Tax Treatment of Damages and Easements in Oil and Gas Operations. Presented by: James R. Browne Strasburger & Price L.L.P.

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1 Tax Treatment of Damages and Easements in Oil and Gas Operations Presented by: James R. Browne Strasburger & Price L.L.P. Dallas, Texas

2 Speaker Strasburger & Price, LLP 901 Main Street, Suite 4400 Dallas, Texas Tel: Fax: JAMES R. BROWNE Jim is a partner in the Dallas office of Strasburger & Price, LLP law firm, specializing in general tax planning. He has over 30 years of experience in the area of taxation, having served as lead counsel in matters involving federal, state, and foreign taxes. He regularly advises clients on the U.S. income tax aspects of domestic and international business transactions involving a diverse range of industries, including healthcare, manufacturing, energy, real estate, and financial services. Prior to joining Strasburger in 2005, Mr. Browne served as chief tax officer for several large publicly traded multinational companies, was a partner in a "Big 4" accounting firm, and was a partner in a nationally prominent law firm. He earned his law degree from Vanderbilt University (1981) and his undergraduate degree in business administration from the University of Michigan (1978). He is a licensed lawyer and certified public accountant in Texas. Strasburger & Price, a full-service law firm with seven offices, is one of Texas largest and most respected firms. Strasburger serves as a trusted adviser to publicly and privately held companies, entrepreneurs, executives, governmental entities and individuals. Since the firm s founding in 1939, Strasburger attorneys have been privileged to represent more than half of the Fortune 500 companies. For more information, visit 2

3 Agenda Property damages: examples and general tax rules Easements: examples and general tax rules Gilbertz case Related tax issues Information reporting for damages 3

4 General Rule Damages Working interest owner has dominant right to enter land to explore for, produce, and transport minerals The working interest owner s surface use rights are very broad, but are increasingly being limited by contract or by local laws The lessee is generally liable only for damages from negligent, unreasonable, or excessive operations May be modified by contract or by local law Strict liability for some acts (pollution) Obligation to restore lands at termination of lease varies by jurisdiction 4

5 Surface Damage Acts Damages Intended to protect agricultural and ranching uses from disruption by oil and gas operations Impose strict liability for surface damages (surface owner need not prove negligence or unreasonable operations) Encourage negotiated advance payments for damages and release of claims Right to Recovery Can be provided by contract (including advance payments and liquidated damages); or Recovered through judicial action for violation of statute or for negligent, unreasonable, or excessive operations 5

6 Examples Damages Damage to land (natural vegetation and land features) Damage to or unauthorized depletion of water supply Damage to crops and timber Damage to personal property and improvements Livestock Fences, equipment, and structures Lost profits from loss of use of land or disruption of surface operations Unauthorized use or damage to surrounding surface areas Nuisance 6

7 Damages Sample Texas lease provision: Lessee shall, upon termination of this Agreement, remove all of Lessee's equipment, fill and level all pits, and restore the surface. Lessee shall pay for all damages resulting from operations under this Agreement to the lands, including trees, fences, crops, pasture, native or cultivated grass, improvements, or to any other structures, or to any agents or invitees of Lessor. Lessee s liability shall exist whether or not damage is due to negligence of lessee or its agents or invitees, and whether or not the operations under this Agreement are reasonable and not excessive. Alternatively, the contract might specify amounts to be paid at inception or annually, or both, for anticipated use of or damage to the surface estate, and include a waiver of landowner claims for actual damages (other than damages from negligent, unreasonable, or excessive operations). 7

8 Tax Issues Damages Payee s tax consequences from receipt of damage payment Ordinary income, or return of basis/capital gain? If return of basis, allocation of basis Payor s tax consequences Deduct or capitalize? If capitalize, cost recovery period 8

9 Payee Tax Consequences Payment for damage to property = recovery of capital Any payment in excess of basis is sale or exchange gain Taxpayer must allocate basis to damaged property unless it is impossible or impractical to do so (e.g., because damage affects the entire property or an indeterminate portion) Rev. Rul Payment for use of property = ordinary income Payment for lost profits = ordinary income In the typical fact pattern, the IRS is arguing for ordinary income treatment and the taxpayer has the burden of proving otherwise 9

10 Operators Payor Tax Consequences Incurred prior to lease acquisition (e.g., shooting seismic) = amortizable geological and geophysical (G&G) Incurred after lease acquisition incident to drilling of wells and preparing wells for the production of oil and gas = intangible drilling cost (IDC) Incurred after lease acquisition incident to operation of completed wells = operating costs Incurred after lease acquisition incident to production equipment or structures having a salvage value (e.g., damage associated with construction of pumping station or barracks) = depreciable capital cost 10

11 Payor Tax Consequences Pipeline Companies Payments for damages negotiated and paid at the time of the grant of the easement = included in cost of easement (amortizable section 197 intangible) Rev. Rul Incurred during construction If paid for utilization of the easement = cost of easement Tenneco, Inc. v. United States, 433 F.2d 1345 (5 th Cir. 1970) Otherwise = depreciable pipeline construction costs Incurred during operation Generally = operating cost Rev. Rul (pollution) If paid for utilization of the easement and contemplated at inception, probably treated as cost of easement 11

12 Definition Easements An easement is a limited right to use land, and is granted by contract or arises by implied consent (prescription) Comparison to damages Damages typically flow from unauthorized use of the land An easement may or may not involve physical damage to property or other adverse economic consequences to the grantor Damages, by definition, always involve physical damage or other adverse economic consequences to the landowner 12

13 Examples Access for shooting seismic Easements Access rights to well site (roads, utilities) Use of surface area at well site Use of surrounding surface area for storage tanks, flow lines, equipment storage, operations Gathering pipeline easement Use of surrounding surface area for housing Pipeline or utility line right of way 13

14 Landowner Tax Consequences Payment for temporary easement = rent Examples Easement to shoot seismic where no damage to land is expected Easements for well drilling and operations (terminate upon exhaustion of production) Vest v. Commissioner, 481 F.2d 238 (5th Cir. 1973) Note: although the easement is inherent in the working interest, lessees sometimes agree to pay separate consideration for an easement Payment for permanent easement = recovery of basis Example:transmission pipeline or utility line (term not tied to production of specific minerals or otherwise limited in time) Applied to basis allocable to the permanent portion of the easement, unless allocation is impossible or impractical Rev. Rul

15 General rules Payor Tax Consequences Temporary easement: Incurred prior to lease acquisition (e.g., easement to shoot seismic) = amortizable geological and geophysical (G&G) Incurred at or after lease acquisition incident to drilling of wells and preparing wells for the production of oil and gas (e.g., access road) = intangible drilling cost (IDC) Incurred after lease acquisition incident to production (e.g., roads for operating phase; area for flow lines, storage tanks, and production equipment and structures; and production reservoirs) = depreciable capital cost Permanent easement: amortizable section 197 property; 15-year amortization Rev. Rul

16 Gilbertz 1 case F. Supp. 177 (D. Wyo. 1983), aff d 808 F.2d 1374 (10 th Cir. 1987) 16

17 Facts Gilbertz Case Gilbertz owns 6,400 acre cattle ranch Federal government owns the minerals and has entered into leases with various individuals and companies By statute, lessee has right of entry and use, but is liable to landowner for damage caused by negligence and for damage to crops and tangible improvements Gilbertz has three types of contracts Release and Damage Payment contracts with lessees Right of Way Easement contracts with pipeline companies Surface and Damage Agreement with a drilling company All contracts require rehabilitation of land on termination of the activity covered by the contract 17

18 Tax Reporting Gilbertz Case Gilbertz contends all payments are for damages to land (recovery of entire basis in ranch and then as capital gain) IRS contends all payments are rent/ordinary income 18

19 Gilbertz Case District Court Analysis Release and Damage Payment contracts Key findings Payment = compensation for damages caused by well drilling and completion and for release of claims for such damages Excludes damages to personal property or other property Annual payment ceases on termination of leases Parties intended the payments to be in the nature of damages or for the release from liability for damages Conclusion: payments are for damage to land and are not rent Vest case distinguished Vest contract was negotiated by the mineral owner (who had right to demand rent for use of land) Vest contract called for separate payments for damages Termination of payments on expiration of lease not dispositive 19

20 Gilbertz Case District Court Analysis (con t) Right of Way Easement Key findings: Grants a right of way easement to the pipeline company in exchange for a fixed payment Gilbertz releases claims for damages Parties intended an easement and advance payment for damages Written contract recorded in property records Easement is assignable Perpetual even though extinguished upon abandonment Conclusion: Contracts create an easement (interest in real property) not a license; payments are for damage to property and are not rent 20

21 Gilbertz Case District Court Analysis (con t) Surface and Damage Agreement Key findings: Grants right to build a road across Gilbertz property to access a well drilled on an adjoining property Called an easement in the contract Payment is an advance from damages and right of way use Additional compensation for extraordinary losses Agreement is recordable, but was not recorded Expires on termination of driller s oil and gas lease Conclusion: Contract creates an easement. Payment = capital gain 21

22 Gilbertz Case District Court Analysis (con t) Apportionment of Basis Damages and easements affected the ranch as a whole, therefore all payments applied against basis in the entire ranch, and excess treated as capital gain Result: Taxpayer wins on all issues 22

23 10 th Circuit Analysis Gilbertz Case Release and Damage Payment Receipt contracts District court decision reversed; payments are ordinary income No evidence that operations were negligent, unreasonable, or caused excessive use of surface areas (which are the only ways a lessee could be liable for damage to Gilbertzes land) No evidence of actual damages to land Evidence indicates that the payments were for loss of use of land, impact on cattle raising operations and cash crops, and resulting lost profits 23

24 10 th Circuit Analysis Right of Way Easement Gilbertz Case District court decision affirmed; payment is for sale of capital asset and recovery of basis Gilbertz possessed the surface rights granted to the pipeline companies Easement is perpetual despite reversion on abandonment Evidence of permanent disruption of natural grasses and damage to grazing lands Surface and Damage Agreement District court decision reversed; payments are ordinary income Easement was not perpetual; terminated when minerals exhausted 24

25 Gilbertz Case 10 th Circuit Analysis (con t) Apportionment of Basis District court decision reversed and remanded Only payments for pipeline easements can be applied against basis District court to determine portion of ranch affected by pipeline easements and the damage to the native sod caused by construction of the pipeline If apportionment is impossible or impractical, District Court must enter specific findings Result: taxpayer wins only pipeline easement issue 25

26 Implications of Gilbertz Case In most cases IRS will characterize contract payments as ordinary income To obtain recovery of basis/capital gain, taxpayer must prove payments are for damage to property and not for use of property or lost profits Difficult to prove (especially if lessee must repair the damage) Advance payments: must prove actual, recoverable damage Designation of payments in contract or settlement agreement not controlling Allocation of basis: must prove affected area 26

27 Related Tax Issues Involuntary conversion ( 1033) Rev. Rul : damages received for contamination of water supply due to seepage from salt water disposal pit are eligible for tax free reinvestment in other property similar or related in services or use (e.g., purchase of other water supply) Same for damage to crops, timber, or livestock; reinvestment in other farm property may qualify ( 1033(f)) Casualty Loss ( 165(c)(3)) Deduction for uncompensated loss to property Requires suddenness (e.g., gas line explosion; well blowout) Can deduction for repair costs also be claimed? T.D would require capitalization of repair costs (and permit an election to forego casualty loss deduction) but R.R. Hensler inc. v. Commissioner, 73 T.C. 168 (1979) and C.C.A are contrary. 27

28 Damages Information Reporting Operator probably has an obligation to report payments to noncorporate payees on Form 1099-MISC (Box 3 Other income) unless the payment is clearly non-taxable Instructions require reporting for taxable damages other than payments for replacement of capital Nevertheless, damage payments are often not reported to landowner Landowner is obligated to report receipt of damage payments as income if landowner cannot establish that the payment was for damage to property Temporary Easement = report as rent Permanent Easement = purchase of a property interest 28

29 Landowner Summary Damages: generally represent ordinary income unless landowner can prove compensation for actual damage to property Easements Temporary = ordinary income (rent) Permanent = recovery of basis/capital gain Operator/Pipeline Company Damages: payment characterized by stage of development Easements Temporary = cost of related activity Permanent = amortizable intangible property 29

30 Disclaimer This document is not intended to provide legal, tax, or other advice as to any specific matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. Any tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter. 30