Tax Court - Operating Agreement for Oil and Gas Interests Created Partnership.

(Parker Tax Publishing May 9, 2015)

The Tax Court held that the operating agreement under which a taxpayer received working interests in oil and gas ventures created a partnership under the broad definition found in Code Sec. 7701(a)(2) and thus the taxpayer was liable for self-employment taxes on his net income from the interests. Methvin v. Comm'r, T.C. Memo. 2015-81.

Background

For most of his professional life, David Methvin was the CEO of a computer company. In the early 1970s, Methvin acquired working interests in several oil and gas ventures, with his ownership ranging between 2 percent and 3 percent in each venture. These working interests were governed by a purchase and operation agreement entered into by Methvin and Egan Resources, Inc. (Egan).

Under the agreement, Egan managed the operations of the ventures and allocated to Methvin the income and expenses from his working interests. Methvin had no right of involvement in the management or operation of the ventures, and in the agreement the parties elected under Code Sec. 761(a) to be excluded from the application of subchapter K.

During 2011, Methvin's working interests generated $10,797 in revenues, and he was allocated expenses totaling $4,037. For 2011, Egan identified the revenues as nonemployee compensation and issued the taxpayer a Form 1099-MISC. Methvin did not receive a Schedule K-1 from Egan, and Egan did not file a Form 1065 relating to any of the taxpayer's working interests.

On his 2011 return, Methvin reported $6,760 of net income ($10,797 in revenues less $4,037 in expenses) from his working interests as "other income" and did not pay any self-employment tax on the income from the oil and gas venture. The IRS determined that Methvin's income from his working interests was subject to self-employment tax, and issued a notice of deficiency.

Analysis

A partnership is broadly defined as a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term partner' includes a member in such a syndicate, group, pool, joint venture, or organization (Code Sec. 7701(a)(2); Reg. Sec. 1.1402(a)-2(f)).

At the election of all the members of an unincorporated organization, the organization may be excluded from applying all or part of the subchapter K rules if the income of the members of the organization may be adequately determined without the computation of partnership taxable income (Code Sec. 761(a)).

The IRS argued that Methvin's net profits from his oil and gas working interests were subject to self-employment tax as income from a trade or business carried on by a partnership or a joint venture taxable as a partnership. Methvin contended that he was not engaged in a trade or business and was not a partner in a partnership, arguing that his minority working interests were merely investments and that his activity in connection with them did not rise to the level of a trade or business.

In support of his contention, Methvin emphasized his lack of active involvement in the operation of the wells, his lack of knowledge and expertise in the oil industry, and the fact that his working interests were small, minority interests. The Tax Court was unconvinced, noting that a taxpayer who is not personally active in the management or operation of a trade or business may be liable for self-employment tax if the trade or business is carried out on his behalf and that "net earnings from self-employment" include the distributive share of income from a partnership in which he was a member (Cokes v. Comm'r, 91 T.C. 222 (1988)). Additionally, since the question was whether the taxpayer was a member of a partnership or a joint venture treated as a partnership, the court determined Methvin's lack of control due to his minority interests would not affect that question, citing Perry v. Comm'r, T.C. Memo. 1994-215.

Methvin also argued that the agreement could not be considered a partnership because he and Egan specifically elected to be excluded from the application of subchapter K. However, the Tax Court pointed out that in Bryant v. Comm'r, 46 T.C. 848 (1966), it had held that such an election simply prevents the application of subchapter K and does not change the nature of the entity. Accordingly, the court determined the election under Code Sec. 761(a) did not prevent it from finding that the operating agreement created a partnership.

Finding none of Methvin's arguments persuasive, the Tax Court concluded that the working interest owners and well operator created a pool or joint venture for operation of the wells. Accordingly, the court found the taxpayer's income from the working interests was income from a partnership of which he was a member under the broad definition of "partnership" found in Code Sec. 7701(a)(2). The court therefore held that Methvin was liable for self-employment tax on the net income received from his working interests.

For a discussion of net earnings from self-employment, including the rules relating to partners and partnerships, see Parker Tax ¶ 13,120.30. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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