule E. On my 1099MISC there is a separate tax amount which does not show up in any of the boxes, but is separate either on the top of the 1099MISC or elsewhere on the page, that is for production tax, and that shows up on line 16 of the 2013 Schedule E. Line 18 on Schedule E is where the 15% depletion shows up. TurboTax automatically figures the 15% depletion of gross value. Schedule C is not necessary unless you are doing something fancier than just getting royalties. Hope this helps.

T Starkweather said:

First time tax payer of Royalties. HELP! (ok now that I got that out of the way…) Sch C, E or ???

Like Connie, I’m a tiny fish in the pond. Doing taxes for the first time involving royalties is daunting at best. You might see a portion of the below on a different page I found when looking just for tax info. Content and concern remains the same and ANY help or suggestions will be appreciated.

2 siblings and myself began receiving royalties in 2013. Prior to 2013, my investments and income has been simplified. Adding royalties has seen a mind-boggling change for in 40 years of filing taxes I will be paying a huge/whopping amount back to the IRS.

Depletion: having inherited mineral rights, I read about the 15% depletion. Thru 2013 I did not automatically set aside a monthly amount to prepare for a penalty.

Without knowing different, I bought a simplified software program for not having a 2nd business, rental income or other investments to deal.

Basic allows the intro of the 1099-Misc amount but WHERE does one file the Depletion? The volume/s of info provided by the IRS is taxing (pardon the pun) and the head is swimming at this time. Schedule E has been identified. So has Schedule C for Profit/Loss but I am receiving income…not selling or losing to warrant capital gains, etc.

If I have to step up to a business form of the software I’ll do that as it appears Sch C or E is not accessible.

As it is I took a trip to a local H&R office, pointing out ahead of time I wanted to talk solely to a person who had dealt with royalties or depletion in the past only to sit there for 1.5 hours while the 40 year veteran fumbled through IRS info that I could have done at home. The agent was making a big deal about my having to know ahead of time the “basis for the rights received by the siblings” that I interpret to be the size of the pool of oil being drilled for I do not recall having gotten anything stating the overall size as in 100k barrels or a million etc. to take depletion against.

My understanding of the depletion is that a 15% can be taken against the GROSS value of the yearly take between gas and oil in my/our case. That amount could be inputted where? Sch C? Sch E? just on the 1040?

Any help I gain will be passed to my siblings. Hate to come across as ignorant but truly am at this moment and hope nothing else changes to add to confusion in 2014 moving forward.

Thanks in advance!

Appreciating as would anyone looking at this site helpful suggestions!

12

Thanks for the reply Connie for like that offered by RW and anyone else out there who has experienced the pangs and the learning curve, I still say it’s faster, easier and far more beneficial to get help from others who have walked that mile or two already.

I did return to my tax schedule and will completely start over tomorrow to see if something else was missed. I had somehow missed the input of depletion on a line on Sch E. It made a difference to the good by a bit over $4000 in the penalty but still a significant impact from my entire life of filing. I just can’t see paying a consultant at times when they, too, can make mistakes for not looking at an item like royalties on a regular basis.

I did read somewhere and passed that in a prior reply to RW that I saw different values placed on depletion %. Considering I quickly went thru Sch E it may well be a set 15% value to input. However if the depletion % is dependent on $$ earned and values vary, any change to the better will be sought out.

You are correct…I had nothing else to mess with or so I believe so taking the royalties and depletion could well be all I need to worry about…now or 2 years from now. I just can’t believe there is this much of a hassle for mineral owners down thru the years and why it’s soooo complicated to understand. Add to this if you decide to sell or split to someone and have to contend with that it makes me wonder why anyone ever gets excited about buying in to minerals to begin with. In my case and 2 siblings it is inherited like yours. My mother and father didn’t contend with royalties but did have a lease agreement until it began producing in 2012 (the well we share).

One thing is certain is to keep aside something for the taxes…so next year…I won’t face this again. Thx

13

How does one go about finding an accountant or tax preparer who knows about these things? I am in Minnesota and inherited mineral rights in North Dakota. I have exhausted everything I can think of and am unable to find anyone familiar with these issues. Do I have to go to North Dakota to find someone who knows?

14

Janie, I don’t know how complicated your taxes are so I can’t answer that question absolutely. I think some people may have a tendency to make things harder than they have to be. Royalty is ordinary income. If you are filing the 1040, you get 15% depletion.

I forget what the personal allowance for filing the 1040EZ form is but I believe it is $3,000 higher than personal deduction on 1040. If you made $20,000 in royalty and have other deductions, you should file a 1040, if you have no other deductions and only made a couple thousand in royalty, I would file the EZ because you will not have enough deductions on the 1040 form to give you a savings over the greater personal deduction of the EZ form. This is worst case, I hope everyone is doing well enough that it does not make sense to file the EZ form.

15

Unsure about MN Janie, I have a sister in MN & brother in WI who will be filing also. I started with a non-state H&R block software for my obligations this past year were minimal. After 2 days of frustration I called to a local H&R office explaining I wanted to speak to someone who had years of royalty experience. In TN that isn’t about to happen. I was assured someone in house was competent so with hesitation I drove there. After 1.5 hrs of the 35-year veteran fumbling through paperwork, the conclusion from the person was that I needed a “basis” for the whole pool of oil vs taking the 15% against the gross and that I needed to contact Continental (in our case) to find out what the original pool size was…try to get that info…right! Fortunately I didn’t pay that consultant a cent but why in my 40 years of filing I do my own taxes if help from those in the know can offer some thoughts.

Those more senior to myself in this forum have pointed out what makes sense. Publication 535 is lengthy to read but I printed that out along with other information. Most will lead to if you are an independent soul, that a 15% Depletion can be offset from the original gross. I missed this on my first go around with the software. I have found the H&R software to be frustrating. I believe the depletion is included on Sch E and that the general software would have taken care of this.

Yesterday I was on the phone for nearly 45 minutes with an H&R person who ended up hanging up on me after I stated to her twice I had already gone to a person locally days earlier. She wanted to schedule me for a follow-up appointment when she could not assist with the Royalties portion of the software and page I was on. I said “why would I want to return when for 1.5 hours my time was wasted”. She hung up saying “Have a Nice Day!”.

For Federal 15% taken from your Gross on your 1099-misc will reduce your tax penalty. Through 2013 I did not set aside in a separate account 25% of each royalty check but was prepared to pay a penalty at the end of the year. I did not realize though, the chunk it would result in so depending on what you received, what kind of deductions you have, prepare for a surprise.

Regarding state filing. Our royalties come from ND. The ND state legislature signed a bill making oil companies responsible in 2014 moving forward to charge state taxes. Currently it is not on my 1099misc but will be next year. As pointed out by RW, just because it isn’t there doesn’t mean a person isn’t responsible. A shame that things are so misleading and oil companies can’t offer general guidelines to the royalty owners as a goodwill gesture is my thought!

The IRS employee I spoke with told me of one woman who they caught and who has to pay back to 1966 back taxes.

This morning I drove to town and bought Turbo Tax software as I used years ago and this time for a Federal and state for I will be filing. I did a google search after talking to the person for ND Income Tax withholding from Oil and Gas companies and in PDF form is an 8-page document geared toward the companies producing the 1099misc for royalty owners. On page 4 of that report under Amount to Withhold will be seen the note that for calendar year 2014 and after, the withholding rate is 3.22% if the royalty owner is an individual.

I have not opened the state form yet as I will be redoing the tax using the Turbo Tax software. I was told one more thing though…that the 3.22% tax would be taken against the “NET”…not the “Gross” as the depletion tax on the federal form allows.

That is where I am at for the moment. Either way, next year’s taxes I will be a bit better prepared. Paying the piper this year on mailing out a check for over $13,000 isn’t as much as many have paid…but what a drain.

16

If you have access to an office of Eide Bailly, the accountant you see should be able to consult one of their associates in North Dakota. I would speculate any of the firms that have locations in areas should be able to do the same.

17

Hire an accountant to review your 1099s, activity, and accounts and to construct accurate K-1s for you. My brothers and my sister and I are new to this and we formed an LLC for the mineral interests we inherited from our late father. We used his accountant to make K-1s for each of us for both the IRS and state (CA). I will then take these to my guy at H&R Block, who will help me with my Federal tax return, and a California non-resident tax return for 2013. I have used TurboTax before, but no way would I try to use it with royalty income in the mix. For sure, you have to pay an accountant, but you never know what savings they might find for you, and his/her fees are costs that can be thrown onto the K-1s.

18

I would be careful using the H&R Block software for it DID NOT REVEAL nor allow for the NET PRODUCTION Tax as seen on my 1099misc. It also was misleading about deductions on a personal level whereas the TT software pointed out the discrepancies. To each their own… but I got 4 different answers from H&R Block both online and in person this past week and verified what I felt over 25 years ago… that it is better to prepare yourself to do things yourself with a bit of help, be much more knowledgeable and next year it would be easier. Most have simplified earnings that don’t require the services of a paid consultant… just saying…

19

I inherited all of my royalty interests and I have taken the deduction every year for a decade without any problem with IRS.