By Chris Zoller, Chris Bruynis & David Marrison, OSU Extension Educators & Peggy Hall, Extension Specialist, Agricultural Law
The leasing of land for oil and gas drilling throughout eastern Ohio has provided landowners with substantial revenue. OSU Extension has received many calls from landowners asking how they can avoid paying taxes on these payments. The quick answer is that there are very few ways to avoid paying taxes on lease bonus payments or royalty income. Oil and gas revenue payments are classified as Miscellaneous Income and are subject to both federal income and Ohio taxes (and should be reported appropriately).
Taxation on Lease Bonus Payments: Cash payments received by the landowner prior to drilling, commonly referred to as lease bonus payments (typically paid on a per acre basis) are considered ordinary income for tax reporting purposes and are subject to ordinary income taxes. These payments might be made on an annual basis each year of the lease’s primary term, or could be made as a lump-sum payment that combines all annual payments into one payment made upon executing the lease. All lease payments are reported to landowners on IRS form 1099 MISC, Box 1, Rents. Lease payments must also be reported on page 1 of Schedule E, Supplemental Income and Loss. This amount then flows to line 17 of IRS Form 1040 and is not subject to any self-employment tax. Some oil and gas lease agreements will refer to a Delay Rental Payment. This payment will be made to the landowner to allow the developer additional time to begin drilling activities . These payments are also considered ordinary income.
Taxation on Royalty Payments: If drilling results in a producing well, you will receive periodic payments for your share of the production in accordance with the terms of the lease. This is known as royalty income , which will continue over the productive life of the drilling unit Royalty payments are ordinary income reportable on Schedule E (Form 1040) for an individual taxpayer. The royalty payments are reported in Box 2 of Form 1099MISC. Royalty payments are not subject to self-employment tax and are reported on Schedule E (Form 1040). Royalty payments are reduced by allowable depletion and other related expenses (if any) to arrive at ordinary income to the landowner.
How Much Will I Owe in Taxes for my Lease Bonus Payments? The answer to this depends upon your tax bracket. These payments are added to other income you receive to determine your tax bracket. Currently, the highest federal income tax bracket is 35%, for those with an adjusted gross income (AGI) of $379,150 or higher. The highestOhio income tax bracket is 5.925%, for those withOhio taxable income over $204,200. When combined, these two equal 40.925%. However, your actual taxable income will probably be lower because of how the tax is calculated. Your income tax is calculated separately for each tax bracket you pass through on the way to the 35% rate. As a general rule, landowners should set aside 35% of the income received to account for their tax liability.
How Can I Avoid these Taxes? Making management decisions to minimize taxes is appropriate. Evading the taxes due is not a wise management decision and is illegal. There are some expenses landowners may incur as a result of negotiations or production that may be deducted to help reduce the tax burden. For instance, in many cases, an attorney is hired to assist in negotiations. Payments associated with lease negotiation made to the attorney can be deducted. This expense is reported on Form 1099 MISC,Box 14, Gross Proceeds Paid to an Attorney.
Because the oil & gas payments are reported on Schedule E there are very few ways to “minimize” the taxable portion of the lease and royalty payments. However, landowners and farmers should look for ways to reduce their taxable income from Schedule C (small business), and Schedule F (farms). Many strategies are used by businesses to reduce their taxable income through these Schedules (such as prepaid expenses, Section 179 expensing or Special Bonus Depreciation). Taxpayers should also examine ways to maximize their 1040 deductions through contributions such as retirement plans and charitable giving. Landowners who have an operating interest in the production of oil and gas (which are very few) can deduct intangible drilling and development costs, operating expenses, production taxes, and depletion expenses.
Conclusions: For landowners who lease their oil and gas rights there is the potential for significant income. While a landowner can’t avoid paying taxes on oil and gas income, the landowner can use strategies to manage the taxes. To do so, a landowner should seek the assistance of a qualified attorney and accountant before, during and after the negotiations to fully understand and utilize all available tax management strategies.