WORKING INTEREST OWNER'S DONATION OF OVERRIDING ROYALTY OR NET PROFITS INTEREST NOT DEDUCTIBLE, BECAUSE HE RETAINED CONTROL OF THE PROPERTY.

Rev. Rul. 88-37

ISSUE

If the owner of the working interest under an oil and gas lease gives an overriding royalty interest or a net profits interest to a charitable organization, is the gift deductible as a charitable contribution under section 170(a) of the Internal Revenue Code?

FACTS

SITUATION 1. A, an individual, is the owner of the entire working interest under an oil and gas lease. During the taxable year, A donates to a charitable organization described in section 170(c) of the Code an overriding royalty interest equal to 10 percent of the gross production from A's working interest under the lease.

SITUATION 2. The facts are the same except that the interest contributed is a net profits interest equal to 10 percent of the net profits from the donor's working interest.

LAW AND ANALYSIS

Section 170(a) of the Code provides, subject to certain limitations, a deduction for any charitable contribution (as defined in subsection (c)), payment of which is made within the taxable year. Section 1.170A-1(c)(1) of the Income Tax Regulations provides that if a charitable contribution is made in property other than money, the amount of the contribution is the fair market value of the property, reduced as provided in section 170(e) of the Code.

Section 170(f)(3) of the Code denies a charitable contribution deduction for certain contributions of partial interests in property. Section 170(f)(3)(A) provides that no charitable deduction is allowed for a contribution of less than the taxpayer's entire interest in property unless the value of the interest contributed would have been allowed as a deduction under section 170(f)(2) had it been transferred in trust.

Section 170(f)(2) of the Code provides, in the case of property transferred in trust, that a charitable deduction is allowed if the trust is a charitable remainder annuity trust, a charitable remainder unitrust, or a pooled income fund. Further, a deduction is allowed for the value of an interest in property (other than a remainder interest) transferred in trust if the interest is in the form of a guaranteed annuity or the trust instrument specifies that the interest is a fixed percentage distributed yearly of the fair market value of the trust property and the grantor is treated as the owner of such interest for purposes of applying section 671.

By its terms, section 170(f)(3)(A) does not apply to a contribution of an interest that, even though partial, is the taxpayer's entire interest in the property. If, however, the property in which such partial interest exists was divided in order to create such interest and thus avoid section 170(f)(3)(A), and deduction is not allowed. Section 1.170A-7(a)(2)(i) of the regulations.

Section 170(f)(3)(B)(ii) of the Code and section 1.170A-7(b) of the regulations provide that a deduction is allowed under section 170 of the Code for a contribution not in trust of a partial interest that is less than the donor's entire interest in property if the partial interest is an undivided portion of the donor's entire interest. An undivided portion of a donor's entire interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the donor in such property. A charitable contribution in perpetuity of an interest in property not in trust will not be considered a contribution of an undivided portion if the donor transfers some specific rights and retains other substantial rights.

In enacting section 170(f)(3), Congress was concerned with situations in which taxpayers might obtain a double benefit by taking a deduction for the present value of a contributed interest while also excluding from income subsequent receipts from the donated interest. In addition, Congress was concerned with situations in which, because the charity does not obtain all or an undivided portion of the significant rights in the property, the amount of a charitable contribution deduction might not correspond to the value of the benefit ultimately received by charity. The legislative solution was to guard against the possibility that such problems might arise by denying a deduction in situations involving partial interests unless the donation is cash in certain prescribed forms. See H.R. Rep. No. 91-413, 91st Cong., 1st Sess., 57-58 (1969), 1969-3 C.B. 200, 237; S. Rep. No. 91-552, 91st Cong., 1st Sess. 87 (1969), 1969-3 C.B. 423, 479. The scope of section 170(f)(3) thus extends beyond situations in which there is actual or probable manipulation of the non-charitable interest to the detriment of the charitable interest, or situations in which the donor has merely assigned the right to future income. Compare Estate of Brock v. Commissioner, 71 T.C. 901 (1979), aff'd per curiam, 630 F.2d 368 (5th Cir. 1980).

A working interest is the operating interest under an oil and gas lease. It is typically created by a transaction in which the owner of a tract of land, or the owner of the mineral rights to a tract of land, grants the right to exploit the oil and gas under the land, while at the same time retaining a royalty interest in production. Alternatively, the owner of a tract of land, or the owner of mineral rights to a tract of land, may, as in the instant case, retain the working interest and grant a royalty interest to another person. The owner of the working interest has the exclusive right to exploit the oil and gas resources. For federal tax purposes, a working interest is defined as an interest in oil and gas in place that is burdened with the cost of development and operation of the property. Brooks v. Commissioner, 424 F.2d 116 (5th Cir. 1970).

An overriding royalty interest is an economic interest in oil and gas in place, created from the working interest. An overriding royalty entitles its owner to a specified fraction of gross production, free of operating and developing costs. The term of an overriding royalty interest is coextensive with the term of the working interest from which it was created. The transfer of an overriding royalty is an assignment of a property interest and is not an anticipatory assignment of income. See Rev. Rul. 67-118, 1967-1 C.B. 163.

A net profits interest is, for federal tax purposes, an interest in oil and gas in place that is defined as a share of gross production measured by net profits from operation of the property. It is created out of the working interest and has the same duration. Unlike the income accruing to an overriding royalty, the income accruing to the net profits interest is reduced by specified operating and development costs, but the interest bears these expenses only to the extent of its share of the income. Unlike the working interest, the net profits interest is not required to pay out, advance, or become liable for such costs. Burns v. Commissioner, 78 T.C. 185, 209 (1982). Like a transfer of an overriding royalty, the transfer of such a net profits interest conveys, for federal tax purposes, a depletable property interest in oil and gas in place. See Kirby Petroleum Co. v. Commissioner, 326 U.S. 599 (1946), 1946-1 C.B. 69; Burton-Sutton Oil Co., Inc. v. Commissioner, 328 U.S. 25 (1946), 1946-1 C.B. 237.

The right to exploit the oil and gas resources under the land is a right inherent in the ownership of a working interest. Even an owner of only a percentage of the working interest has the right to participate in decisions on the exploitation of the oil and gas resources. The owner of an overriding royalty interest or a net profits interest does not have this right.

In Rev. Rul. 81-282, 1981-2 C.B. 78, an individual donated stock in a corporation to a charitable organization but retained the right to vote the contributed shares. The ruling notes that the right to vote stock is inherent in the ownership of common stock and, as such, is a property right. This right gives the holder a voice in the management of the corporation and is crucial in protecting the stockholder's financial interest. Therefore, the ruling concludes that the right to vote the stock is a substantial right in that stock. The ruling points out that although the taxpayer's retention of the right to vote the stock would not defeat the donee's interest in the transferred property, nevertheless, the taxpayer did not transfer all substantial rights in the stock to Y. The ruling holds that a deduction under section 170 is not allowed because the taxpayer transferred only a partial interest in the property and the interest assigned was not an undivided portion. See also Rev. Rul. 76-143, 1976-1 C.B. 63.

In Rev. Rul. 76-331, 1976-2 C.B. 52, Situation 1, a corporation transferred a tract of land to a charitable organization but retained all mineral rights with respect to the land, including the sole right to exploit any minerals obtained from the property. The ruling holds that a deduction under section 170 is not allowed because the taxpayer retained a substantial interest or right in the property and cannot be considered as donating an undivided portion of the taxpayer's entire interest. In 1980, Congress provided for a deduction in such a situation by adding an exception to section 170(f)(3) of the Code in the case of a "qualified conservation contribution." See sections 170(f)(3)(B)(iii) and 170(h)(2)(A) of the Code. The holding of Rev. Rul. 76-331 remains valid, however, for contributions that do not satisfy the requirements of a qualified conservation contribution.

In both Situation 1 and Situation 2 of the present ruling, even though the working interest was itself only a partial interest in the land, it was the individual's entire interest prior to the transfer to charity. Assuming, therefore, that the property in which the working interest existed was not previously divided in order to avoid section 170(f)(e)(A), and assuming that the other requirements of section 170 were met, a deduction would be allowable for the contribution of all or an undivided portion of the working interest. See sections 1.170A-7(a)(2)(i) and 1.170A-7(b)(1)(i) of the regulations; Rev. Rul. 76-523, 1976-2 C.B. 54.

In both Situations 1 and 2, however, the donor did not contribute the donor's entire interest in the property but carved out and contributed only a portion of that interest. Further, the portion contributed was not an undivided portion of the donor's interest because it did not convey a fraction of each and every substantial interest or right owned by the donor in the property. By transferring an overriding royalty interest or a net profits interest, the donor has retained the right inherent in the ownership of a working interest to control, or, in the case of ownership of a part of the working interest, to participate in the control of, the development and operation of the lease. This right to control or to participate in control, similar to the retained voting rights in Rev. Rul. 81- 282, is a substantial right, the retention of which prevents the donated interest from being considered an undivided portion.

After the transfer, in both Situations 1 and 2, the contributed interest is a separate property interest for federal tax purposes. However, if the charitable interest is created by dividing a greater interest held by the donor, the application of section 170(f)(3) to deny the charitable contribution deduction is not precluded merely because the contributed interest is a separate property in the hands of the donee and the incidence of taxation on income from the contributed interest is shifted from the donor to the donee. Rev. Rul. 70-477, 1970-2 C.B. 62, for example, holds that for years after the effective date of section 170(f)(3), a contribution of the rent- free use of property, even if recognized as a conveyance of property under local law, does not give rise to a deduction under section 170.

In both Situation 1 and Situation 2, therefore, the contributed interest is less than the taxpayer's entire interest within the meaning of section 170(f)(3) of the Code, and is not an undivided portion of the taxpayer's entire interest. In each case, the partial interest was not transferred in trust and was not in a form that would have resulted in an allowable deduction under section 170(f)(2) had it been transferred in trust.

HOLDING

In both Situation 1 and Situation 2 no deduction is allowed under section 170 of the Code.

DRAFTING INFORMATION

The principal author of this revenue ruling is Andrew Irving of the Interpretative Division. For further information regarding this revenue contact Stephen Weidman of the Individual Tax Division on (202) 566-3540 (not a toll-free call).