Tax questions regarding oil royalties

[tallguy]

I recently received my first check for oil royalties.  I am in Washington, but will have to pay state income tax in North Dakota on these monies.  The accompanying paperwork shows my gross, the owner's share of taxes, and the net.  There was also withholding (I believe for state tax.)  Can anyone tell me how this works?  Will I declare the gross as income and then deduct the owner's share of taxes to offset it on a North Dakota return?  And can I deduct the tax paid to North Dakota off of my federal tax return?

We have in the past had the option in Washington (because there is no state income tax) of deducting state sales taxes if we itemize.  Assuming that option is back this year, would I be able to deduct Washington sales taxes AND North Dakota income taxes, or is it strictly one or the other even with different states involved?  Thanks for any help.    

[mwcpa]

"Can anyone tell me how this works? Will I declare the gross as income and then deduct the owner's share of taxes to offset it on a North Dakota return? And can I deduct the tax paid to North Dakota off of my federal tax return?"

In January 2015 you will receive a form called 1099.  It will report the "gross" royalties paid to you. 

On your 2014 tax filings you will report this on schedule E.  The share of "taxes" (and other expenses, some withheld by the drilling company, others you may have paid directly and "depletion" will be claimed also) on the same schedule.

The State of North Dakota tax withholding will be an itemized deduction reported on schedule A as a state and local income tax.

I do not believe Congress has acted here yet, but the deduction was "sales tax" expired on December 31, 2013.  There is a chance that this deduction will be extended, but the way Congress works these days expect a big debate, lots of horse trading and an 11th hour (or 13th as it was a couple of years ago) compromise (I would expect that "extenders" for this and others would take place in mid to late December as they have for the last few years)

You will be required to file a North Dakota tax filing.  You will report income and expenses as required by the state on a non-resident tax filing and claim the State withholding as a tax payment made to North Dakota, offsetting any actual tax liability calculated.

[tallguy]

Thank you, mwcpa.  I recall how it is always up-in-the-air each year whether Congress will approve the deductibility of state sales taxes.  (I've always hated that, actually, that those nine or so states are held hostage to the whims of Congress each year.)  I'm still assuming that only one or the other (sales tax OR income tax) will be deductible on my federal return IF the sales tax deduction is extended.  Does that sound right?

[mwcpa]

Yes tall guy... Income tax or sales tax... Not both....
there are a lot of inequities in the tax law... AMT is a big one... Designed to ensure the rich pay some tax it now impacts the middle class by not allowing state and local income tax as a deduction (amongst others).

[tallguy]

Thanks for the help.  I appreciate it.

[rangerj]

Because of the nine common law states we are all held hostage to the married filing joint and married filing separate filing status'. Every time Congress simplifies the tax code it gets more complicated, in my opinion.

[Bonny]

tallguy are you sure the operator is withholding taxes? That seems a little odd to me because our oil operators do not. The amount being deducted on our checks is for operator "costs" which as mwcpa refers to above is considered "depletion".

BTW be careful on how much you "count" on this stream of income. We got a rather nasty surprise last year when our operator "found" a bunch of expenses that they had previously not charged us for before. Then they went back 4 years (statue of limitation in CA) to "recapture" those expenses. We tried to fight it but the lease language (from 1936!) was loose enough that it was going to cost us more in atty fees than the "recouped" expenses.  

Net result was that for one year our income irrespective of the cost of oil has dropped by 20%. And they are piling any kind of expense (marketing et cetera) against the lease income. In the past this income was always banked but now it's the bulk of our retirement income. Fortunately we had two new leases added so we didn't feel the pinch but beware of this nasty little trick! 

[tallguy]

Bonny,

I now have three producing wells with another that is in confidential status until September.  Because it took until recently to get everything cleared up with regard to title, I have just started receiving checks.  The first check was two weeks ago (covering two wells) from one company.  They did withhold for North Dakota taxes.  The statement shows gross, owner's share of taxes, and net for each well and each month.  At the bottom is a note with "W/H Amount:  ND   -xxx.xx"

I just received the first check for the third well (different company) today.  They do not withhold ND taxes.

I am curious (if you don't mind) where your wells are and how long they have been producing?  If it has been a number of years, what has been the decline from initial production levels to now?  I know production will not stay at this level, but I am curious how sharply it drops off.

[mwcpa]

Some of the "taxes" paid in ND for "oil and gas" extraction

www.nd.gov/tax/oilgas/

"The oil and gas gross production tax is imposed in lieu of property taxes on oil and gas producing properties.

Oil Gross Production Tax
A 5% rate is applied to the gross value at the well of all oil produced, except royalty interest in oil produced from a state, federal or municipal holding and from an American Indian holding within the boundary of a reservation.

Gas Gross Production Tax
The tax on gas is an annually adjusted flat rate per mcf of all nonexempt gas produced in the state. The annual adjustments are made according to the average producer price index for gas fuels.

Oil Extraction Tax
The oil extraction tax is levied on the extraction of oil from the earth."

In addition, ND now "requires" withholding tax (income) on oil and gas royalties paid to non residents

www.nd.gov/tax/indwithhold/pubs/guide/royaltypaymentsguideline.pdf?20140607051701 "A remitter is required to withhold North Dakota income tax from North Dakota oil or gas royalty payments made on or after January 1, 2014, to nonresident individuals and non-North Dakota domiciled business entities."

[tallguy]

Interesting.  The second company (which did not withhold) is located in Montana, but since the oil is being extracted from North Dakota that shouldn't matter.  I doubt that they are unaware of the requirement, but I will e-mail them and ask why withholding was not done.  Thanks.  

[Bonny]

Jun 6, 2014 21:18:00 GMT -5 tallguy said:

Bonny,

I am curious (if you don't mind) where your wells are and how long they have been producing?  If it has been a number of years, what has been the decline from initial production levels to now?  I know production will not stay at this level, but I am curious how sharply it drops off.

Our oil producing well are in the Wilmington area (Los Angeles County). I have a picture of DH's grandmother and his dad in front of an oil derrick dated 1936 with the caption "We struck Oil!". I'm guessing that the three checks we've been receiving for the last 14 years are the result of drilling around that time.

They think they've discovered another reserve in the area and last year we were approached to enter into a new lease for another interest in the same general area.

Two years ago we entered into a lease for one of our mineral interests in Ventura County. This is part of the "Monterey Shale" deposit. We've received two annual lease payments but we are not in the prime drilling area. Given the revised estimates we were a little surprised to get this year's check.

I know CA has lots of information on it's State oil and gas dept site such as estimates of reserves et cetera. Also your oil operator probably needs to file information regarding their estimates of reserves and the estimated number of years of extraction. This information should all be public information and accessible via the Web. BTW I know our operator has to pay annual state taxes based on their estimated reserves based on the current value. It's along the lines of a state property tax. These costs are deducted from our royalty share and are entirely separate from DH's and my obligation to pay State and Federal Income Tax on our royalty income.

I hope this information helps!

[mwcpa]

"The second company (which did not withhold) is located in Montana, but since the oil is being extracted from North Dakota that shouldn't matter"

There is an "exclusion" for small producers/operators on the ND withholding tax, it's discussed on the link I provided earlier.

"Exception 1: Exception for a small producing remitter
A remitter is exempt from the withholding requirement if the remitter is an oil or gas producer whose production in North
Dakota for the preceding calendar year was less than 350,000 barrels of oil or 500 million cubic feet of gas. This exception
does not apply if a remitter is not a producer."

[tallguy]

Definitely a possibility.  I know they have a number of wells producing now, but those wells may have been brought online recently so would not have hit the threshold for last year.  I sent the e-mail anyway so I'll see if that's it.