Drilling lease signing is long-term, life-changing financial and land use deal

By Peter H. Milliken



Signing an oil and gas drilling lease or selling one’s mineral rights is a life-changing event that could affect a landowner for many decades, and it calls for an immediate and thorough approach to tax and financial planning, according to a supervisor with a prominent local accounting firm.

An IRS spokeswoman also emphasized the importance of immediately setting enough money aside to pay taxes on large, lump-sum, initial-lease signing bonuses.

“This isn’t just a casual lease you’re entering into. This is something that’s going to encumber your land for potentially decades, and there are significant dollars involved,” said Benjamin DiGirolamo, a lawyer and certified public accountant with the Hill, Barth & King LLC accounting firm’s Boardman office.

Before signing any lease or sale agreement, a landowner should take to a knowledgeable oil and gas lawyer an unsigned copy of any agreement proposed by a drilling company to ascertain whether its terms are favorable to the landowner and be prepared to negotiate with the drilling company any desired changes in the contract, DiGirolamo advised.

Besides financial compensation issues, drilling-pad location and cleanup after drilling are matters the contract can address, he said.

As soon as possible, the landowner also should get advice from a certified public accountant concerning the tax consequences of any signing bonuses and of future monthly or quarterly royalty income from a producing well, he said. Signing bonuses could be as high as $5,000 an acre, he added.

“This can be a considerable amount of money. So it’s not a simple tax matter like you can sit down and do your 1040EZ,” said Jennifer Jenkins, a Columbus-based IRS public information officer.

“It’s usually a pretty good idea for someone who’s getting a large amount of money, and they’re not really sure what to do with it, to talk to a tax professional — a CPA or tax attorney,” Jenkins said.

“Your share of the royalty could far surpass any upfront money that you get under a lease,” DiGirolamo said. “We’ve seen folks, within the first year or two of production, receive in royalties double what they had received in an upfront amount of money.”

Any free gas the landowner gets from the drilling is not taxable, DiGirolamo and Jenkins noted.

DiGirolamo advised consulting as soon as possible with an investment adviser concerning long-term planning for the investment and use of oil and gas income, including such things as tax-deferred retirement accounts, estate planning and tax-deductible charitable donations.

Immediately after receiving a lease signing bonus, the landowner should plan for the possibility of having to pay income tax on it to the IRS during the quarter in which the bonus was paid, DiGirolamo said. Waiting until the following April 15 may subject the landowner to penalties, he said.

The IRS taxes lease bonus and royalty income at the same rates as wages.

Income from sale of mineral rights would be taxed at lower capital-gains rates, DiGirolamo said. A seller of mineral rights forgoes royalty payments, he added.

The landowner also must expect to pay state income tax and, possibly, state commercial activities tax, on the oil and gas drilling income.

Depending on his or her tax situation, it would be prudent for a landowner to save between one-third and one-half of the initial signing bonus for payment of federal and state taxes, depending on advice from a CPA, DiGirolamo said.

In its “fiscal cliff” legislation, Congress raised the top federal income-tax rate from 35 percent last year to 39.6 percent this year, Jenkins noted.

“Be prepared to pay. Whatever your tax rate is, set aside that amount of money from the payment that you receive,” Jenkins added.

The drilling company will send the landowner a copy of the 1099 form the drilling company legally must send annually to the IRS and Ohio Department of Taxation concerning payments from the drilling company to the landowner, but drilling companies don’t withhold any taxes from payments to landowners, DiGirolamo said.

Both Jenkins and DiGirolamo said they are aware of cases where landowners failed to save enough to timely pay taxes on their signing bonuses.

“There have been instances where a taxpayer has been surprised, and somewhat chagrined, to find out that they have more of a tax bill due than what they anticipated,” Jenkins said. “A number of those individuals have run into difficulty with paying the tax bill,” she added.

Jenkins said the IRS may allow them to pay their taxes according to an installment plan, but she noted the IRS charges fees for installment arrangements, and such arrangements are entered into at the discretion of the IRS.

“The individual facts and circumstances of the taxpayer’s situation are going to dictate whether or not an installment agreement is going to work,” Jenkins concluded.

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