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.

Many deals, especially those financed by investment funds, have a tiered or waterfall structure for allocating income and distributions.  It is normal for the partners who are putting the deal together and who will run the day-to-day operations to have a relatively small ownership percentage on the front end since most of the capital will come from an investment fund.

Over time, based on the entity’s performance and the increase in value of the enterprise, these “operations partners” may increase their ownership percentage in the income and profits of the partnership.  This will usually occur once certain return hurdles are met for the “investment partners.”  Unless provided for in the partnership agreement, this switch in sharing percentages will result in the “investment partners” being allocated more income and therefore more distributions over time that the parties intend.

Although there are several options, the best way to make sure all partners end up being allocated the income and distributions everyone intends each party to receive over time, is to handle income allocation and distribution provisions independently in the partnership agreement.