OIL AND GAS TAX

A LOOK AT THIS YEAR’S HOT CONCEPTS

August 20-21, 2009 Brian Dethrow Jackson Walker, L.L.P.

901 Main Street, Suite 6000 Dallas, Texas 75202 [email protected]

214-953-5794

Change is coming . . . or “proposals floated for sinking you” Hodge podge of new tax plans mentioned

No percentage depletion, only “cost” remains No current expensing of IDC, really big as IDCs account for up to 80% No “working interest exception” from the passive activity loss rules

applies to investors looking for current tax deductions (but the deductions . . . and maybe the investors . . . are gone anyway) Carried interest rules for "investment services partnership interest" -- aimed at hedge funds and private equity funds regardless of underlying character of net partnership income (e.g., capital gain), service provider will book ordinary income subject to self-employment tax applies to a person who provides a substantial quantity of services (picking, managing, arranging financing)

applies to real estate and commodities (oil and gas is traded) may hit oil and gas deals Examples: consulting geologist gets a working interest in a prospect (if no opt-out from Subchapter K) consulting geologist is granted a partnership profits interest in investment partnership "promoter" brings in outside investors on similar basis Higher tax rates--both capital and ordinary rates; really serious for oil patch given loss of depletion/IDC

Crystal ball conclusions

Accelerate income - if you can stand it (low present values, low present tax rate) Be thoughtful making the election to "opt-in" to Subchapter K in your JOAs Explore overseas…..but check-a-box is under attack, too Drill now to get your IDC (drill baby, drill)

Key oil and gas issues we've seen lately

Net operating losses -- Section 382

Corporate and individual Huge now, especially with the potential loss of current oil and gas tax write-offs It could be your only "appreciating" asset, with tax rates rising Generate some gains before NOLs expire or get suspended use taxable exchanges (do NOT elect 1031 for like-kind exchanges) generate depletable basis BUT run pro formas on AMT and Texas margin tax (no free lunch)

Corporate NOLs get help to retain lose on 50% change in ownership over 3-year period new investors can essentially kill NOLs Individual NOLs don't die

Closed deals -- second thoughts!

Things looked good; closed deal; going to pay tax; now not so hot (consideration now not too valuable) Key date for valuation: closing--not today Times were great; now a crash in values Same issue with taxable equity grants to executives (stock or partnership interest)

Ideas to consider: Un-wind transaction Rescind -- if SAME TAX YEAR; not otherwise By December '09, be looking at "closed" deals to see if un-wind is feasible

Squeeze into installment sale reporting (Section 453) But what if a demand note? No 453 Bad basis recovery may be a toll charge

See if closing actually occurred European deal requiring "notorial seal" -- none obtained Taxable roll-up with IPO planned (you know the rest of the story)…..

Maybe it was a partnership interest Income partner stake not taxable upon receipt Perfect "partnership agreement" not required but clean facts and industry documents

Tex-Penn Taxable stock deal Speculative Lock-up

Discount consideration received Discount consideration received Discount consideration received Amend return Won't work on promissory notes On equity, hire valuation firm Lock-up creates discount Thin (or no) trading creates discount

When all else fails Generate losses to offset gains Use NOLs

Bad Investor Partnership Deals - Hotel California

IRRs from hell Looked good at the time Now deeply underwater Never going to see daylight?

Never going to see daylight?

Go-forward changes in partnership allocations/distributions not a tax problem Tough negotiations!

Non-competes???

Make lemonade: use today's low values to . . .

Corporations -- make the S election to be a pass-through entity C corp double tax is expensive C corp double tax avoided on FUTURE growth in value 10-year hold (7-year if made S election ’02 or ’03) Low value for double tax on current built-in gain each shareholder gets to handle his own depletion (like partnerships), choose cost/percentage

Incentivize the heck out of management at low values --

huge future upside; less cash cost today low current tax cost, but low current deduction to company, too income partner interests -- IRS certainty in safe harbor under section 83(b) liquidate today, management gets nothing must be held for two years (make protective 83(b) election - just in case) re-allocate income at liquidation to make proportionate (to extent possible)

capital interest current taxation to executive but nominal amount?

facts and circumstances test minority and marketability discounts risky--no safe harbor; return preparer issues?

Make family gifts

outright gift of (current) low value property outright gift of deep strata in Haynesville (retain shallow producing piece for current income and to diminish gift value) keep the current value -- gift the upside acronym techniques -- GRAT, IDGT Appalachian oil family with younger generation E&P company

community property agreement for old marriage community property basis step-up on death of first spouse 8-10 years of virtually tax-free income Get solid valuations – of industry interest and entity interest gift early, gift often

Housekeeping Issues

Opt into tax partnership in your Joint Operating Agreements give money partner full tax write-offs for money invested (IDCs--on money invested) avoid Rev. Rul. 7.176 for multiple operating interests in exchange for drilling services (unrelated property taxation) specially allocate tax items separately make depletion decisions (percentage vs cost) bring in workers using profits interests – see above BUT partnership tax returns annually, maintain capital accounts, etc. and potentially carried interest rules may apply

Be mindful of Texas margin tax -- 1% of gross receipts less COGs depletion may NOT be allowable as a COGs deduction passive entities are non-taxable entities LPs, GPs, trusts…..but NOT LLCs

at least 90% of federal gross income must be passive sourced; this is "passive": net capital gain from sale of real property (working interests) royalties, bonuses and delay rental income income from non-operating mineral interests (even working interests, if not the operator, including affiliates) if GP owns more than 50% of a partnership (including post-flip) and GP/affiliate is operator, partnership NOT passive

Brian Dethrow Partner – Tax, International

Brian Dethrow focuses his practice on tax and business planning for complex corporate, family, and inter-generational transactions. Mr. Dethrow has broad experience with innovative tax and corporate planning, including in the oil and gas arena. He has worked extensively with large business owners on business succession, asset protection, and gift and estate tax reduction strategies . Mr. Dethrow is admitted to practice in Texas. EDUCATION Mr. Dethrow received his B.A. degree,

with high honors

, from the University of Texas, where he was a member of

Phi Beta Kappa

. He received his J.D. degree from Harvard Law School .

Brian Dethrow Jackson Walker L.L.P.

901 Main Street, Suite 6000 Dallas, Texas 75202 214-953-5794 [email protected]