Example 1 Depletion Allowance Deduction:

Transcription

1 Memorandum To: From: Re: Noble Royalties, Inc. Honigman Miller Schwartz and Cohn LLP Certain Tax Advantages of Interest in Non-Working Mineral Interests Date: February 2, 29 A royalty interest is the right to receive a specified amount of the gross income or production from a mineral property. A royalty interest, as opposed to a working interest, is not charged with the costs of exploration, development, or operation and is therefore treated as a non-operating interest for federal income tax purposes. I. Royalty Interest Deductions In addition to the return on their investment, the depletion allowance deduction gives holders of royalty interests a special tax benefit. Mineral interest holders are allowed an annual depletion deduction equal to the greater of cost or percentage depletion. Cost depletion allows the mineral interest holder a depletion deduction based on the ratio between the amount of minerals sold and the remaining mineral reserves. The percentage depletion allowance is based on the amount of income generated annually from a mineral interest, without regard to the amount of minerals that are exploited. Example 1 Allowance Deduction: Investor purchases a $5, Mineral Interest, from Noble Royalties, Inc. ( Noble ), which represents a 2% equity interest in Property A. From 23 through 28, Property A produces gross revenues of $3,24,, $2,47,, $2,727,, $2,852,, $2,372,, and $3,38, respectively. The table below compares the cost depletion and the percentage depletion available to Investor in the 23 through 28 taxable years. 229 First National Building 66 Woodward Avenue Detroit, Michigan

2 February 2, 29 Page 2 Comparison of Cost v. Percentage Tax Yea r Adjuste d Basis Gross Revenues Participant s Revenue (2%) Net Revenu e Cash Yield 1 Percentag e Cost 2 Cash & Deductio n Yield 3 23 $5, $3,24, $64, % $9,72 $21,5 14.4% 24 $478,95 $2,47, $49,4 9.88% $7,41 $12,15 1.7% 25 $466,8 $2,727, $54, % $8,182 $15,15 12.% 26 $451,65 $2,852, $57, % $8,557 $13,7 12.4% 27 $437,95 $2,372, $47, % $7,117 $18,55 1.8% 28 $419,4 $3,38, $67, % $1,14 $14, % Over 6 years the royalty interest has yielded a $34,85 return through Investor s 2% share of gross revenue, as well as a $94,75 tax deduction. II. The Advantage of Percentage : Like-Kind Exchanges for Royalty Interests A unique characteristic of the percentage depletion method is that an interest holder can deduct a percentage depletion allowance even if the deduction exceeds its basis in the depletable property. The excess percentage depletion deductions (1) do not create a negative basis, (2) are not added onto the amount realized upon subsequent disposition of the property, and (3) are not subject to the recapture rules under Section 1254(a)(1). 4 In other words, percentage depletion is 1 Yields based on actual annualized returns for all 74 Noble royalty interest funds.* 2 Based on Production Sold/Reserve Ratio of: 23: 4.21%; 24: 2.43%; 25: 3.3%; %; 27: 3.71%; 28: 2.83%. The ratio was arbitrarily produced but accurately portrays an approximately 3 year life for the mineral interest, which is representative of Noble s standard purchasing preference.* 3 Value of deduction based on assumed 35% tax rate. 4 All Section references are to sections of the Internal Revenue Code of 1986, as amended (the Code ), or the Treasury Regulations promulgated thereunder. 229 First National Building 66 Woodward Avenue Detroit, Michigan

3 February 2, 29 Page 3 a deduction without any offsetting increase in future gain recognition! The unrecaptured depletion deduction ensures that royalty interest owners, aside from any gains on the interest itself, will derive a tax benefit equal to the amount of the allowed percentage depletion deduction. Investors maximize the tax benefit of the percentage depletion deduction when their basis in the mineral interest is reduced to zero. This can be achieved when the royalty interest is acquired in a tax-free like-kind exchange. In a like-kind exchange, the investor could exchange appreciated real estate (in which he has a very low basis) for an equally valuable royalty interest, without being subject to tax. The investor s basis in the royalty interest would be the transferred basis from the real estate. Irrespective of his basis, the investor would be able to take the percentage depreciation deductions, increasing the bottom-line value of the royalty interest investment. Example 2 Like-Kind Exchanges and Deductions Investor owns commercial property with a fair market value of $5, in which his adjusted basis is $5,. Investor sells the commercial property and invests the proceeds in a royalty interest. Investor does not recognize any gain on the sale of commercial property, because the investment in the royalty interest qualifies as likekind property under Section 131. Although Investor s basis in the royalty interest will probably be reduced to zero within a short period, it will not affect his ability to continue taking the percentage depletion deduction. Tax Yea r Adjuste d Basis Gross Revenues Participant s Revenue (2%) Net Revenu e Cash Yield Percentag e Cost Cash & Deductio n Yield 23 $5, $3,24, $64, % $9,72 $21,5 14.4% 24 $28,95 $2,47, $49,4 9.88% $7,41 $12,15 1.7% 25 $16,8 $2,727, $54, % $8,182 $15,15 12.% 26 $1,65 $2,852, $57, % $8,557 $13,7 12.4% 27 $ $2,372, $47, % $7,117 [$18,55] 5 1.% 5 Cost depletion not available because it would reduce the basis below zero. 229 First National Building 66 Woodward Avenue Detroit, Michigan

4 February 2, 29 Page 4 28 $ $3,38, $67, % $1,14 [$14,15] % Over 6 years the royalty interest has yielded a $34,85 through Investor s 2% share of gross revenue, as well as a $79,37 tax deduction. $17,257 of that deduction was not offset by a corresponding decrease in basis and will be a permanent tax benefit. 6 III. Working Mineral Interests Passive Loss Limitations on Deductions In contrast to royalty interests, the owner of an operating or working interest is charged with the costs and responsibilities of developing and operating the property. Since this interest bears the costs of developing and operating the property, its owners are usually entitled to receive most of the production income. Although working interests initially give a greater return on investments, royalty interests, over time, typically provide investors with a greater return.* Furthermore, royalty interests provide investors with significant tax advantages. Deductions from working interests are generally subject to the passive loss limitations and cannot be used to offset ordinary income. Under Section 469 of the Code, losses from any trade or business activity in which the taxpayer does not materially participate ( passive losses ) cannot be deducted against non-passive income. Deductions from working interests are passive unless the owner holds the interest directly or through an entity that does not limit the owner s liability. Holding a working mineral interest directly is extremely risky because it leaves the owner unprotected from claims associated with the mineral interest. Income or deductions from a royalty interest, however, are not subject to the passive loss limitations unless derived in the ordinary course of a trade or business. Income from a royalty interest is treated as derived in the ordinary course of business only if it is derived from the activity of trading or dealing in mineral interests. 7 Consequently, for the typical investor, ownership in a royalty interest is more beneficial from a federal income tax perspective because it allows the investor to take percentage depletion deductions against ordinary income, without exposing the investor to the potential liability issues that may arise from direct ownership of a working interest. IV. Summary: Unique Tax Benefits of Royalty Interest Ownership 6 Generally, depletion and depreciation deductions only defer the payment of tax, which is (to some extent) recaptured when the taxpayer sells the asset. In this case, because the deduction is not offset by a reduction in basis, the deduction is never recaptured. 7 See Treas. Reg T(c)(3)(ii) and IRS Private Letter Ruling 9174 (Jan. 29, 199). 229 First National Building 66 Woodward Avenue Detroit, Michigan

5 February 2, 29 Page 5 Investors in royalty interests can utilize depletion deductions to offset ordinary income. The depletion deduction can be used even if it exceeds the basis in the royalty interest. The excess deductions are not offset or recaptured by any future gain recognition. Royalty interests may be treated as real property; for purposes of Section 131. Therefore, investors could fund the purchase of a royalty interest with a nontaxable exchange of appreciated real property. A low basis from the appreciated real property would transfer to the royalty interest. Once the basis in the royalty interest is reduced to zero, the tax benefits to investors are maximized since the depletion deductions will not be offset by reductions to basis. Although working interests initially provide a greater return, royalty interests, over time, outperform working interests by providing a consistent cash yield, as well as significant tax benefits. =================== IRS Circular 23 Disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any person for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed in this communication. ==================== DETROIT First National Building 66 Woodward Avenue Detroit, Michigan