The oil and gas industry is famous for its complex and sometimes crazy partnership arrangements. One common situation is referred to as the "carried interest." When one partner is "carried," the other partners typically foot the bill for drilling costs, while the carried partner receives his interest in the production for putting together the deal.
Third for a Quarter Example
For example, Greg forms an LLC and acquires some acreage in Oklahoma. Greg convinces Peggy, Ron and Frank to invest $1 million each to drill a deep gas well in the Anadarko Basin. Greg does not put any money into the LLC. The cost of the well will be $3 million. After the well is drilled, each member has 25 percent of net income from the well. Greg receives his 25 percent interest for his services in putting the LLC together. Peggy, Ron and Frank each paid a third of the drilling costs in exchange for 25 percent of the revenue interest. This deal is commonly referred to as a "third for a quarter."
Presumably, the deduction for intangible drilling costs (IDC) was allocated to Peggy, Ron and Frank with each receiving one-third. The question is whether Greg must recognize income on his receipt of his 25 percent profits interest. For many years, the answer was not entirely clear. Rev Proc 93-27 has reduced much of the confusion related to the receipt of a profits interest, though some questions still remain. The answer to this scenario is Greg is not currently taxed on the receipt of a 25 percent profits interest, provided that Greg did not receive an interest in the capital of the LLC. If Greg received a capital interest, he will be currently taxed on the receipt of 25 percent of the value of the LLC's assets.
To determine whether Greg received a capital interest, rather than a profits interest, we simply assume all assets are sold at fair market value (FMV) at the date the interest was received. If Greg is entitled to any proceeds from the gain, then his interest is a capital interest. However, if Greg is not entitled to anything, then he has a profits interest. The determination is made at the time the LLC was formed and capitalized, but before any monies are expended on IDC. Greg would have a zero capital account while Peggy, Ron and Frank each have $1 million capital accounts. If the LLC were liquidated and assuming certain liquidating provisions in the operating agreement, Peggy, Ron and Frank should get their money back while Greg would receive zero. Thus, Greg has no income upon formation of the LLC.
Profits Interest vs. Capital Interest
Carried interests are very common in our industry. Still, most deals are not as simple as this example. The distinction between a profits interest and a capital interest can be hard to define when more complex situations arise. Participants in these new ventures are encouraged to speak with a qualified tax advisor.
