Are Oil and Gas Royalties Qualified Business Income?
The US Energy Information Administration predicts that oil consumption will rise by 4% by the end of this year while increasing by 3% by 2023. So if you earn royalties passive income through oil and gas, you might see a potential increase in your revenue and net income.
But, mineral royalty owners might face a hike in their taxation compared to previous years. So while you will have to pay the 3.8% tax on royalties, rents, dividends, and capital gains, there’s still a way out.
If oil and gas royalties qualify for the qualified business income deduction, you can save a considerable amount yearly. This discourse will provide further insight into the subject.
What Are Oil and Gas Royalties Passive Income?
Royalties are mainly the income you receive when someone uses your property, patent, copyright, or natural resource.
In the case of oil and gas royalties, if you own a mineral-rich property, you can sell the oil and gas to an operating company and receive a royalty. You will still remain the owner of the mineral rights on the property and earn a steady passive income.
However, the royalty amount will be different every month, attributed to factors such as extraction quantity and fluctuating prices. So, while your income might usually be qualified business income, on some months, you might not be entitled to the 20% deduction that comes with it.
But what is a qualified business income, and do oil and gas royalties fall under this umbrella term?
You see, the Internal Revenue Service (IRS) categorizes oil and gas royalties as passive income. Nevertheless, you will still have to pay taxes on your passive income stream. This is because royalties are treated as part of your taxable income, and you must declare them in the same section when filing taxes.
An excellent way to save taxation money on your oil and gas royalties is by claiming the qualified business income deduction mentioned in Section 199A.
What is Qualified Business Income?
The primary definition of your qualified business income is the net income generated from businesses and trades that qualify. While this generally denotes the net profit of your business, there are some exceptions to qualified business income.
These include:
- Dividends
- Income generated from interest
- Capital gains and losses
- Income earned outside the US
- Payments made to partners and shareholders
You will have to deduct the mentioned amount from your net income to calculate your monthly qualified business income. Then, if your income amount meets the deduction threshold mandated by Section 199A, you’ll be entitled to the 20% deduction.
What is the Qualified Business Income Deduction?
We know what you’re thinking; what exactly is a qualified income deduction, and who is eligible for it? This taxation clause allows certain businesses to deduct up to 20% of their qualified business income from their taxes.
However, even if your oil and gas royalties passive income is considered qualified business income, your overall income should be under $170,050. Similarly, if you are a joint filer, your income should be under $340,100.
This threshold is mandated to rise in 2023 to $182,100 and $364,200, respectively. However, even if your income crosses that limit, you are still entitled to a full or partial deduction from your taxation amount.
Is Royalties Passive Income Qualified Business Income?
Mainly, qualified business income refers to all the income you would report on your tax return.
However, your monthly income amount and the type of business you earn royalties from may determine how much of your income is qualified business income.
The business entities specified by the IRS as qualified business income include:
- Sole Proprietorships
- Partnerships
- S Corporations
- Limited Liability Companies
Even if your income from the mentioned entities is above the mandated threshold, you can still claim the deduction depending on the nature of your business. So while you might not get the total 20% deduction, in this case, there’s a chance you can qualify for a limited percentage.
Does That Mean You Won’t Get the Qualified Income Deduction on Oil and Gas Royalties?
Regarding exclusions, the IRS has yet to precisely exempt oil and gas royalties’ passive income from qualified business income. However, whether or not royalties earned from this sector are entitled to the qualified business income deduction remains a daunting question.
Apart from the income limitations and business entity specifications, there are other exemptions from qualified business income deductions. For example, if your company is a specified service trade or business, you cannot receive the deduction even if your income falls below the limitations.
These industries include,
- Performing arts
- Athletics
- Consultancy
- Health
- Law
- Accounting
- Investment management
- Actuarial Science
- Trading
- Working with securities, partnership interests, and commodities
In a nutshell, an SSTB, specified service trade or business, is any business that involves a skill or reputation of an individual as a primary asset. However, the IRS still needs to have explicit rules regarding this subject, and with each business being unique, it is difficult to determine whether yours qualifies.
Are Oil and Gas Royalties Qualified Business Income?
Now that you have all the necessary information for discussion, it is time to answer the main question. Are oil and gas royalties qualified business income?
The net amount of qualified income items of gain, deduction, and loss that do not come from a C corporation are qualified business income. However, while the rules mention organizations and corporations, we need to take the qualified business income of an individual into perspective in the case of oil and gas royalties.
While the qualified business income deduction exceptions are mentioned above, it does not explicitly exclude mineral royalties or working interests. Therefore, to claim this deduction, you must look into other areas to determine whether the income is qualified business income.
Mineral-related income is classified into two main sectors, working income and royalty interest. The former is when an extraction company owning the mineral estate of a property earns from trading the oil and gas. The latter is when the owner of the mineral rights earns royalty.
While working income from oil and gas does produce qualified business income, the definition of royalty income remains obscure. However, royalties are usually treated as investment or portfolio assets, so income from royalties may not qualify as qualified business income.
Conclusion
Wrapping the discussion up, oil and gas royalties may or may not be regarded as qualified business income. That’s because while passive income is denoted in the taxable income, certain exceptions exclude certain passive income types from qualified business income.
It is important to note that Section 199A does not include any details about mineral royalties. This is because while a working interest in minerals is usually treated as a business activity, it is qualified business income. Still, the same cannot be said for royalty interest generated in exchange for a capital asset.
But, if your total qualified business income is within the mandated amount, referring potential tax advantages to qualified consultants is ideal when claiming deductions.
