2016 Maine Tax Forum Selected Issues in Taxation of Natural Resources Lee J. Chick, CPA November 2, 2016 2016 Maine Tax Forum
Natural Resources • Taxation covered in Subchapter I, which includes the following sections: – Deductions: Secs 611 – 617 – Sales & exchanges: Sec 631 – Mineral production payments: Sec 636 – Continental shelf areas: Sec 638 • In broadest sense, it includes all valued naturally- occurring characteristics including sunlight, atmosphere, water, land, minerals, vegetation and animal life November 2, 2016 2016 Maine Tax Forum 2
Natural Resource Tax Issues to Cover Today • Cost recovery – depletion • Limited coverage on oil & gas • Most time spent on timber issues Today’s goal: No V-8 moments! November 2, 2016 2016 Maine Tax Forum 3
Natural Resource Depletion • The basic theory of resource depletion is that the taxpayer is entitled to cost recovery as units of the resource are consumed • A reasonable deduction for depletion is allowed in computing taxable income from mines, oil and gas wells, other natural deposits, and timber • Depletion is allowable to the owner of an economic interest in the resource. November 2, 2016 2016 Maine Tax Forum 4
Natural Resource Depletion • The term ‘Economic Interest’ is undefined in the Code but provided in Reg 1.611-1(b)(1) and includes royalty interests, operating or working interests, and net profits interests. Some production payments are also economic interests November 2, 2016 2016 Maine Tax Forum 5
Depletion Methods – Section 611 through 613A • Cost depletion - units of production • Percentage depletion – Based on lesser of • Gross income from resource property times the stated depletion rate (rates range from 5%-22% based on the resource extracted), or • 50% of the taxable income from the property • Taxpayer deducts the higher of cost or percentage depletion November 2, 2016 2016 Maine Tax Forum 6
Cost vs. Percentage Depletion • Both methods are not available for all resources Cost Percentage Depletion Depletion Oil & Gas yes yes Coal yes yes Minerals & metals yes yes Gravel, peat, sand yes yes Soil, sod, turf yes no Timber yes no Water maybe no November 2, 2016 2016 Maine Tax Forum 7
Character of Natural Resource Income • Most revenue from sale of extracted natural resources is ordinary income, but Sec 1231 treatment is available for – Coal or domestic iron ore disposed of by a contract under which the seller retains an economic interest in the coal or domestic iron ore sold (Sec. 631(c)) – Qualifying sale of timber under either • Contractual disposal where seller retains an economic interest in the cut timber (Sec. 631(b)) • Election to treat the cutting of timber as a sale or exchange for tax purposes (Sec 631(a)) November 2, 2016 2016 Maine Tax Forum 8
Types of Interests in Mineral Properties • Operating or working interest: typically describes the party responsible for getting the resource out of the ground • Royalty interest: entitles the owner to a share of the gross production from a specific mineral property. It is a “ non- operating ” interest since a royalty doesn't bear any part of the exploration, development and operating costs • A “production payment” is, in general, a right to a specified share of the production from mineral in place, or the proceeds from that production. A production payment may be limited by a dollar amount, a quantity of the mineral extracted, or time. November 2, 2016 2016 Maine Tax Forum 9
Natural Resource Interests in Estates & Trusts • Maine has adopted the Uniform Principal & Income Act of 1997 (Title 18-A, Article 7, Part 7) – Special rules are provided for allocation of receipts between income vs. principal for minerals, water and other natural resources (Sec. 751) and timber (Sec. 752) – Trust documents should be reviewed for flexibility afforded to Trustee November 2, 2016 2016 Maine Tax Forum 10
Oil & Gas Investments in Master Limited Partnerships • Restructuring prevalent due to volatility in energy markets – two major motivations: – Reduce the cost of capital (eg, Kinder Morgan, Plains All American) – Bankruptcy and debt restructuring (eg, Linn Energy, Breitburn Energy, Atlas Resource Partners) November 2, 2016 2016 Maine Tax Forum 11
Timber Tax Issues • Reasons for holding timber and its impact on tax reporting • Qualifying timber sale income as Sec 1231 • Establishing timber accounts • Road cost recovery • Timber incentives • Maine issues November 2, 2016 2016 Maine Tax Forum 12
November 2, 2016 2016 Maine Tax Forum 13
Reasons for Holding Timberland • Personal Use • Investment – Timber sale proceeds reportable on Sch D – Expenses to Sch A • Trade or business – Schedule C or F reporting – Qualifying timber sale proceeds reportable on Form 4797 November 2, 2016 2016 Maine Tax Forum 14
Timber Income Considerations • Whether gain/loss from timber transactions qualifies for capital gain rates is determined by: – primary purpose for holding timberland – how the timber is disposed of – holding period • Sec 631 provides two options to provide certainty for use of capital gain rates: – 631(b): disposal of timber with retained economic interest, or lump sum sale – 631(a): election to treat cutting of timber as a sale or exchange November 2, 2016 2016 Maine Tax Forum 15
Disposal of Timber under Sec 631(b) • Timber must have been held for at least 1 year • Disposition is via contract that takes the form of either a lump sum sale, or a contract for disposal where the owner retains an economic interest in the standing timber November 2, 2016 2016 Maine Tax Forum 16
Section 631(a) Election • Legislative compromise to deal with the issue of a land owner cutting his/her own timber and disposes of the resulting products: is it ordinary income or 1231 gain? Sec 631(a) operates to split the income recognized between the appreciation of the timber while standing (1231 gain), and the value-added activities that occur after the tree is cut (ordinary income) November 2, 2016 2016 Maine Tax Forum 17
Section 631(a) Election • Timber must be held 1 year to qualify • Election must be made on the original return for the year you first want it to apply – Election can’t be made on an amended return – Election can be revoked only with permission of the IRS – Make election by using checkblock on Form T November 2, 2016 2016 Maine Tax Forum 18
Effect of Section 631(a) Election Total Sec 1231 Ordinary gain Income Delivered price at mill 18,000 18,000 Logging & trucking costs (7,000) (7,000) Cost of logs sold (10,000) FMV of standing timber at BOY = 10,000 10,000 Basis of standing timber for depletion (3,000) (3,000) Total profit from activity 8,000 Profit allocated 7,000 1,000 November 2, 2016 2016 Maine Tax Forum 19
Sec 631(a) Election to treat cutting of timber as a sale or exchange • Issues to be aware of: – Cut, but untrucked timber at year end – Gain recognized for the excess of stumpage value over cost for depletion purposes – Impact on tax-exempt timberland owners – Capital gain income is excluded from UBTI by Section 512(b)(5), but gains from Sec 631(a) transactions fall outside the exclusion November 2, 2016 2016 Maine Tax Forum 20
Qualified Timber Gain of C corps. • PATH Act change (Sec 334(a)) provides for 23.8% rate for Qualified Timber Gain • Qualified Timber Gain = Taxpayer’s 631(a) & 631(b) gains over 631(a) & 631(b) losses, but only for timber held more than 15 years • Effective for tax years beginning in 2016 November 2, 2016 2016 Maine Tax Forum 21
Establishing Timber Accounts • Upon acquisition of timber property, basis is allocated among assets acquired – Land – Merchantable timber – Young growth – Road system, bridges – Shorefront lots – Mineral deposits – Other assets November 2, 2016 2016 Maine Tax Forum 22
Establishing Timber Accounts • Taxpayer purchases a 500-acre parcel for $250,000 and incurs the following: Purchase price 250,000 Legal fees 2,000 Timber cruise 5,000 Survey costs 3,000 Total cost 260,000 November 2, 2016 2016 Maine Tax Forum 23
Establishing Timber Accounts • The timber cruise determined that the tract contains the following: – 3,000 cords of merchantable timber with stumpage value of $210,000 – Young growth of $30,000 – Raw land at $40/acre = $20,000 – Road system = $25,000 November 2, 2016 2016 Maine Tax Forum 24
Establishing Timber Accounts • Purchase price allocation Asset Value % of Cost allocated total Land 20,000 7.0% 18,200 Young Growth 30,000 10.5 27,300 Merchantable timber – 210,000 73.7 191,620 3,000 cords Road system in place 25,000 8.8 22,880 Total 285,000 100.0% 260,000 • Depletion rate = 63.87 per cord (191,620/3,000) • Could things be done differently? November 2, 2016 2016 Maine Tax Forum 25
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