Revenue Ruling 83-46: Taxing Royalties for Services
Under Rev. Rul. 83-46, a royalty for services is taxed as income upon receipt, creating a basis that impacts future depletion and gain or loss.
IRS Revenue Ruling 83-46 establishes how to tax service providers who are compensated with an interest in mineral properties. When a person receives an overriding royalty interest for services, the fair market value of that interest is considered income and must be recognized in the year it is received. The ruling’s principle is the application of Section 83 of the Internal Revenue Code, which governs property transferred for services. This means the transaction is a taxable event at the moment of transfer.
Scope of the Ruling
This ruling impacts independent contractors like geologists, engineers, lawyers, and accountants who contribute to oil and gas properties and accept an economic interest in a mineral lease as payment. The ruling addresses situations where these providers receive an overriding royalty, which is a right to a share of production revenue, free of drilling and operations costs.
Revenue Ruling 83-46 clarifies the “pool of capital” doctrine. Previously, some taxpayers argued that receiving a mineral interest for services was a non-taxable contribution to a shared investment pool, with taxation deferred until the property generated income. The ruling narrowed this doctrine by stating it does not apply to these exchanges, making the receipt of the royalty interest the immediate taxable event.
Determining Fair Market Value
The taxpayer bears the burden of proving the fair market value of an overriding royalty interest. This can be a complex task for interests in unproven properties where future revenue is speculative. The value is not based on future potential alone but on what a willing buyer would pay a willing seller for the interest on the date it is transferred.
Several factors are considered when appraising the fair market value. These include geological and geophysical survey data and the prices of recent, comparable sales of mineral interests in the same geographic area. Often, a formal appraisal by a qualified expert specializing in mineral properties is necessary to substantiate the value reported to the IRS.
The valuation must be performed at the moment the interest is received and becomes substantially vested, meaning it is either transferable or not subject to a substantial risk of forfeiture. This timing is important because the value of mineral properties can fluctuate dramatically with new discoveries or changes in commodity prices. The determined fair market value represents the amount of ordinary income the service provider must recognize.
Tax Reporting and Subsequent Treatment
The service provider must report the determined fair market value as gross income for the tax year in which the royalty was received. For an independent contractor, this income is reported on Schedule C, “Profit or Loss from Business,” and is subject to self-employment taxes.
The amount of income recognized establishes the taxpayer’s cost basis in the overriding royalty interest. As the property begins to produce royalty payments, the taxpayer can recover this basis through depletion deductions. Cost depletion allows the taxpayer to deduct a portion of their basis each year as mineral reserves are extracted, reducing the taxable portion of the royalty income.
The cost basis is used to calculate the taxable gain or loss if the royalty interest is later sold or transferred. The gain or loss is the difference between the sales price and the taxpayer’s adjusted basis at the time of the sale. The adjusted basis is the original basis less any depletion deductions previously claimed.