Appellate Court Affirms Bonus Payments as Ordinary Income

Posted on Thu, Jul 16, 2015 ©2021 Drucker & Scaccetti

The Court of Appeals for the Third Circuit has held that an over $800,000 bonus payment taxpayers received under an oil and gas agreement was taxable as ordinary income and not as capital gain as the recipients had reported. 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.  When an owner of the land retains an economic interest in the deposits, the transaction is regarded as a lease.


The Case

Michael and Brenda Dudek owned approximately 353.3 acres in Pennsylvania.  In 2008, the Dudeks entered into a five-year lease agreement with EOG Resources, Inc., in connection with the property.  Under the terms of the agreement, EOG could develop, extract, and sell any gas or oil discovered on the property. EOG bore the entire cost of exploration, development, and operation of the property. In return, the Dudeks were entitled to a royalty payment equal to 16% of the net profits of any oil and gas extracted from the property.


The primary term of the agreement was five years and also provided that the term could be extended with an extension payment of $2,500 per acre.  In 2008, the Dudeks entered into the agreement and received a payment of $883,250.  The payment was not dependent on any extraction or production of oil or gas.  The Dudeks received a Form 1099-MISC for the same amount and reported the $883,250 as a long-term capital gain on their 2008 return.


In 2012, the IRS issued a notice of deficiency for 2008 to the Dudeks. They timely filed a Tax Court petition disputing the determinations in the notice of deficiency.  The Dudeks argued that the agreement was not a lease but was in substance a sale of their rights to any oil and gas on the property.


The Ruling

The Tax Court found that the agreement was a lease because it bestowed on them the right to share in the proceeds of any oil and gas extracted from the property.  Furthermore, the agreement did not reflect the economic realities of a sale, which would be evidenced by an exchange of a determinable quantity of oil and gas for a determinable price. Accordingly, the Tax Court held that the $883,250 bonus payment was taxable as ordinary income, not capital gain.


The Dudeks continued to argue that the agreement should be treated as a sale, not a lease.  Upon appeal, the Third Circuit noted that the Supreme Court long ago determined that bonus payments made as part of an oil and gas lease are ordinary income, not capital gains.   The Third Circuit affirmed the Tax Court conclusion that, because the Dudeks clearly retained an economic interest in the property, the agreement was, in fact, a lease.


Tax Warrior Perspective

With the rise of fracking for natural gas resources, particularly in Pennsylvania, agreements of this type are becoming more common between energy companies and private land owners. Like any agreement involving your property, you should have the appropriate professional(s) review it before signing.  You should be sure to consult with a tax professional to determine the tax impact of the agreement, and if there is more favorable language that can be included or a different transaction structure which may make the transaction more tax efficient.


For 25 years, The Tax Warriors® at Drucker &Scaccetti have helped clients understand the tax impact of a wide variety of agreements.  We can help you determine tax advantages or traps before you sign on the proverbial dotted line.  Call on us for all your tax needs related to real estate holdings.

Topics: real estate, Capital Gain, Tax, royalty, Bonus Payments, lease agreement

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