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TCJA: Mining the Tax Benefits for Natural Resources Holders
Dec 1, 2021, 13:01 PM
by
Edward A. Kollar, CPA, EA, CSEP
Pennsylvania has a vast wealth of natural resources: minerals, coal, stone, forests, and, of course, natural gas and petroleum. This abundance can result in an economic benefit for property owners as well as for those who develop, mine, and harvest such resources.
This story was published in December 2018
Pennsylvania has a vast wealth of natural resources: minerals, coal, stone (Pennsylvania bluestone or flagstone), forests, and, of course, natural gas and petroleum. This abundance can result in an economic benefit for property owners as well as for those who develop, mine, and harvest such resources.
These economic benefits bring obligatory tax consequences. In December 2017, Congress passed the Tax Cuts and Jobs Act1 (TCJA), which led to the most sweeping changes to the U.S. tax code in over 30 years. This feature looks at how the TCJA affects those taxpayers with natural resource sector interests.
One of the TCJA’s most pronounced changes concerns the tax rate for C corporations. As of Jan. 1, 2018, the rate is now a flat 21 percent, rather than at graduated rates between 15 percent and 35 percent. Another significant effect on C corporations is the elimination of the Alternative Minimum Tax (AMT), which can affect small operations to major companies.
Generally, the owner of an economic interest in a mineral property is taxed on the income from that property, and is allowed to claim the corresponding deduction for depletion.2 The depletion deduction applies to mines, oil and gas wells, other natural deposits, and timber. Other than timber – upon which depletion is computed solely upon the adjusted basis of the property – the owners of other exhaustible natural resources are entitled to compute the depletion deduction upon either cost or percentage depletion, whichever results in the greater deduction.
The amount of percentage depletion in excess of cost depletion is a tax preference item for AMT purposes other than oil and gas independent producers and royalty owners.3 Prior to the TCJA, AMT didn’t apply to smaller C corporations whose average gross receipts did not exceed $7.5 million for a three-year period; now, no C corporations are subject to the AMT. Businesses involved in the mining industry – such as those that quarry bluestone in northeastern Pennsylvania – who are organized as C corporations will be allowed to take percentage deletion without concerns of the AMT affecting their tax liability. If the corporation had any unused minimum tax credit, it is refundable in tax years 2018 through 2021.4
With the new lower C corporation tax rate, tax advisers have been looking at whether taxpayers organized as an S corporation should revoke the S election and become a C corporation. The biggest concern here is the rule whereby after an S corporation terminates its S status, it cannot reelect S status for a period of five years without IRS consent.5 As part of reviewing a conversion from an S corporation to a C corporation, the TCJA added Internal Revenue Code (IRC) Section 481(d), whereby any IRC Section 481(a) adjustment resulting from an accounting method change that is attributable to an eligible S corporation’s revocation of its S election will be taken into account over a six-year period. Practitioners involved in such a situation should review Revenue Procedure 2018-44. The elimination of the AMT adds a new layer of complexity to the planning of such a conversion, as individuals are still subject to the AMT. Adding another layer: the tax rate for Pennsylvania C corporations stays at 9.99 percent, while for individuals it remains at 3.07 percent.
The TCJA provides for the cash method of accounting, and it eliminates both the requirement to use inventories and the requirement to apply the uniform capitalization rules for businesses with gross receipts of $25 million or less. A number of businesses involved in natural resources are smaller, family operations; this should help streamline the accounting operations for many. This change does not affect the $25 million gross receipts test that had applied to family farming corporations and those parts of IRC Section 447 that were removed.
Taxpayers in the oil and gas industry and other natural resource operations organize in a variety of entities: C corporations, partnerships, S corporations, and directly by an individual. New depreciation rules included in the TCJA will affect all of them. Bonus depreciation increases from 50 percent to 100 percent for qualified property placed in service after Sept. 27, 2017, and begins to phase out after Jan. 1, 2023. Taxpayers may elect to use the 50 percent rule for qualified property placed in service during the taxpayer’s first tax year ending after Sept. 27, 2017. While the increase to 100 percent is significant, more significant is that used property now qualifies for bonus depreciation.6 Many businesses in natural resources may purchase used equipment as cost savings. This now allows the taxpayer to take bonus depreciation on the purchase, and deduct the entire cost. Previously, to deduct the entire cost the taxpayer was required to use IRC Section 179. However, IRC Section 179 is limited to taxable income. By taking bonus depreciation, a taxpayer may be able to create a loss in the business operations.
In addition to the change in bonus depreciation is the elimination of like-kind exchanges for depreciable tangible personal property. The TCJA allows like-kind exchanges on real property only after Dec. 31, 2017.7 This requires a taxpayer, such as in a mining operation, to record a gain or loss on the trade-in of a piece of equipment, and then record the sale at the full purchase price. It is possible the net result would be the same. As a result, the taxpayer would then be able to take bonus depreciation on the cost of the replacement equipment to offset any gain.
Another component of the TCJA is the increased IRC Section 179 deduction to $1 million and the investment limitation to $2.5 million for years beginning after 2017. These increases are permanent and adjusted for inflation. Even though IRC Section 179 is limited to taxable income, this does allow for tax planning in determining whether to take bonus depreciation or IRC Section 179.
Equipment purchases for drilling, mining, and timbering operations can easily run into the hundreds of thousands of dollars, leading to considerable debt for the taxpayer. The TCJA amended IRC Section 163(j) to limit business interest for tax years beginning after 2017 to 30 percent of adjusted taxable income. The limitation does not apply to small businesses with gross receipts of $25 million or less. Any interest disallowed as a deduction may be carried forward and treated as business interest in the succeeding tax year, and may be carried forward indefinitely. However, for partnerships and S corporations, any excess business interest is allocated to each partner or shareholder. The excess business interest carries forward to the next succeeding year by each partner or shareholder, but is limited to the taxable income from the entity in the succeeding year. Specific rules relate to the computation of adjusted taxable income in that it is computed without regard to any item of income or deduction not properly allocated to a trade or business; any business interest or business interest income; any net operating loss deduction; the 20 percent qualified business income deduction; and, for years beginning prior to Jan. 1, 2022, deductions for depreciation, amortization, or depletion.
Prior to the TCJA, taxpayers in certain qualified domestic production activities received a deduction of an amount equal to 9 percent of the lesser of the qualified production activity income of the taxpayer for the year or the taxable income for the taxable year. Commonly known as the domestic production activities deduction (DPAD), activities used in calculating the deduction included receipts from property grown or extracted within the United States and natural gas produced in the United States. In a major hit for taxpayers involved in these activities, Section 13305(a) of the TCJA repealed the deduction. However, the TCJA added IRC Section 199A, known as the qualified business income deduction. This new rule provides for a deduction of up to 20 percent of certain qualified income from a partnership, S corporation, or sole proprietorship for the tax year. Note that IRC Section 199A is not allowed for C corporations, as their tax rate has been changed to a flat 21 percent as described above. For C corporations, the loss of the DPAD is offset by the lower tax rate. The new IRC Section 199A deduction applies to tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026.
Depending on the situation, calculation of the deduction can be complex. All one has to do is look at the proposed regulations issued in August 2018. Generally, the deduction is limited to the greater of 50 percent of the W-2 wages paid by the business or the sum of 25 percent of the W-2 wages paid plus 2.5 percent of the unadjusted basis of certain property the business uses to produce qualified business income. Certain trades or businesses do not receive the deduction, but there is a phase-in for taxpayers whose taxable income meets certain threshold requirements.8 IRC Section 199A does not specifically address whether farming, mining, or oil and gas working or operating interests qualify for the deduction. However, IRC Section 199A states that a taxpayer must be engaged in a “qualified trade or business,” which is any trade or business other than a specified service trade or business, or the trade or business of performing services as an employee.9 IRC Section 199A does address which specified trades or businesses do not qualify.10 Based on the preceding, farming, mining, and oil and gas working or operating interest would qualify for the deduction. Also benefiting will be oil and gas companies structured as partnerships, including master limited partnerships.
Where does that leave owners of a royalty interest? IRC Section 614(d) defines “operating mineral interest” to include only an interest for which the “costs of production of the mineral” are borne by the operator. IRC Section 614(e) defines “nonoperating mineral interest” as interests that are not operating interests. A royalty interest is a nonoperating mineral interest since royalty interest owners bear no portion of the costs of exploration, development, or production. Unfortunately, IRC Section 199A does not mention royalties in its list of investment items that are not taken into account as a qualified item of income, gain, deduction, or loss.11 However, looking at IRC Section 1411, the Net Investment Income Tax (NIIT), it appears that most of the items subject to the NIIT are the same items not eligible for qualified business income deduction. Also, consider that the IRS Oil and Gas Industry Market Segment Specialized Program specifically states that portfolio income includes oil and gas royalties, with two exceptions:
- Treas. Reg. Section 1.469-2T(c)(3)(iii)(B) provides active income treatment for royalties derived in the ordinary course of a trade or business. This exception does not apply to a taxpayer who is not a dealer in royalties.
- Treas. Reg. Section 1.469-2T(c)(3)(ii)(G) requires the income to be identified by the commissioner as income derived in a trade or business. The taxpayer must request a ruling to have the royalties characterized as trade or business income. Industry publications suggest that taxpayers should request a ruling to treat oil and gas royalties as nonpassive income derived in a trade or business. Until, or if ever, the commissioner expands the regulations to include certain oil and gas royalties as business income, oil and gas royalties are to be included as portfolio income.
Another item that may affect taxpayers in the natural resource arena is a change in the net operating loss (NOL) deduction.13 Prior to the TCJA, generally NOLs carried back two years or forward 20 years. Section 13302 of the TCJA amended the code so that NOLs arising after 2017 may only be carried forward, but they may be carried forward indefinitely. However, as part of the new law, the NOL may only reduce 80 percent of the taxpayer’s taxable income in the carryforward year. NOLs arising in years beginning prior to Jan. 1, 2018, are not subject to the 80 percent limitation. Thus, it is possible that a taxpayer may have taxable income even though the NOL carryforward is greater than the taxpayer’s gross income.
Also, the TCJA put a $10,000 limit on the state and local tax deductions on Schedule A.14 Considering that many gas lease royalty owners pay much more than that in estimated state tax payments, this will be a hit to them. However, the TCJA increased the standard deduction – almost doubling it.15 Married individuals are now entitled to a deduction of $24,000; the deduction for head of household is now $18,000; and the deduction for single individuals and those married individuals filing separately is now $12,000. These are all to be adjusted for inflation.
As stated above, the amount of percentage depletion in excess of cost depletion is a tax preference item for AMT purposes, other than for oil and gas independent producers and royalty owners. This means that royalty owners of mining operations may be subject to AMT. The TCJA increases the exemption amount phase-out thresholds significantly, and allows for the amounts to be adjusted for inflation. Considering that the state and local tax deduction (an AMT preference item) is now limited to $10,000, fewer taxpayers should be subject to the AMT.
The TCJA ushered in major changes to the U.S. tax code. Tax rates for both corporations and individuals decreased. Many deductions were eliminated or reduced. A significant new one in the form of IRC Section 199A was added. Changes to the AMT, both on the individual and business side, are meaningful. Finally, and most importantly, the TCJA is an opportunity for CPAs who have clients involved in natural resources to take a fresh look at their operations. These changes provide a new perspective for companies and their CPAs to evaluate the tax effects of owner compensation, rental of business property, acquisition of equipment, financing, and overall business structure.
1 P.L. 115-97, signed by President Donald J. Trump on Dec. 22, 2017.
2 Reg. Section 1.611-1.
3 IRC Section 57(a)(1).
4 IRC Section 53(e).
5 IRC Section 1362(g).
6 IRC Section 168(k)920(A)(ii).
7 IRC Section 1031(a)(1), as amended by P.L. 115-97.
8 IRC Section 199A(d).
9 IRC Section 199A(d)(1).
10 IRC Section 199A(d)(2).
11 IRC Section 199A(c)(3)(B).
12 IRC Section 6662(a).
13 IRC Section 172.
14 IRC Section 164(b)(6).
15 IRC Section 63(c)(7).
Edward A. Kollar, CPA, EA, CSEP, is firm director for Baker Tilly Virchow Krause LLP in Wilkes-Barre. He can be reached at ed.kollar@bakertilly.com.
