Oil- and gas-related activities must be reported for both federal and state income tax. The most common types of oil and gas interests are royalty interest and working interest. The royalty interest entitles the taxpayer to receive a royalty from any oil and gas production. Moreover, the royalty interest participates in the production revenue without incurring an obligation to pay the costs of developing and operating the interest. The working interest generally bears all costs of developing and operating the property, and fully participates in the revenues of the wells. Working interest is considered a trade or business.
Let’s look at the reporting by individuals on Form 1040 for various type of payments and expenses.
Lease and lease bonus
The extraction of oil and gas involves lease and lease bonus payments paid to the landowner. These payments can be lump-sum or multi-year payments.
For royalty owners, the lease bonus and lease payments are generally reported on Form 1099-MISC, Box 1, Rents. This amount should be reported as income on Schedule E, page 1, as Rents Received.Any expenses related to the leases can also be deducted on Schedule E, page 1, including attorney and accountant fees. Royalty owners receiving lease payments are not subject to the self-employment tax.
For working interest owners, the lease bonus and lease payments are reported on Form 1099-NEC, Box 1, Nonemployee Compensation. This amount should report this income on Schedule C, Gross Receipts and Sales. This income is subject to self-employment tax on Schedule SE.
Royalty payments
Royalty income is reported on Form 1099-MISC, Box 2, Royalties. The oil and gas company will generally also report related expenses, including production tax and other revenue deductions. The person will continue to receive these royalty payments while the well is still producing. This should be reported on Schedule E, page 1, as Royalties Received. The production tax and other revenue deductions on the Form 1099-MISC along with other expenses you incur, including property tax, legal, and tax preparation should be shown on the Schedule E under Expenses.Depletion is another expense you should take that is normally 15 percent of the net income amount is also reported on Schedule E, line 18. This income is not subject to self-employment income.
Overriding royalty interest (ORRI) is an interest carved out of the working interest which does not require the owner to bear a share of the developing or operating cost. It exists only for a stipulated time, but never longer than the life of the working interest. This type of royalty is not subject to self-employment income.
The royalty and lease payments for those that hold royalty interest are considered passive income that make them subject to the Net Investment Income surtax of 3.8 percent of the net amount. This would be reported on Form 8960, Line 4.
Working interest
The working interest would be reported on a Schedule C for the gross receipts, expenses and depletion. The taxpayer will receive the gross receipts (including lease and bonus payments) on Form 1099-NEC, Box 1, Nonemployee Compensation. This will be reported on Schedule C, along with the expenses directly related and indirectly related. These include overhead, dry hole, legal and administrative, taxes, and other operating expenses.
While working interest would not be subject to the Net Investment Income surtax, it would be subject to the self-employment tax (Social Security and Medicare) reported on Schedule SE.
Depletion
Both royalty and working interests may use one of two types of depletion, cost and percentage, to determine which method yields the greater depletion deduction. For primary oil and gas, the percentage method is limited to the lesser of 15 percent of the taxable income from the property, or 65 percent from taxable income from all sources. The depletion should be reported on the Schedule E for royalty interest, and on Schedule C for working interest as an expense.Cost depletion is generally the amount reported to the taxpayer by the producer. It is calculated by using the formula:[Current units sold divided by (current units sold + ending reserves)] multiplied by tax basis for depletion before current depletion.
State income and tax withholding
Most states now require oil and gas producers to report the income on the Form 1099, Box 18, along with any state tax withheld, Box 16. The required state tax withholding varies by state with percentages ranging from from 1% to 3% of gross amount reported on the Form 1099. Filing a state tax return to report that income can result in a refund of the state tax withheld or an additional amount due.
Editor’s note: This article originally published on Aug. 16, 2015, and was updated with additional content on April 13, 2020, April 14, 2022, and May 3, 2023.
