Treatment of term assignments in oil and gas lease

Hoping to get some guidance and/or confirmation that I’m going in the right direction.

Picked up an oil and gas client this year, cash basis, S Corp. As is typical in o&g, not all deals are exactly the same but my client will lease minerals from mineral owner, 36 month lease for $100k let’s say, give 25% royalty and have right to all of the working interest. They will then assign all of the working interest to an operator for $200k and retain no working interest or override for a term of 35 months. At 35 months, the primary lease reverts back to my client which has the right/obligation to renew at 36 months. Often they do and reassign the lease for additional consideration at that time.

Previous returns appear to show these assignments as capital gain transactions. I’m uneasy with that due to the reversion interest. However, I’m not comfortable with it being a sublease either since no economic interest was retained and the reversionary interest goes away if drilling commences. I understand that the operator would acquire the working interest at that point.

I came across a cash and carry arrangement in the IRS examination manual that indicates that this is like a real estate option, so could my client receive the money in year 1, but not recognize the income until the term assignment terminates in year 3? Or, if the operator starts to drill in year 2, my client would recognize the capital gain at that point when the operator would actually acquire the working interest?

I’m hoping you guys have some thoughts, guidance or authority on this type of transaction.

I dont think the manual example is applicable. The taxpayer owned the working interest and gave an option to acquire a working interest. Unless and until the third party performed, the third party had no interest in the minerals.

Your taxpayer does not own the working interest, but has leased the working interest, and assigned the working interest to a third party.

The reversion does raise a question, and it can probably be argued both ways, but looking at it overall, practically speaking, your client gave up all of its interest in the property for the lease term.

Another question is whether your client is holding them for investment or is a dealer.

Thanks for the explanation. I think I was confused with ownership of the minerals. So if I own the mineral estate, I have the right to develop the underlying minerals, or I have the working interest. For some reason I had it in my mind that the lease created the working interest, which was a new real property created by the lease. I now see the error in my thinking.

As far as being a dealer, we have discussed this issue with the client. There are times when acquiring the lease is specifically for resale to a third party. Those leases are treated as ordinary income. However, some leases are taken with a primary investment objective. They aren’t buying them for sale in the ordinary course of business. The leases are assigned if and when a potential buyer needs the acreage or when the price is right. This is not the primary business activity of the company. These transactions are sporadic and the proceeds from these assignments are not used to acquire more leases.