Article on Estate Planning With Mineral Interests
The federal tax rules for energy resources are based on the concept of an “economic interest.” Interestingly, the term “economic interest” is not a clearly defined term. It is used more than seventy times in the Internal Revenue Code and the Treasury Regulations, but neither the courts nor the IRS has provided a specific definition. In practical terms, an economic interest can be thought of as a clear and direct interest in a mineral property and the income from its production, which has enough substance to be treated as an ownership interest for income tax purposes (i.e., the awarding of taxable income and related deductions). The regulations simply provide that:
An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place . . .and secures, by any form of legal relationship, income derived from the extraction of the mineral . . . , to which he must look for a return of his capital. Treasury Regulation Section 1.611-1(b).
This definition is derived almost word for word from the Supreme Court’s decision in Palmer v. Bender, 287 US 551 (1933), which established the “economic interest” concept as a key element in natural resources taxation.It is important to understand what constitutes an economic interest in order to understand what types of tax consequences a landowner-client may have with respect to the property owned by them. Having an economic interest is a prerequisite to obtaining a depletion deduction. To this end, some of the more common types of economic interests (e.g., royalty interests, overriding royalty interests, working interests, carried interests, production payments, and net profit arrangements) are discussed in more detail below. Most commonly, landowners seeking counsel regarding estate planning will have leased their mineral property and retained a royalty interest. However, there are occasions when an ambitious or sophisticated landowner will seek to either develop the mineral interest themselves or will cut a deal to be paid for the exploitation of their mineral property in a form other than a royalty interest. For these reasons, a short discussion of overriding royalty interests, working interests, carried interest arrangements, production payments, and net profit arrangements are included in this outline.