Key Takeaways
- Working vs. royalty interests: Working interests are treated as active (non-passive) income, while royalty interests are passive, affecting how deductions and losses apply.
- Loss utilization: Losses from working interests can offset ordinary income, unlike royalty losses, which are limited to passive income.
- Deductions & expenses: Working-interest owners may deduct intangible drilling costs (IDCs), operating expenses, and depletion, but may also face self-employment tax.
- Entity structure matters: To maintain non-passive treatment, working interests must be held directly or through non-liability-limiting entities (like a general partnership).
- Strategic tax planning: Proper planning is essential for managing self-employment tax, maximizing deductions, and preparing for exit strategies or recapture rules.
Unlike other investment vehicles, oil and gas get special tax treatment. They are treated like active income, rather than passive income, as rental properties would be. But why is this the case? Basically, the US tax code treats certain oil-and-gas interests differently because Congress has long used tax rules (depletion allowances, immediate write-offs for drilling costs) to encourage risky energy exploration and domestic production. In a nutshell, this means that losses from a working interest in an oil or gas property can generally offset other (non-passive) income.
And this has a number of practical tax consequences. So in this blog, we’ll walk you through what you need to know about the tax implications of oil and gas.
Working Interest vs. Royalty Interest in Oil and Gas
In terms of oil and gas, there’s an important distinction to be made between working and royalty interest. Working interest implies you’re actively sharing in the costs of exploration, drilling and operating a well. It means you’re bearing the risk, control and obligations. Royalty interest, on the other hand, is more passive. Here, you’ll receive a fixed percentage (or other share) of production revenue. However, you are not responsible for drilling or operating costs and generally have no operator control or liability.
And the differences between these interests extend beyond your involvement; it also affects the tax consequences.
For tax purposes, a working interest is generally excluded from the definition of “passive activity”. This is when the owner holds the interest directly or through an entity that does not limit liability. In other words, it is treated as non-passive (active).
That has two big downstream effects. Firstly, losses from the activity can offset non-passive (or ordinary) income. Secondly, the income may be subject to self-employment tax depending on the structure and participation.
But royalty income is treated as passive or portfolio income for most taxpayers. That is to say, it is reported differently (often via Schedule E), and is not eligible to offset active wage income under the passive-loss rules. However, royalty owners may still be eligible for limited depletion deductions.
Confused? Here’s an example
Say you have two investors in the same well. Investor A has a working interest: they’ve invested $300,000 to drill and develop. If they’ve allocated 75% share of that investment to intangible drilling costs (IDCs), this is $225,000. Under the tax rules, an operator can elect to currently deduct IDCs (or amortize under different rules), producing a large immediate tax deduction.
That deduction reduces their taxable income in year 1 (subject to at-risk and basis limits). Because a working interest is treated as non-passive, any net operating losses from the working interest can offset the investor’s other ordinary income (like wages or investment income). However, because Investor A is effectively in the business, portions of the income may be subject to self-employment tax.
And then there’s Investor B, with royalty interest. They have no drilling cost exposure, and get a 15% royalty on production revenues. Their royalty payments are reported as passive or portfolio income, and are not eligible to be offset by the operator’s business losses (unless the taxpayer has other passive income to offset them).
Instead, Investor B can claim depletion (cost or percentage depletion). But percentage depletion for oil or gas is tightly limited by barrel limits and other restrictions.
So what’s the tax impact?
In year 1, Investor A could potentially deduct IDCs approximately $225,000, significantly reducing their taxable income. If the project produces a net loss overall, Investor A may use those losses to reduce wages or ordinary income.
Investor B receives royalty receipts (taxable), and might claim a small depletion deduction. Although royalty income does not reduce the royalty owner’s wages or other ordinary income via passive losses (unless they have separate passive income).
Why Working Interests in Oil and Gas Are Treated as Active Income
The US tax code treats oil and gas working interests differently from most other types of investments. In fact, working interest in an oil or gas well is specifically excluded from the passive-activity loss rules, as long as it is not held through a liability-limiting entity such as an LLC or limited partnership.
In practice, this means that, unlike rentals or royalties, which are usually considered passive activities, income and losses from a working interest are non-passive (active) by definition.
And that makes them unique in the world of tax law.
But why did Congress make this distinction? Basically, lawmakers recognized that working-interest investors are more than just financial backers. After all, they share directly in operating costs such as drilling, labor, and equipment. They also bear significant business risks, including dry wells, cost overruns, and production volatility. Overall, active owners function like participants in the trade or business, rather than passive investors.
The result? Even if a working-interest investor doesn’t meet the traditional “material participation” standards, tax law still treats them as active participants because of the risks and responsibilities involved.
Tax Implications of Active Income from Working Interests
There are a number of tax consequences associated with active income. These include:
- Self-employment tax exposure: Working-interest income is considered to be earned business income, which means it is subject to self-employment tax.
- Expense deductions: Owners enjoy the ability to deduct a wide range of expenses, including operating expenses (like supplies, insurance, utilities), and around 60–80% of drilling costs, as well as depreciation and depletion on qualifying assets.
- Impact on losses: The non-passive classification of working interests losses to offset wages, business income, or other investments.
However, to make the most of the potential tax benefits of oil and gas, there are a few practical considerations you need to remember.
The first is the structure of your business entity. To maintain non-passive treatment, the interest generally must be held directly or through a non-liability-limiting entity such as a general partnership. Holding a working interest through an LLC or limited partnership could change its classification and subject it to passive-activity rules.
You must also carefully weigh the risk-to-reward ratio. On the upside, working-interest investors in oil and gas can apply substantial deductions against ordinary income. But on the downside, your earnings are exposed to self-employment tax, and you’ll take on the financial and operational risks of drilling and production.
It’s also vital to consider your tax strategy. Smart tax planning can make a big difference to self-employment tax management, loss utilization, and even an exit strategy. Keep in mind that when selling a working interest, gains are generally capital in nature, but previously deducted IDCs and depletion may be recaptured as ordinary income.
How our CPA Team can support your oil and gas investment strategy
If you’re exploring oil and gas investments, the right tax strategy can be just as important as the investment itself. The Fusion CPA team can help you navigate self-employment tax, maximize deductions, and plan ahead for future gains or exits. To discuss how we can support your oil and gas investment strategy, schedule a free Discovery Call with us today!
