As property owners who have successfully negotiated an oil and gas lease receive the welcome bonus check, it is only natural to want to avoid paying taxes to the extent legally possible.
The tax impact of a bonus payment will depend on the facts and circumstances of the individual lessor. Each lessor should seek good tax advice. Payments to an oil and gas lessor can be subject to unique rules and benefits, and a qualified advisor needs to know them.
Lessors sometimes want to spread the bonus payment over more than one year in order to lower the tax bite. Some suggest setting up installment plans or adjust lease wording to allow this.
This will probably not work, and could result in very bad financial consequences for the lessor.
Most oil and gas leases are leases (obviously) and not sales of property in a legal sense. In a mineral lease, the lessor usually reserves some portion of a non-operating interest leased to the lessee, in the form of a royalty.
The bonus payment is generally an incentive paid to a lessor for entering the lease, which is not tied to production from the property. It is ordinary income that is actually or constructively received by the lessor near the commencement of the lease.
There is practically no way to receive the bonus, but defer paying tax on it. And if a bonus or other lease payment is only conditionally promised and not received, or is tied to future production from the leased interests, there is clear risk that it will not be paid.
A sale, by contrast, generally involves the transfer without retaining any economic interest such as a royalty, which is based upon oil or gas production. Installment sale treatment (obviously) applies to a sale, and does not work for a lease.
It is possible for a landowner to sell all its land including mineral rights, or to sell just the minerals to a drilling company. Such a sale might qualify for installment treatment. But a lease generally will not.
Should a lessor unwittingly enter an agreement with an annuity company or some other scheme to apply installment payment procedures to a lease bonus payment, it is possible that the lessor could be taxed on the full bonus amount, but only receive part of it due to the installment arrangement.
The moral of this, to repeat: Seek qualified counsel before agreeing to any device that is represented as a way to avoid payment of taxes on payments from an oil and gas lease.
Alan D. Wenger is an attorney in Youngstown, Ohio. His practice areas include oil and gas law, public utilities law, labor and employment law, land use law, environmental law, construction law and school law.