The Surprising Tax Implications of Overriding Royalty Interests

August 20, 2021 Paige Buxton Graham

ORRI

An overriding royalty interest (ORRI) is a unique oil and gas economic interest which, at times, takes on the characteristics of both working interests and royalty interests. The ORRI is “carved out” of the operator’s working interest and is a fractional, undivided interest in the proceeds from the sale of oil and gas produced from a tract (or tracts) and expires once the lease has expired and production has stopped. Unlike working interests and royalty interests, ORRIs are not connected to an ownership of minerals under the ground but derive from the ownership of a portion of generated revenues.

An ORRI can be created through many means but is commonly created in one of three manners:

1) assignment or transfer of a lease;

2) assigned to a party who assisted in acquiring or developing a lease as a form of compensation; or

3) a means of raising capital. The tax treatments amongst these methods can vary greatly.

Many taxpayers who assign or transfer a lease are surprised at the tax treatment of the income received. When operators assign a working interest lease to a new operator for consideration and the retention of the ORRI this is often thought by the taxpayer to be a sale; but, for tax purposes, this acts as a sub-lease and not a sale. Because this is not a sale, the assignor does not get to immediately offset the income received by any leasehold costs paid and these costs would, instead, be ported over to be leasehold costs of the ORRI and would not be deductible until the ORRI is sold or expired. Also in a sale, the seller would typically be able to characterize a portion of the taxable income as long-term capital gains, which are taxed at a more favorable rate than ordinary income. Lease bonus income is taxed as ordinary income and, because it’s considered a bonus, is not eligible for federal depletion. The good news is any income received as payments of the fractional interest of production is eligible for depletion using either the cost or percentage depletion method.

Taxpayers can also be taken by surprise when ORRI is being subject to self-employment taxes. Non-operated interests are GENERALLY considered passive income and are not subject to self-employment taxes; however, there are instances when these payments are subject to self-employment tax. When a non-operated interest is obtained as a result of personal services and the value is not taxed when received (i.e. – reported on a W-2 or a 1099 to be reported on the taxpayer’s income tax return), self-employment tax would be applicable to all ORRI income received. The IRS has also held that income from ORRI where retained by taxpayers in connection with their operation of an oil and gas exploration and production company that constitutes a trade or business is subject to self-employment tax.

ORRI obtained as a means of raising capital would be taxed in the same manner royalty interests are taxed. The royalty payments would be taxed as ordinary income, subject to the passive activity rules; and, if held for one year or more, the sale or disposition of these interests would be taxed as capital gain or loss.


HoganTaylor's Energy Practice

If you would like more information about the Marginal Well Tax Credit and how it could potentially benefit your  business, please contact the author of this article, Paige Buxton Graham, at pgraham@hogantaylor.com, Energy Practice Lead, Jeff Koweno, at jkoweno@hogantaylor.com, or any other member of the HoganTaylor Energy practice.

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.

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