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Third Circuit Denies Capital Gain Treatment of Oil and Gas Lease Bonus Payments.

(Parker Tax Publishing January 20, 2015)

The Third Circuit affirmed the Tax Court's determination that a bonus payment made under an oil and gas agreement was taxable as ordinary income because the agreement was a lease and not a sale of taxpayers' rights in their land. Dudek v. Comm'r, 2014 PTC 603 (3rd Cir. 2014).

Background

Michael Dudek, a CPA and attorney licensed to practice in Pennsylvania, and his wife, Brenda, purchased acreage that was subject to oil and gas leases with Ohio Lease Development Co. between 1996 and 1998. The Dudeks entered into an oil and gas lease agreement with EOG Resources, Inc. in 2008, under which EOG could develop the couple's acreage and drill for, extract, and sell any gas and oil discovered on the property, and the couple would receive royalty payments equal to 16 percent of the net profits of any oil and gas extracted.

Pursuant to the terms of the agreement, the Dudeks received a bonus payment of $883,250.00 in 2008, which they reported as a long-term capital gain on their 2008 tax return. The payment was not dependent on any extraction or production of oil or gas. In 2013, the IRS issued a notice of deficiency, claiming the bonus payment should be treated as ordinary income. Michael and Brenda argued that the agreement was not a lease; rather, it was, in substance, a sale of their rights to any oil and gas on the property that generated capital gains, and filed a suit in the Tax Court.

Before the Tax Court, the Dudeks argued that if the court determined that the bonus payment was ordinary income, then they were entitled to a percentage depletion deduction of approximately $130,000. The Tax Court disagreed, and held that the agreement between the Dudeks and EOG was a lease and the bonus payment to the couple was taxable as ordinary income. Additionally, the Tax Court held the bonus payment was not eligible for percentage depletion because the payment did not relate to the extraction or production of oil and gas.

Appeal and Analysis

On appeal, the Dudeks continued to assert the agreement was a sale, not a lease, and therefore the bonus payment should be treated as a long-term capital gain. The IRS maintained the agreement was a lease and therefore the bonus payment was ordinary income.

Where the owner of land retains an economic interest in oil and gas deposits, the transaction is regarded as a lease and the proceeds are taxable as ordinary income (Laudenslager v. Comm'r, 305 F.2d 686 (3d Cir. 1962). A lessor has an economic interest if, by virtue of the leasing transaction, he has retained a right to share in the oil produced (Palmer v. Bender, 287 U.S. 551 (1933)).

The Circuit Court affirmed the Tax Court decision, ruling that the bonus payment was ordinary income. Adopting the Tax Court's reasoning, the Circuit Court relied on Laudenslager, which held that bonus payments for mineral deposits obtained where the owner retained an economic interest in the mineral deposits was regarded as a lease, and the proceeds were taxable as ordinary income. Under the oil and gas agreement, the Dudeks were entitled to royalty payments equal to a percentage of the net profits of any oil or gas extracted from the property. The court stated this royalty interest was an economic interest, because the Dudeks retained the right to share in the proceeds of any oil or gas extracted from the property.

The court noted the agreement could not be a sale as it did not provide for a determinable quantity of oil and gas to be transferred to the lessee, thus failing to reflect the economic realities of a sale. The court also dryly noted that the Supreme Court long ago had held in Burnet v. Harmel, 287 U.S. 103 (1932) that bonus payments made as part of an oil and gas lease are ordinary income, not capital gains.

Consequently, the court concluded the Dudek's received the bonus payment as part of a lease and therefore the payment was ordinary income.

For more on determining whether a natural resource transaction is a sale or a lease, see Parker Tax ¶ 117,545. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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