SC Taxation of Out-of-State Mineral Royalties

I have a prospective client that is involved in a Trust that rents land and extracts minerals from properties located in PA and TX. It is six figure royalty income. They are a full-time SC resident.

This prospective client claims this income is exempt from taxation in SC and should only be subject to PA's low 3.07% tax vs SC's 7%. Their claim is based on an e-mail from some random person at SCDOR stating "rental real estate income received from property located in PA is out of state income. This income is not taxable to South Carolina." I will say it appears this taxpayer correctly stated they are full-time residents of SC and sources of income when seeking a response from SCDOR, but I do not believe the individual at SCDOR actually knows the tax code. I would agree with that statement if they were a part-year or non-resident of SC, but SC tax code seems pretty clear that full-time residents have all sources of income taxed in SC.

Out-of-state income/gain from rentals/royalties is indicated as being a subtraction from Federal income IF from out-of-state rental properties, businesses located out-of-state, and gain from real property located out-of-state IF the taxpayer is not a full-year resident subject to tax on all sources of income. This is reiterated when looking at excluded income when filing a non-resident return. I find no such exclusion available for full-time residents.

Additionally, the SC1041 K-1 allocates ALL of the income to SC. Absolutely no entries exist in Column C, "Amounts Not Allocated or Apportioned to SC," but just shy of $100k is reported as PA sourced income with PA NR WH on the PA1041 K1.

Am I overlooking some exception in SC's Tax Code, or is this prospective client trying to find a tax preparer that will incorrectly prepare a tax return? They already told me they have spoken with several other CPAs here and "none of them get that it should not be taxable to SC." In other words, I guess these other CPAs are seeing a full-time resident not wanting to report out-of-state income to SC. I currently disagree with their stance and believe it is requires both PA and SC tax returns and remains taxable in SC...

Wouldn't the subtraction on Line 4h of the SC1040 cover this?

Wouldn't the subtraction on Line 4h of the SC1040 cover this?

That's the debate except SC Code Sec. 12-6-1720 under Article 13, which describes the treatment for this type of income, only references part-time and non-resident filings--not full-time residents. I cannot find any exclusion for full-time residents.

SECTION 12-6-560. Computation of resident individual's gross, adjusted gross, and taxable income.

A resident individual's South Carolina gross income, adjusted gross income, and taxable income is computed as determined under the Internal Revenue Code with the modifications provided in Article 9 of this chapter and subject to allocation and apportionment as provided in Article 17 of this chapter.

This is the only thing I can find that may allow the subtraction, under Article 17 Sec. 16-2-2220(3), but this section pertains to allocations from "personal services":

(3) Rents and royalties received from the lease or rental of real estate or tangible personal property, less all related expenses, are allocated to the state where the property was located at the time the income was derived providing the property was not used in or connected with the taxpayer's trade or business during the taxable year.

If this indeed applies, the SC1041 K-1 is incorrect as it allocates all of the income to SC instead of the actual situs or sources of income.

Does Kaestner apply? If not, might that be the source of client's confusion?

Wish I could help more, but I am not a SC expert so my input will end with this...

I have a client who is a SC resident who also has NC wages and NC rental income. After I completed my research, which was limited to instructions and publications, I emailed the Tax Credits department at SC-DOR. They confirmed that the SC resident was allowed a credit for taxes paid to other states on the tax paid to NC on the NC wages, and a deduction on line 4h for the NC rental income. I have filed their tax return this way for the last several years and have had no correspondence about it.

I only have one full time SC resident tax return that I prepare, so I don't know a lot. However, on the Form SC1040 there is a place to subtract out-of-state business/rental income, line 4h. Isn't that only used for full-time residents? Part-time residents and non- residents would use Schedule NR instead of this section?

The form instructions sure appear to allow the out-of-state business/rental deduction, just no deduction for wages. I have deducted income from a NC K-1 there for years with no issues.

I haven't been doing this for full-time SC residents because it indicates something about wages and business earnings. This is a passive activity. I'll look up Kaestner...it should not be this difficult to identify for resident vs. PT/NR. If PT, I would have already responded with "sure, no problem!" It does not mean it is correct, but I have taken over a lot of returns with out-of-state K1 income, including royalties and rentals, and no former CPA claimed a subtraction from Federal income on the SC1040--probably for the same reasons I have not.

To me the code is making a distinction between passive income and providing personal services for the same source of income for being able to take this subtraction for the PA royalties. "...providing the property was NOT used in or CONNECTED with the taxpayer's trade or business during the taxable year." Well, it is passive, but it is also referencing the subtraction in connection with personal service income (I think Article 9 refers to it as personal service income exception, then references allocations discussed under Article 17). Banging my head...

However, on the Form SC1040 there is a place to subtract out-of-state business/rental income, line 3h.

It is actually 4h. The SC1040 doesn't list the line number first, only the letters. Then it totals those amounts on the line number at the bottom. line 4h.

However, on the Form SC1040 there is a place to subtract out-of-state business/rental income, line 3h.

It is actually 4h. The SC1040 doesn't list the line number first, only the letters. Then it totals those amounts on the line number at the bottom. line 4h.

LOL, you're correct. I edited my post above.

Royalty income is not passive (as in passive v nonpassive) but instead is investment income. The land rental piece would be passive.

Just a thought, is the land generating the rental income the same as the land generating the mineral royalty income?

Here's the thing: there is NO rental income. It is all royalty income from minerals. It is reported as rental income on the 1041 K1.

The client messaged me today and cited the exact same thing I found as a "possible" subtraction from Federal taxable income, but it is directly connected with an area of the code specifically discussing tax treatment of personal services. How is earning royalties a personal service?

I found this, which references rental of real property and allocating income from it to the state of situs.

117–705. This regulation contains provisions for allocation of out of state income by a resident.

117–705.1. Allocation of Out-of-State Income and Losses.

Income or loss realized by resident individuals or partnerships from an established business, or from the lease or rental of tangible personal property or real property, the situs of which is in another state, shall be allocated to the state in which the business or property is located. Except, income of a resident individual or partnership, derived from personal services, is allocated to this State as provided in Section 12–6–2220(6).

However, in the case of a resident individual or partnership, conducting a business of a unitary or
homogenous nature, partly within and partly without this State, such income or loss is apportioned in
accordance with the provisions of Sections 12–6–2250 through 12–6–3360

My issue is this: The 1041 K1 describes the income as rental income, but it is actually royalty income from minerals being mined on the properties. But, instructions for Box 5 indicate it is for royalty income not subject to Sec. 469. Box 5 has a small amount but Box 7 is $260k, most of which is derived from TX property. Since TX does not have individual income tax, would that income not be subject to taxation in SC or does it appear the SC code section I cited above allows it to be fully excluded from SC income?

Also this and while the title includes "personal services," I think it is only in reference to Paragraph 6 that I did not copy since it specifically references personal service income.

SECTION 12-6-2220. Allocation of interest, dividends, rents and royalties, gains and losses, and income from personal services.

The following items of income must be directly allocated and excluded from the apportioned income and the apportionment factors:

...

(3) Rents and royalties received from the lease or rental of real estate or tangible personal property, less all related expenses, are allocated to the state where the property was located at the time the income was derived providing the property was not used in or connected with the taxpayer's trade or business during the taxable year.

...

What do you think, fully excludable from SC income? Is it not odd that the fiduciary allocated/apportioned ALL of the income to SC, including $100k allocated/apportioned to the PA K-1?

I feel like I am really overanalyzing this, it is excludable, but I am not following why the fiduciary prepared the K-1s in the manner they did.

It is my understanding that your mineral royalties should all go in Box 5 because it is not passive. An example of passive royalties would be someone who wrote a book and is earning royalties on the book sales. Sec. 469 is for royalties previously tied to a trade or business.

So what is their reasoning for putting the royalties in Box 7?

I don't know about mineral royalties being non-passive--I'll have to research that. I do not think this prospective client is telling the full story. Based on the K-1, I am thinking they own property they are renting out and also happen to receive a small sum of royalties from mineral extraction. It is the only structure I can identify where the K-1 then makes sense. In this case, I agree the PA portion is excludable from SC taxation, but I am not sure about the TX portion since TX is not taxing it. My thought process concerning TX being taxable to SC is based on the "no free lunch" concept.

This prospective client made it sound like a REIT investment that also provides mineral royalties. That seems incorrect, assuming the K-1 is properly prepared.

The TP is adamant all income is from mineral rights despite how it is reported on the K-1. This is their verbatim statement, which only addresses a portion of what I asked:

we own mineral rights on property via a Trust, and all the income is derived from the mineral rights.

So, does it really MATTER? I assume there are ways to buy into oil and mineral rights without owning the property, but if it is not property they own, why are there six figures of rental payments reported on K1 and less than $6k in royalties? The K1 makes no sense unless my brain is simply overlooking something, or I am not being told what the taxpayer needs to tell me...

And this still does not address what is majority TX-source income and if SC can tax it since TX is not.

In many western states you can own mineral rights and water rights and not own the land.
You can own land and not have the right to use the water on it or to extract the minerals on it.

I assume there are ways to buy into oil and mineral rights without owning the property, but if it is not property they own, why are there six figures of rental payments reported on K1 and less than $6k in royalties?

Perhaps the rents are drilling bonuses. You can’t take depletion on those.

Interesting. There is not any depletion indicated on the K-1.

Any thoughts on TX-sourced income? My only experience with TX is for taxpayers receiving income involving personal services, which are then taxed to SC.

From post by Cornerstone:

I don't know about mineral royalties being non-passive--I'll have to research that.

I didn't say that mineral royalties are "non-passive". I said that they are neither passive nor non-passive. They are investment income.

Yes, one can own some aspects of real estate and not others. Real property ownership is actually a "bundle of sticks" and each stick represents some "right". Water rights, mineral rights, surface rights, airspace rights, etc. It is extremely common in an oil-producing state like Texas where mineral rights are NOT sold with the land. So even if your client is leasing the surface rights (= rental income=passive), the mineral rights would be royalties=investment and they are reported and treated separately/differently.

The "lease income" could also be where the oil operator has leased some rights to the surface so that they can access and drill new wells with all the use of portions of the surface that entails. That would also be separate from the royalties that will ultimately be paid on the extracted minerals, if any. If this is a lucrative oil/gas field, those leases could be quite handsome. These leases could be new locations, while the current minerals are from a separate piece of land. Remember that the surface owners can get lease payments (temporary Right of Way agreements) even if they do not own the minerals underneath and will never get those royalties. There can be easements as well, that are considered an actual sale of some portion of the land surface due to their permanence.