A decision from the United States Tax Court in December 2013 has interesting implications for Texas oil and gas leases and Texas mineral owners. In Dudek v. Commissioner, the Tax Court examined the characterization of lease bonus and whether bonus is eligible for depletion allowance.
The Dudek decision dealt with three main issues: 1) whether the bonus payment received by the taxpayer pursuant to an oil and gas lease is taxable as ordinary income or as a capital gain; 2) whether the taxpayer is entitled to a depletion deduction; and 3) whether the taxpayer is liable for an accuracy-related penalty under section 6662(a) for a substantial understatement of income tax.
Michael Dudek, the taxpayer and the petitioner in this case, is a certified public accountant and an attorney licensed to practice law in Pennsylvania. In 1996 and 1998, Dudek and his wife, Brenda, bought a total of 353 acres of land. The Dudeks leased the oil and gas rights to EOG Resources Inc., receiving a 16% royalty and a bonus of over $883,000. As many of you know, bonus is consideration for the primary term of the lease and is not contingent on any extraction or production of oil or gas. The Dudeks reported the lease bonus as a long term capital gain on their income tax return.
The Tax Court found that “the receipt of a bonus payment by a lessor pursuant to an oil and gas lease is taxable as ordinary income, not as gain from the sale of capital assets.” The Court cited the U.S. Supreme Court in Burnet v. Harmel, a case from 1932. The Tax Court found that the arrangement was a lease, because the Dudeks retain an economic interest in the property due to the royalty payments as a share of the oil and gas produced. Therefore the bonus was taxable income, not capital gain.
Having lost on the first issue, the Dudeks also argued that even if bonus is ordinary income, they were still entitled to a depletion deduction of $132,488. Section 611(a) of the Tax Code provides that a reasonable allowance for depletion is to be allowed in computing the taxable income derived from oil and gas wells. However, Section 613A(d)(5) provides that percentage depletion for income from oil and gas wells does not apply to “any lease bonus, advance royalty, or other amount payable without regard to production from property.” Since the Dudeks’ bonus was not related to extraction or production of oil or gas, they were not entitled to a percentage depletion. Cost depletion is calculated from the taxpayer’s basis for depletion, the amount of the bonus payment, and the royalties the taxpayer expects to receive. In this case, no evidence was presented on the amount of royalties the Dudeks expected to receive, therefore they were not eligible for cost depletion either.
On the last question, whether the Dudeks were liable for the understatement of their federal taxes, the Tax Court found that lack of knowledge on the specific requirement of the tax laws was not a defense. The Dudeks were assessed an accuracy-related penalty.
One of the problems I have with this case is that oil and gas leases, despite their title, are not leases. Instead, they are the simple determinable deeds. While the mineral owner retains a reversionary interest, an oil and gas lease is actually a sale. The bonus is compensation for that sale. Since an oil and gas lease is a sale, it is logical for bonus to be treated as a capital gain. I don’t pretend to be a tax attorney, but this outcome seems to be at odds with the reality of an oil and gas lease in Texas. Also note that Internal Revenue Code Section 7463(b) provides that summary opinions like the one in this case may not be treated as precedent for any other case.