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Oil and gas royalty reporting.

Cost depletion computation The cost depletion computation for oil and royalty and working revenues must reflect prospective reserves. Regs. Sec. 1.611-2(c)(1) requires a denominator of recoverable units (barrels for oil or thousands of cubic feet (MCF) for gas) reasonably known or believed to have existed in place as of the date of acquisition for date of death for a decedent's estate and its beneficiaries). The estimate or determination of recoverable units must be made according to the method current in the industry in light of the most accurate and reliable information available.

However, no provision is expressly made in the regulations for economically recoverable deposits. In the mid-1980s many taxpayers reduced their estimate of recoverable units when the values of oil and gas property declined and properties were no longer economically feasible to develop or operate. In similar fashion, secondary and tertiary reserves may be considered recoverable but are usually excluded from the denominator since an investment is required to start the recovery process.

A reservoir engineer is frequently employed by a decedent's estate to estimate the value of recoverable reserves over the expected life of the property. The engineer then ascribes present values to the revenue stream in future years, typically using a 15% discount factor, so that very little value is ascribed to the production in the "out years." Even so, the regulation literally appears to require that the recoverable units in barrels for oil and MCF for gas reflect all units--even though their value has been severely discounted in making the estate tax computation. In these circumstances taxable income would be more accurately reflected if an "income forecast" approach were used under which the recoverable units would be reduced to conform to the present value profile for the value determined in the decedent's estate.

Self-employment income

A self-employment income question can also arise concerning royalty income. In general, royalties are not considered self-employment income per Rev. Rul. 69-355, unless the royalty income or, in particular, overriding royalty income is part of an overall working interest syndication activity (see Letter Ruling (TAM) 8427006). The IRS concluded in Letter Ruling 8541058 that nonoperated working interests, as well as overriding royalties, could be business assets for Sec. 367 outbound rulings if the properties were being transferred to a foreign corporation. These rulings suggest that, if royalties are received on these properties as part of an overall business, the royalty income could be self-employment income. The Montana District Court in Kaufman, DC Mont, 1987, held that oil and gas lease brokerage income was not selfemployment income when the activity was casual and did not amount to a trade or business. Note: The U.S. Supreme Court decision in Engel, 464 US 206 (1984), was overruled by an amendment in the Tax Reform Act of 1986 to Sec. 613A(d)(5)to prevent percentage depletion deductions on lease bonus and advance royalty income.

From John R. Braden, CPA, Houston, Tex.
COPYRIGHT 1993 American Institute of CPA's
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Author:Braden, John R.
Publication:The Tax Adviser
Date:Jan 1, 1993
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