OIL AND GAS INVESTMENTS
OIL AND GAS INVESTING
Several different avenues are available for oil and gas investors. These can be broken down into four major categories: mutual funds, partnerships, royalty interests and working interests. Each has a different risk level and separate rules for taxation.
While this investment method contains the least amount of risk for the investor, it also does not provide any of the tax benefits listed above. Investors will pay tax on all dividends and capital gains, just as they would with other funds.
Several forms of partnerships can be used for oil and gas investments. Limited partnerships are the most common, as they limit the liability of the entire producing project to the amount of the partner’s investment. These are sold as securities and must be registered with the Securities and Exchange Commission (SEC). The tax incentives listed above are available on a pass-through basis. The partner will receive a Form K-1 each year detailing his or her share of the revenue and expenses.
This is the compensation received by those who own the land where oil and gas wells are drilled. This income comes “off the top” of the gross revenue generated from the wells. Landowners typically receive anywhere from 12-20% of the gross production. (Obviously, owning land that contains oil and gas reserves can be extremely profitable.) Furthermore, landowners assume no liability of any kind relating to the leases or wells. However, landowners also are not eligible for any of the tax benefits enjoyed by those who own working or partnership interests. All royalty income is reportable on Schedule E of Form 1040.
This is by far the riskiest and most involved way to participate in an oil and gas investment. All income received in this form is reportable on Schedule C of the 1040. Although it is considered self-employment income and is subject to self-employment tax, most investors who participate in this capacity already have incomes that exceed the taxable wage base for Social Security. Working interests are not considered to be securities and therefore require no license to sell. This type of arrangement is similar to a general partnership in that each participant has unlimited liability. Working interests can quite often be bought and sold by a gentleman’s agreement.
Potential Risks in Oil and Gas Investments
- Oil and Gas investments are notoriously riskier than many other investments and should be evaluated carefully by tax and legal advisors with expertise in the oil and gas field.
- Oil and Gas resources are depleting so in order to maintain a cash flow stream new sources of oil and gas must be developed and produced to replace the depleting components.
- Fees and Expenses associated with Oil and Gas Investments can negatively affect their performance and should be thoroughly reviewed in the PPM.
- The following SEC Investor Alert on Oil and Gas has some helpful information as you review potential investments http://www.sec.gov/investor/alerts/ia_oilgas.pdf
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