Working Interest A working interest owner is the person who owns the oil and gas lease—so called because the working interest owner is entitled to “work” the land by drilling and developing the minerals. The working interest owner is also liable for all of the costs of operations. The term “working interest” is usually used to distinguish that interest from the royalty and other non-cost bearing or non-participating interests. Because a royalty interest is a share of production free of costs, the working interest owners must pay the royalty “off the top,” thus reducing the revenue available to recoup their drilling and operating costs and turn a profit. Most investors indirectly hold working interests via a limited partnership offering, either as general or limited partners. General partners have greater liability, but are entitled to increased deduction benefits.
Overriding Royalty Interest (ORRI) An ORRI is carved out of the lessee’s interest (or the working interest) under an oil and gas lease, creating an interest in oil and gas produced at the surface, free of the expense of production, and in addition to the usual landowner’s royalty reserved to the lessor in an oil and gas lease. Unlike a royalty interest, an overriding royalty interest owner does not own the minerals. Rather, an ORRI owner owns a right to a portion of the proceeds of produced minerals. The ORRI is carved out of the leasehold interest (or working interest); ORRIs generally conclude when the lease terminates.
TAXATION NUTSHELL —Owners of working interests can deduct both intangible and tangible costs. Intangible drilling costs (IDCs) are costs necessary to prepare wells for production, but have no salvageable value. IDCs include wages, fuel, chemicals, hauling, supplies, ground clearing, survey work and repairs. Approximately 60-85% of total drilling costs are intangible. IRS regulations allow well owners (investors) to deduct 100% of IDCs against their income in the first year. Tangible drilling costs (TDCs) are the components of a well that have salvageable value. TDCs include certain heavy equipment, casings, pump jacks and wellheads. IRS regulations allow investors to deduct 100% of TDCs against their income over the course of seven years. The extent to which an investor can deduct IDCs or TDCs against income depends in part on whether the investor is a general partner or limited partner. Royalties are taxed as ordinary income, but may be partially offset by the percentage depletion allowance. Percentage depletion is a modest tax advantage for royalty owners. It is calculated by applying a reduction of 15 percent to the taxable gross income of a productive well’s property. The allowance cannot exceed 65 percent of taxable income, and is limited to the first 1,000 barrels of oil (or 6,000 mcf of natural gas) produced per day. Some mineral interest offerings are designed to be eligible as like-kind replacement property in a §1031 exchange. Taxpayers may acquire fractional, deeded interests in a “basket” of mineral rights across several properties in multiple jurisdictions. The program sponsor then handles the revenue collection, accounting and reporting for all of the royalties in the basket.
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