What is a tax partnership and why should I care?

Assistance on this post provided by Emily Strong.

A tax partnership is a tool used in certain drilling arrangements to ensure that the working interest owner who bears the cost of drilling a well also gets the tax benefits related to those costs.

Consider the following example.  A working interest owner who doesn’t have the cash to drill and develop his property strikes a deal with a third party operator to fund all of the drilling costs in exchange for a working interest in the property.  Even though the operator will incur all of the costs to drill that well, he can only deduct IDC in proportion to his ultimate working interest percentage.  The remaining IDC is treated as additional leasehold cost and is depleted (deducted) over time.  As a result, tax deductions for IDC paid in one year are not realized for tax purposes until later years. 

Here’s where a tax partnership  can be a huge benefit to the operator.  By establishing a tax partnership and contributing all of the property and the costs of drilling and development to that partnership, all of the costs incurred (and resulting tax benefits) can be allocated to the operator regardless of the ultimate working interest percentages.

Using a tax partnership is not without its hassles.  The biggest headache is the administrative burden of accounting for the activity of the partnership and the requirement to file a federal partnership tax return each year.  Therefore, you should carefully consider the tax implications before deciding to use a tax partnership.

If you have questions about whether you might benefit from using a tax partnership, we can help.