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METHODS TO DEFER TAXATION ON OIL AND GAS TRANSACTIONS

Author: Mark G. Godek, CPA

 Tax Partner, Plante & Moran, LLP

 1999 Walden Drive, Gaylord, Michigan 49735

 (517) 732-1000

 Web Site: www.plante-moran.com

Date: August, 1999

Nearly all entities and individuals want to defer the payment of tax on gains related to oil and gas exploration drilling or property sales. The following discussion outlines two excellent tax planning methods to defer tax that are often overlooked by practitioners.

POOL OF CAPITAL

The pool of capital doctrine is a tool that can help put together drilling projects without creating any current taxable income for the involved parties. This doctrine was first recognized by the IRS as the sharing principal in 19251 and sanctioned by the Supreme Court in Palmer v. Bender (1933). In 1941, the IRS issued G.C.M. 22730 to summarize their position on the pool of capital doctrine and a variety of other oil and gas transactions.  While these are relatively old decisions, they still represent the current IRS position and provide exploration companies opportunities to defer tax.

The concept is that each investor contributes to the 'pool of capital' necessary to extract oil & gas from the ground.  One investor contributes leases, another cash, and another provides legal services. Each contribution of assets or services increases the value of the entire interest.  So when each investor receives a working interest in exchange for assets or services, it represents a share in the growth of the pool.  No one investor's interest has been diminished by another's receipt of a working interest, but rather enhanced by that investor's contribution.  Thereby, no expense, or income, is recognized upon the transfer of the working interest (see Diagram A for an example of the pool of capital doctrine).

The IRS has allowed this non-recognition treatment provided the following criteria are met:

  • The interest must be received in return for services rendered in connection with the acquisition, exploration or development of the property.
  • The interest received must be from the same oil and gas property to which the services relate.
  • The property interest must not be received in return for the satisfaction of any liability other than that created by the contract for the assignment of the interest in the property.

As one would expect, the Internal Revenue Service interpretation of this doctrine is more narrow than that of taxpayers. The IRS has disallowed this treatment for a variety of reasons.2

LIKE-KIND EXCHANGES

Another method that can be used to defer tax is the like-kind exchange.  Per IRC 1031(a)(1), No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

A corporation owns the undeveloped mineral rights for a tract a land with the FMV of $1,000,000 and cost basis of $400,000. If the corporation sells the property, it will trigger a $600,000 gain and potentially $210,000 of tax.

However, if the company uses a deferred like-kind exchange, this tax can be deferred. If the proceeds from the sale (CAUTION: see deferred like kind exchange below) are used to purchase qualified property (see discussion below) no gain is currently recognized.

If less than the full amount of the proceeds is reinvested, gain is recognized up to the gain on the original sale without proration (if only $800,000 are reinvested, a $200,000 gain would be recognized).

Deferred Like Kind Exchange:

A deferred like kind exchange is one where the parties do not simultaneously exchange assets. The method allows you to sell property to one entity and purchase like kind replacement property from a different entity.

In order to qualify for this treatment there are several requirements:

  • You may not have actual or constructive receipt of the proceeds from the sale proceeds or other proceeds until the exchange is completed. 3 A qualified escrow agent may be used to hold the sale proceeds and make distributions to purchase the replacement property.
  • You must identify the replacement property within 45 days of selling your property.
  • Replacement property must be purchased within 180 days of selling your property.

What are like kind assets?

Certain types of assets do not qualify for this nonrecognition of gain treatment (IRC 1031(a)(2)). The most common non-qualifying assets are stock in trade or other property held primarily for sale (i.e. inventory) and stocks, bonds or notes.

For assets defined as personal property by the applicable state law, the IRS is very specific regarding what qualifies as like kind.  Assets must fall in the same depreciation class (not class life) to be deemed like kind.

For assets defined as real property by the applicable state law, the rules are more general and focus more on the type of ownership.  Mineral rights could be exchanged for a building provided that both assets have the same ownership rights. For oil & gas asset this question generally focuses on duration of ownership. If the rights are limited by duration of time or quantity of production, they will not qualify for non recognition treatment if exchanged for property without such limitations.  A lease with 30 years or more to run (or renewal options that could extend the lease for 30 years) is considered to be of like kind to a fee interest in real property.

CAUTION: If the property being disposed has been subject to depreciation, depletion or amortization (intangible drilling cost expense), there are recapture rules that should be closely reviewed before proceeding with a transaction of this nature.

SUMMARY:

The Federal and state income tax on drilling and sale transactions can be deferred via reinvestment.  Please consider these ideas and begin your planning well in advance of large transactions.

 

 

1SM 3322, IV-1 CB 112.

2Revenue Ruling 83-46, Revenue Ruling 77-176, LTR 8520004, LTR 8146006.

3U.S. Treasury Regulation 1.1031(k)-1(g) provides four safe harbors to avoid constructive receipt

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