Locally based CPA firm since 1956

The exploration of the Eagle Ford shale has meant big bonuses and royalties to land owners in South Texas. While royalty income will vary with the production of the wells drilled, the lease bonus will be paid up front for the “right to look.” This payment is normally received within ninety days of signing the lease.  It will normally be paid in a lump sum amount, and is not dependent on any extraction or production of any oil or gas.

Pursuant to a Supreme Court Ruling (Anderson vs. Commissioner), bonus payments are treated as advance royalties.  Therefore, these payments are taxed as ordinary income to the landowner.  These payments are generally taxed in the year received by the taxpayer.  Percentage depletion is not available with respect to any lease bonus, advance royalty or other amount payable without regard to the production.

More recently in the Tax Court Case of Dudek Petitioners vs. Commissioner of Internal Revenue, Respondent, the Petitioners argued that a bonus payment they received as an inducement to enter into a lease agreement should be taxed as a long-term capital gain.   The Internal Revenue Service (IRS) argued that the bonus payment constitutes ordinary income.  The Petitioners attempted to argue that the Agreement was not a lease, but a sale of their rights to any oil and gas on the property.

The Tax Court determined that the Petitioners retained a royalty interest in the natural resources because they were to receive royalty payments on a percentage of the income from any gas or oil extracted from the property.  It was determined they still had an economic interest in the oil and gas in place.  Thus the Agreement was regarded as a lease by the Tax Court.

The Tax Court also determined that the Agreement does not reflect the economic realities of a sale.  A sale would be evidenced by an exchange of a determinable quantity of oil and gas for a determinable price.  The Agreement provided for no definite quantities of transferrable oil and gas.  Therefore it was determined this was not a sale.

The Tax Court found that the Agreement was a lease and that the bonus payment is taxable as ordinary income, not capital gain.