Ohio Tax. Workshop S. Explosion of Shale Gas Drilling in Ohio Mineral Rights: Sell or Lease. Tuesday, January 27, :15 p.m. to 5:15 p.m.

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1 24th Annual Tuesday & Wednesday, January 27 28, 2015 Hya Regency Columbus, Columbus, Ohio Ohio Tax Workshop S Explosion of Shale Gas Drilling in Ohio Mineral Rights: Sell or Lease Tuesday, January 27, :15 p.m. to 5:15 p.m.

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7 Biographical Information Kevin M Krantz, CPA MT, Director of Tax Services McManamon and Co, LLC 1651 Crossings Parkway, Westlake, OH Kevin@mcmanamonco.com Kevin s primary responsibility at McManamon and Co. is to deliver individual and business tax strategies to clients. He works in all areas of tax including research, compliance, planning and audit representation, cost segregation studies, and business research credits. Kevin began his career in 1986 and worked for two regional firms in the Cleveland area for 20 years before joining McManamon and Co. in He developed an expertise in advising closely held business and their owners as well strategies for high income individuals. Kevin frequently lectures around the country for the AICPA, sharing his expertise on various tax topics with other tax professionals. He received his bachelors degree in accounting and masters degree in taxation from the University of Akron. He currently serves on the alumni advisory board to the University s college of business. He is a member of the American Institute of Certified Public Accountants, and the Ohio Society of Certified Public Accountants.

8 Taxation of Conveyances of Oil and Gas Interest Summary of Issues 1. Determine if conveyance is Sublease or Sale a. Sublease Working interest assigns all or part of working interest and retains a continuing nonoperating interest GCM Rev. Rul The majority of initial offers from oil companies to land owners will meet the definition of sublease b. Sale Assigns all or part of any type of interest and retains only an identical interest Working interest assigns any kind of continuing royalty interest in the property and retains working interest Assigns any type of continuing interest and retains only a non continuing interest in production GCM 22700

9 2. Tax Implication of a lease a. Sublessor i. Ordinary income ii. Subject to cost depletion iii. Transfers basis in working interest to the royalty b. Sublessee i. Capitalize the bonus paid as an acquisition cost 3. Tax implications of a sale a. Real property used in a trade or business subject to 1231 b. Mineral Interest sold subject to 1254, including recapture c. Unless basis was established at the time of the land purchase, the mineral rights will not have basis. d. Can qualify for a 1031 like kind exchange 4. Pre-Transaction planning a. Bifurcate the working interest into a working interest and an overriding royalty. b. Sell or transfer the overriding royalty first c. In an unrelated transaction, sell the entire working interest d. Both transfers should qualify as a sale or exchange

10 Figure 3-1 (1 of 3) Tax Treatment of Payments Under an Oil and Gas Lease Type Payor or Lessee Payee or Lessor BONUS Capitalize Ordinary Income Basic consideration for executing lease. Treas. Reg. section (a)(3) Percentage deletion allowed to August 17, Only cost depl. after August 17, Treas. Reg (a)(1) INSTALLMENT BONUS Capitalize Ordinary Income Also consideration for granting a lease; advance payment for oil; each installment is usually larger than normal delay rental. DELAY RENTAL Pure rent; a payment to defer development rather than a payment for oil. Before capitalize Delay Rental consult PIP for the current position under IRC section 263A. Rev. Rul , total amount includible at time of signing lease if right to income is transferable. Generally, this treatment is the same as for lease bonus. Ordinary Income No depletion. Treas. Reg. section (C)(2) ROYALTY Deductible Ordinary Income Payment for oil or gas. See Rev. Rul when ad valorem taxes are involved. Subject to depletion (percentage or cost); percentage depletion is allowed if payee qualifies under IRC section 613A. ADVANCE ROYALTY Deductible Ordinary Income Royalty payment made before production of minerals. ADVANCED MINIMUM ROYALTY Minimum royalty payment required by contract terms. See Rev. Rul when ad valorem taxes are involved. Deductible At option of payor: (1) In year paid or accrued or (2) When oil or gas is sold or recovered. Treas. Reg. section (b)(3) Subject to cost depletion in year payments are made. Percentage depletion allowed until August 17, Ordinary Income Subject to cost depletion. Allowed percentage depletion until August 17,

11 Figure 3-1 (2 of 3) Tax Treatment of Payments Under an Oil and Gas Lease (continued) Type Payor or Lessee Payee or Lessor PRODUCTION PAYMENTS RETAINED (SALES TRANSACTION) Not an economic interest. Is treated as a mortgage. RETAINED (LEASING TRANSACTION) An economic interest. CARVED OUT AND SOLD: NOT AN ECONOMIC INTEREST Simply a loan. CARVED OUT AND SOLD: AN ECONOMIC INTEREST that is, pledged for development of property. DAMAGES BUSINESS AND GOODWILL that is, surface damages. LOSS OF PROFIT that is, crop damages. ANTICIPATED DAMAGES BUT NONE WAS DONE Amount paid based on the anticipation that damages would occur. Repayment of principal and interest expense. Capitalize, bonus paid in installments. Treas. Reg. section (a). Repayment of principal and interest expense. Capitalize as installment lease bonus. If acquired or leased, capitalize as G & G costs. If not acquired or leased, expense. If acquired or leased, capitalize as G & G costs. If not acquired or leased, expense. If acquired or leased, capitalize as G & G costs. If not acquired or leased, expense. Repayment of principal and interest income. Ordinary income. Subject to depletion (percentage or cost). Treas. Reg. section (b). Repayment of principal and interest income. Ordinary, depletable income. Return of capital to the extent of basis of the property. Amounts in excess of basis are IRC section 1231 gain. Ordinary Income. Ordinary Income. 3-16

12 TECHNICAL REFERENCES GENERAL COUNSEL MEMORANDUMS (GCM) AND COURT CASES Compensation for Services Other Than Cash Blake v. Commissioner, 20 T.C. 721 (1953) Depletion on Lease Bonus Engle v. Commissioner, 464 U.S. 206 (1984) Election to Expense IDC Hawkeye Petroleum Corp. v. Commissioner, 18 T.C. 940 (1952) Excess Depletion Tax Preference Item Hill v. United States, 113 S.Ct. 941 (1993) IDC Funds Furnished by Related Taxpayer Island Gas, Inc. v. Commissioner, 30 T.C. 787 (1958) Payments to Promoter-Operator Hedges v. Commissioner, 41 T.C. 695 (1964) Pool of Capital Concept GCM 22730, C.B. 214 Sale of Interest Subject to Capital Gains Tax Glenn v. Commissioner, 39 T.C. 427 (1962) Sand Fracturing is Production Expense, Not IDC Producers Chemical Co, v. Commissioner, 50 T.C. 940 (1968) Unitizations Killam v. Commissioner, 39 T.C. 680 (1963) Unsuccessful Lease Acquisitions Larsen v. Commissioner, 66 T.C. 478 (1976) TR-1

13 REVENUE RULINGS REVENUE RULING NO. Assignments, Sales and Exchanges Acquisition and Option Fees , CB 97 Assignment for Cash at Less Than Equipment Basis , CB 286 Fee Paid for Services Rendered , CB , CB , CB 153 Fees Paid by Investors , CB 41 Management Fee , CB 119 Natural Gas Sold After Removal From Premises Less Than Representative Market Field Price (RMFP) , CB 158 Property Sale With Zero Basis , CB 330 Sale of Interest Ordinary Income or Capital Gain , CB , CB 239 Capital Expenditures Depreciation on Well Equipment , CB 63 Drilling Cost Deductible If Arm's Length , CB 303 Drilling Cost for Injection Wells Primary Development , CB 41 Drilling Cost Incurred Outside United States , CB , CB 72 TR-2

14 REVENUE RULING NO. Drilling Cost Paid for Production Payment Twice Cost , CB 95 Drilling Cost Paid In Turnkey Agreement , CB 94 Drilling Cost With Right to Income During Payout , CB 87 Drilling Cost Partnership Allocation , CB 311 Drilling Cost Underground Storage , CB 97 Drilling Cost Taxpayer's Permanent Fractional Share , CB , CB 145 Drilling Cost 200 Percent Recoup Then Working Interest Terminates , CB 160 Drilling to Acquire an Interest , CB 70 Drilling to Acquire Site and Acreage , CB 77 Easements Underground Storage , CB 96 Geological and Geophysical Costs , CB 76 Installation of Production Facilities , CB 132 Lease Acquisition First Year Rental , CB , CB , CB 210 LPG Injected Into Oil Recovery Process , CB , CB 50 Offshore Platforms, Onshore Fabrication Cost , CB 68 Partial Release of Lease 68-78, CB 294 Prepaid Drilling Cost , CB , CB 146 TR-3

15 REVENUE RULING NO. Royalty Interest Acquired for Services , CB 16 Unrecoverable Gas Underground Storage , CB 95 Definition of Property Foreign Petroleum Deposits , CB 261 Working Interest Not Personal Holding Company Income , CB 158 Cost Depletion Allocation of Lump-Sum Payment IDC and Leasehold Costs , CB 303 Basis , CB 127 Basis for Calculating Surviving Spouse's Depletion Allowance on Community Property , CB 195 Installation Cost Classification , CB 132 Recoverable Reserves Adjustments to , CB 154 Depletion, Gross Income, Net Income Ad Valorem And Production Taxes , CB 176 Ad Valorem Taxes Paid by the Lessee , CB 177 Bonus Exclusion , CB , CB , CB 218 Carbon Dioxide , CB 95 Clifford Trust , CB 147 TR-4

16 REVENUE RULING NO. Contract to Purchase Natural Gas , CB 291 Cost Well , CB 99 Deduction of Loss , CB 112 Depreciation of Lessor's Equipment , CB 264 Foreign Tax Credit , CB 296 Gas Compression Cost , CB 178 Gas Consumed in Manufacturing Process , CB 280 Geothermal Wells , CB 181 Market or Field Price 77-33, CB 165 Net Operating Loss , CB 65 Net Profit Interest , CB 206 Nonproducing Activities , CB 332 Nonproductive Well IDC , CB 167 Oil Removed But Not Currently Sold , CB 189 Prepaid IDC , CB 225 Retailer Exclusion , CB 181 Sales Commissions , CB 252 State and Federal Gasoline Tax Credit , CB 239 "Take Or Pay" Payments , CB 99 Tax or Book , CB 103 Taxes Paid by Lessee , CB 177 Transfers of Proven Property , CB 104 TR-5

17 REVENUE RULING NO. Percentage Depletion Net Profits Interest , CB 196 Retailer's Exclusion , CB 118 Geological and Geophysical Costs Tax Treatment of G&G , CB , CB 51 Intangible Drilling and Development Cost 200 Percent Reversion Then Working Interest Terminates , CB 95 Allocation of Lump-Sum Payment IDC and Leasehold , CB 303 Consolidated Returns , CB 170 Depreciation Underground Storage , CB 97 Downhole Equipment , CB 63 Drilling for Interest , CB , CB , CB 70 Drilling to Acquire Site Plus Acreage , CB 77 Easement Underground Storage , CB 96 Expense Recognition , CB 146 Farm-In of Two Properties , CB 129 Foreign Properties , CB , CB , CB 72 TR-6

18 REVENUE RULING NO. Full Recoupment , CB 87 Geothermal Wells , CB 61 Injection Wells , CB 41 Limited Partnership , CB 106 Nonproductive Wells , CB 167 Offshore Exploration Wells , CB 112 Offshore Platforms , CB , CB 68 Partnership Allocation , CB 311 Partnership , CB 64 "Permanent" Interest Deductible as IDC , CB 145 Prepaid IDC , CB , CB 146 Reversion of Interest after Payout , CB 160 Significance of "Complete Payout Period" , CB 105 Turnkey Agreement , CB 94 Nonconventional Fuel Credit Gas From Tight Formation , CB 4 Oil Produced from Shale , CB 7 Price Support Payments , CB 14 TR-7

19 REVENUE RULING NO. Nonrecourse Loan Acquisition Cost of Property , CB 62 Advanced Royalties , CB 128 Partnerships Distributive Share , CB 311 Limited Partnership , CB 106 Sharing Arrangements 100 Percent Working Interest Until ½ Recoupment Then 1/4 Interest , CB 105 Depreciable Equipment Treated After Drilling Cost Recouped , CB , CB 87 Drilling for an Interest , CB 70 Drilling for Site and Acreage , CB 77 Drilling in a Partnership , CB 64 Lessee Uses Lessor's Equipment , CB 264 Partnership , CB 311 Recoupment of Specified Amount , CB 145 Turnkey Agreement for Productive Wells Only , CB 94 Miscellaneous Advanced Minimum Royalty , CB 104 "Bottom Hole" Contribution , CB 10 TR-8

20 REVENUE RULING NO. Equalization Payments on Unitized Properties , CB 354 Installment Bonus , CB 42 Production Payment Distinguished from Royalty , CB 181 Qualified Tertiary Recovery Methods , IRB 11 Removal Cost of Offshore Platform , CB 167 "Take or Pay" Contract , CB 97 "Take or Pay" Contract Is Not a Production Payment , CB 99 TR-9

21 Case Study Hoyer vs. Manziel Michelle and Paul Manziel owned 200 acres of farm land in Monroe County, Ohio. In 1990, Axel and Julie Hoyer purchased 100 of The Manziel s farmland. In the Deed conveying the 100 acres to The Hoyers, The Manziels reserved to themselves the mineral rights in the property. In 2001 both Michelle and Paul Manziel passed away in a car accident, leaving their child, Johnny, the entirety of their estate. As a result, the estate transferred the parents interest in the 100 acres to Johnny. The transfer from The Manziel Estate to Johnny did not reference the prior reservation of mineral rights from the sale of the 100 acres to The Hoyers. Axel and Julie Hoyer had one son, Brian, who decided he wanted to move back to his home state of Ohio and start a family. He purchased 50 acres from his parents in The Deed conveying the 50 acres from his parents referenced the Recorder s Page and Volume Number when The Manziels transferred the property to The Hoyers, but did not specifically reference mineral rights reservation. In September of 2013, a representative of Big Oil visited Brian Hoyer at his home in Monroe County. Big Oil explained to Brian that if he wanted to lease his property for drilling rights, he could do so for $5,000 an acre; and once drilling began, he would be entitled to 1/8 th royalty rights from all oil and gas produced from his property. Brian, seeing that his career prospects weren t looking very promising, eagerly accepted the offer and signed an Oil and Gas Lease with Big Oil. Big Oil promptly wrote Brian a check for $250,000, which Brian cashed immediately. Upon learning of Brian s Lease with Big Oil, Brian s next door neighbor, Johnny Manziel, became enraged. Johnny marched over to Brian s home and explained to him that when Johnny s parents conveyed the 100 acres to Brian parents, they reserved all mineral rights on The Hoyer s property. After a heated exchange, Brian called his attorney, Jordan Cameron, to ask what he should do. Attorney Cameron said, Brian, you can t let Johnny take anything from you! You must take what is rightfully yours and file an Affidavit of Forfeiture. Brian followed Attorney Cameron s advice and filed an Affidavit of Forfeiture regarding his 50 acres of property. Upon giving notice to Johnny, Johnny failed to file a Notice of Preservation of Mineral Rights. (Brian heard that Johnny may have taken an extended vacation to Texas because on several occasions Brian saw photos on Twitter of Johnny having a good time). Having concluded that he was the rightful owner of the mineral rights, Brian proceeded with allowing Big Oil to drill a deep well on his property and he began to collect quarterly royalty payments. Brian never heard from Johnny again until a year later when Johnny filed a lawsuit against him in Monroe County Common Pleas Court for Quite Title, Declaratory Judgment and Unjust Enrichment. While the lawsuit was pending, Brian and Johnny both received their real property tax bill for tax year In years past, the County valued Johnny s and Brian s property at $1,000 per acre. However, after the lease of Brian s property, the County increased the value of Johnny s property to $1,500 per acre and Brian s to $2,000 per acre. { :}

22 Johnny, fearing that he would need more money to pay his 2013 property taxes, sold his mineral rights to Big Oil for $7,000 per acre. { :}