WV Farm Bureau Magazine July 2013 | Page 11

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 ́