Bonus Payments Are Ordinary Income - Not Capital Gains

Published on: 15:22PM Dec 02, 2013

The Tax Court issued the Dudek case today concerning whether upfront bonus payments received from an agreement to allow an oil and gas company to lease property is considered ordinary income or capital gains. In the case, Mr. Dudek, a CPA (why are some CPAs more likely to go to tax court when they know they will lose is beyond me) had purchased three separate parcels of real estate totaling 353 acres during 1996-1998.

Due to the technological advancements of horizontal drilling and fracking of oil wells, these properties were suddenly more worthwhile to drill on. In 2008, EOG Resources, Inc. (which was a spin-off from Enron before it got in trouble) agreed to pay upfront a $883,250 bonus payment to lock up the property. If EOG drilled a well and it produced marketable oil, then Mr. Dudek would be entitled to a 16% royalty payment.

Mr. Dudek (again a CPA) received a form 1099 showing this payment as miscellaneous income and reported it as a capital gain and argued that this was a sale and not a lease. As you can imagine, the IRS audited his return and assessed additional tax of $147,397 and a $29,479 accuracy penalty on top of it.

I won't go into all of the reasoning by the court since the rules on these payments have been around for a long time. Rather, I just want to inform any farmers who have acreage that may end up with an upfront oil and gas payment or perhaps a wind turbine bonus payment that these payments are ordinary income, not capital gains. Mr. Dudek, being a CPA should have known this and that is why the court upheld the accuracy penalty, but not all farmers are as well informed, but they are more likely to goto a better CPA.

Mr. Dudek also argued that if the payment was ordinary income, he should be entitled to a percentage depletion deduction of 15%. The court shot this down very quickly. In order to have a percentage depletion deduction, the court stated there must be production. In this case, there was no well drilled on the property at the time of payment, therefore no percentage depletion.

In some cases if the payment is for a permanent easement, the payment maybe partially non-taxable, but that was not the case here.

I just got done reading the new book "The Frackers" and I would highly recommend it for anybody that would like to know more about how Fracking and Horizontal drilling has dramatically increased US oil and gas production. There are estimates that we will be the number one producer of oil and gas soon, if not already.