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Income Tax Consequences of Oil and Gas Property Interests Received for Services
Kenton E. McDonald (1)
Overriding royalties or working interests in oil and gas prospects received in consideration for geological services can be structured to be nontaxable upon receipt. Under the so-called "pool-of-capital" doctrine, established in case law and recognized by the Internal Revenue Service, to be nontaxable the interest received must be (1) an economic interest (2) in the prospect to which the services are provided, and (3) the services must "directly" contribute to (4) the exploration or development of the specific prospect.
It is possible to take the position that interests in partnerships or joint ventures engaged in the business of oil and gas exploration which are received for qualified services also quality. However, the position of the Revenue Service is that such interests may not qualify for tax-free treatment, and this position is supported by some, though inconclusive, case authority.
Where interests are received in circumstances such that there is a material risk that they will not qualify for tax-free treatment, it will be important to consider carefully both the question of how to value the interest for federal tax purposes and when such interests may be reportable. These issues are related in that if an interest is deemed to be taxable and subject to either substantial restriction or risk of forfeiture upon receipt, then in the absence of a Section 83 (b) election, the interest will not be reportable in income until the restrictions or risk of forfeiture lapse, at which time the interest will be includable in income at its then fair market value. This may result in the interest first becoming reportable after the prospect in which the interest is received has been proven.
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