Appellate Court Affirms That Bonus Payment Is Ordinary Income.

The petitioner received $883,250 as an up-front bonus payment to allow  an oil and gas company to lock-up his property for an eventual lease.  The petitioner treated the amount as capital gain and argued that the agreement under which he was paid the bonus constituted a sale rather than being a lease.  The IRS claimed that the amount was ordinary income and assessed additional tax of $147,397 and imposed an accuracy-related penalty of $29,479.  The Tax Court agreed with the IRS and also disallowed a percentage depletion deduction because no production had occurred.  No well had been drilled on the property at the time the payment was received and a permanent easement was not involved.  On appeal, the court affirmed.  The appellate court noted that the agreement was for five years and could be automatically extended as long as thereafter as either oil or gas was being produced from the property.  There was also a "shut-in" clause.  Under the agreement, the petitioner was entitled to royalty payments equal to 16 percent of the net profits of extracted oil and gas.  The court determined that the royalty interest was an economic interest that made the transaction a lease.  There also was not determinable quantity of oil and gas for a determined price, which would have been evidence of a sale.  Dudek v. Comr., No. 14-1517, 2014 U.S. App. LEXIS 24428 (3d Cir. Dec. 24, 2014), aff'g., T.C. Memo. 2013-2.

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