Wind Energy Part 3 -- Royalties

I’ve discussed whether the rents from a wind energy deal would be rental income (ordinary income) or gain from the sale of something (presumably capital gain), but what about “royalties”?

Wind leases typically provide for additional payments based, in some fashion, on the income produced by wind energy production. However, unlike oil and gas production, the lessor in a wind transaction doesn’t actually own the production – the electricity. Contrast that with the characterization, for tax purposes, of oil and gas production. In oil and gas production, each owner of an “economic interest” is considered to own his share of production (and will, therefore, have to pay tax on his share of the production). So, a royalty in the oil and gas arena is actually considered to be ownership of production. However, in a wind lease, it seems pretty clear that the income is being produced from the sale of electricity – not from the actual sale of wind. Therefore, it would seem to follow that all of the income from the sale of electricity would be taxed to the developer/lessee. Any “royalty” that was paid would be more in the nature of rent that is simply measured by the income generating activities of the lessee – much like a shopping mall lease.

That conclusion really has no practical effect. That is, the “royalties” would be taxable in the same fashion as any other rent coming due under the arrangement. It is simply semantics. However, when you’re dealing with land-owners who are familiar with royalties in the oil and gas context, it may be a disservice to your client to refer to them as royalties.

But there may be a bundle of rights in a wind energy project that is equivalent, or at least analogous, to the rights of royalty holders of oil and gas production. In the oil and gas context, a royalty is the bundle of rights that gives the holder a non-executory right to oil and gas production. That bundle of rights is carved out of the mineral estate. And, it is considered, for federal income tax purposes, to be an “economic interest,” or property. Mightn’t there be a similar bundle of rights that can be carved out of a larger bundle of rights that, for tax purposes, is considered to be an “economic interest,” or property? If so, how “big” does that bundle of rights have to be for it to gain the status of an “economic interest,” or property, for federal income tax purposes?

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Comments (2) Read through and enter the discussion with the form at the end
lisa - September 26, 2008 10:51 AM

In a divorce in texas, what is the law on the inherited oil and gas royalties that was deposited in a joint bank account?
Oil and gas royalties were inherited during the marriage. Have been collected for the last 20 years, of a 35 yr marriage.

Jack Howell - September 26, 2008 12:29 PM

Lisa: There are a myriad of issues that should be addressed regarding the fact situation you describe, and you should probably seek legal counsel to get them all resolved. The following is not legal advice and you are not my client.

Royalties from oil and gas interests that are separate property are considered as sales of the separate property and not income from the separate property. As such, if the oil and gas royalties are separate property, the royalties would be separate property when earned. However, if they were co-mingled with community property after they were earned, then they may have lost their character as separate property.


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