Plan for Gas Taxes to Save Money

Written by Michael Jacobson, Penn State School of Forest Resources
Penn State Cooperative Extension

Leasing land for natural gas extraction has many tax implications for the landowner. While there is no substitute for sound financial planning and advice, this article provides a few tips and explanations about tax implications of leasing.

The development of the Marcellus Shale brings the potential for significant wealth for landowners. A downside is dealing with taxes. Everyone is currently debating the severance tax on Marcellus shale production, but there are other taxes such as income, property, and estate taxes affecting those leasing or operating gas wells. Whether one is a Pennsylvania company becoming involved in the gas business or a landowner who just signed a lease, tax issues are probably new and complicated. It was Einstein who apparently once said “the hardest thing in the world to understand is the income tax,” but oil and gas taxation takes “hard” to a new level. There is unique terminology and special tax rules just for the oil and gas industry. Before this article loses the reader with tax jargon, it is important to note that there is no substitute for good tax advice when dealing with this new found wealth. At a minimum, the taxpayer should speak to a well-qualified financial adviser and understand what options they have for reporting gas income and expenses.

What follows are a couple quick tips that may save taxpayers money.

• Make sure the “property unit” and “economic interest” in mineral rights is well-defined. Most landowners who lease mineral rights (gas) retain a royalty interest. However, they could also have a working (or operating) interest in the gas. Typically, the gas companies are the ones with working interest and are eligible for numerous production-related deductions. Things get interesting tax-wise when interests are created from working interests (aka overriding royalties) or when working interests are transferred to another gas company. Questions may arise about whether these transactions are subleases or sales. Leases, subleases, or sales of mineral rights have vastly different tax implications for how cash received is treated.

• Another tip is that owners with an economic interest in the gas are eligible for a depletion deduction on income earned from production. How many landowners (lessors) know about this depletion deduction? There is both a cost and percentage depletion in oil and gas. What is unique to the oil and gas industry is that percentage depletion is not dependent on having a cost basis. Therefore, it is essentially a tax-free return on capital consumed in producing gas since there is no expenditure tied to it. However, as mentioned above, it is complex and not as straightforward as it sounds. There are limitations that the taxpayer needs to be aware of especially if they in the business of gas production.

Landowners who have a royalty interest need to consider their taxable income now and in the future. This may require additional tax and even estate planning to shelter some of the immediate tax burden. Before jumping into leases it is wise to think ahead about all the tax implications of those leases. Penn State extension has some materials on gas taxation and is offering workshops this Fall– visit http://extension.psu.edu/naturalgas or http://sfr.psu.edu/ for more information.