What is a working interest
First, let’s take a very high-level look at how a typical investment in an oil and gas partnership
works. The income from an oil and gas property
is usually divided between the mineral interest owner (the royalty owner) and the operator (the working interest owner). In a typical lease arrangement, this usually results in the royalty owner retaining 12.5% and the working interest owner owning an 87.5% interest. In general, the normal working interest consists of the remaining share of production or income after the royalty interest's share is satisfied. The working interest is subject to all of the costs of exploring for, developing, and producing the minerals. The holder of the working interest can retain ownership throughout the life of the lease or assign all or part of the interest during the term of the lease.
The royalty owner incurs none of the cost to explore, develop, or operate the mineral production. These costs are borne by the working interest owner. This is where the investor comes into play. In order to fund the exploration, development, or operations, the working interest owner transfers various interests in the property to the investor in exchange for their capital.
So what is so great about the working interest investment?
As the operator begins the exploration and development of the property, these costs are allocated to the investor. In the beginning, these are geological survey costs, well equipment (also called tangible costs), and intangible drilling (IDC) costs which, for tax
purposes, are allowed to be deducted rather than capitalized. The partnership passes these IDCs through separately to the investors on the K1. In the early years, these investments create large losses. Normally these passive activity losses would only be deductible to the extent that the investor has passive income. Most investors find themselves with large passive losses that they cannot deduct. But if you own a working interest in any oil or gas property, either directly or through an entity that doesn't limit the taxpayer's liability
with respect to the interest, it is non-passive activity, regardless of the taxpayer's participation. What a great deal for the taxpayer! For you CPAs looking for the specific reference to this, see Reg § 1.469-1T(e)(4)(i) and watch this short video about the benefits
of this investment here.
Technical Side Note
Under Reg § 1.469-1(e)(4)(iv), for these purposes, a working interest in oil or gas property is defined by reference to the depletion rules
. These rules cover "minerals in place," including ores of metals, coal, oil, gas, and all other natural metallic and nonmetallic deposits. So, where taxpayer's activity is the production of fuel from landfill, a man-made non-conventional source, it doesn't qualify as a working interest in oil and gas property. Landfill gas is derived from the biodegradation of municipal solid waste, i.e., not from minerals (oil and gas).
What Limits a Taxpayer’s Liability?
This one is fairly easy. For the purposes of this rule, an entity limits the liability of the taxpayer for purposes of this rule if the interest in the entity is in the form
1. a limited partnership interest in a partnership in which the taxpayer isn't a general partner;
2. stock in a corporation; or
3. an interest in any other entity that, under applicable state law
, limits the potential liability of the holder of an interest for all obligations to a determinable fixed amount - generally this would be an LLC
or similar entity type.
An important note is that there are arrangements that can be put into place that do not violate this rule. Some of these arrangements are:
• an indemnification agreement
• a stop loss arrangement
• a similar arrangement or combination of the above arrangements
For example, let’s say that Joe owns a 20% interest as a general partner in the capital and profits of Top Oil and Gas, LP, a partnership which owns oil or gas working interests. The other partners of Top Oil have agreed to indemnify Joe against liability in excess of Joe’s capital contribution
for any of Top Oil's costs and expenses with respect to Joe's working interests. As a general partner, however, Joe is jointly and severally liable for all of Top Oil's liabilities. The indemnification agreement isn't taken into account in determining whether Joe holds the working interest through an entity that limits his liability. As a result, the partnership doesn't limit Joe's liability with respect to the drilling or operation of wells under the working interests; Joe is therefore considered non-passive with respect to his investment in Top Oil and can deduct IDCs passed through to him against his other non-passive (or earned) income. This video explains how to set your investment up correctly.
What if you own a limited and general partnership interest?
This is great for you also. If you are both a general and a limited partner in a partnership that owns a working interest, your entire interest in each well drilled under the working interest is treated as an interest in a non-passive activity, whether or not you materially participate.
So, assuming from the example above that Joe and his wife Amy each owned a 1% general partnership interest and a 5% limited partnership interest in a partnership and were jointly and severally liable for the partnership's activities, the partnership's oil and gas working interests will be non-passive activities
However, let’s take the same facts from the example above, except that Joe owns a 20% limited partnership interest in Top Oil. As a limited partner, Joe’s liability with respect to his investment in Top Oil is limited and, therefore, he is considered a passive investor. As such, any losses passed through to him by the partnership could only be deducted to the extent of other passive income he might have. Here is the important part – if he has no other passive income to offset his passive losses, the passive losses are suspended and carry forward to future tax years
until he has passive income to offset or he disposes of his investment in the partnership.