Income Tax 101:
The Basics for Marcellus Shale Owners
Marc A. Monteleone and Emily R. Lambright
A
s promised in our last
article, “Estate Tax
101: “The Basics” for Marcellus
Shale Owners,” published in the
May edition of the Farm Bureau
News, this article provides new
information to Marcellus gas
owners on how to reduce the
income tax burden when they are
contacted to lease their Marcellus
gas rights.
The thought of being able to
lease gas rights for substantial
sums of money is both exciting
and a little scary, particularly when
gas owners start thinking what
that lease might mean on their tax
returns. The Internal Revenue
Service has made it clear that the
lease of gas rights will lead to
taxable income, but how much
and what type of income depends
upon the way you structure the
transaction. It can be a challenge
trying to translate what that
agreement says into actual dollars
and cents, but understanding
how that income is taxed is
important because, in the right
circumstances, gas owners can
save themselves substantial tax
dollars.
The first step is to know what
gas “terms” mean, in relation to
income taxes. For example, gas
owners who lease their rights
receive payments of cash called
royalties. There are lease bonuses
(which are normally one-time, upfront payments based on a per acre
price), operating royalties (which
are paid by the drilling company
once the gas well is in production),
advance royalties (amounts
paid in anticipation of more
future royalties), and minimum
royalties (smallest amount of
royalties payable under the lease
agreement). There are various
other terms associated with the
royalties, such as delay rentals,
production payments and the like.
All of those terms are usually
contained in a lease agreement,
which is the most common type
of agreement between a gas
owner and a production company.
The agreement will set out the
percentage of royalty that the
owner can expect to receive for
his or her gas rights. This lease
royalty is taxed by the IRS as
“ordinary income.” Ordinary
income is the most common
type of income. It is what most
people think of when they hear
income. It includes income from
employment wages, salaries, tips,
rent, and the like. The other type
of income commonly talked about
is a capital gain, which happens
when someone sells a capital asset,
like a home or land or a share in a
business.
Why does it matter whether
payments are considered ordinary
income or a capital gain? The
main reason is that ordinary
income is currently taxed at a
higher rate than capital gains. The
highest tax bracket for ordinary
income in 2013 is 39.6% and the
highest bracket for long-term (held
for more than a year) capital gains
is 20% So what, you ask? Well,
ordinary income costs more in
taxes than capital gains does. For
example, say Bob has ordinary
income of $500,000 and Tom has
capital gains of $500,000. Bob’s
tax bill is $198,000 and Tom’s
tax bill is only $100,000. Tom is
paying $98,000 less in tax, simply
because his income is treated as a
long-term capital gain.
Ga ́