Understanding Self-Employment Tax in Oil and Gas Partnerships
Investing in oil and gas partnerships can provide significant tax advantages, but it also brings unique tax obligations—particularly regarding self-employment tax. Many investors enter these ventures without fully understanding how their working interest affects their self-employment tax liabilities. Here’s what you need to know.
What Is Self-Employment Tax?
Self-employment tax is imposed on individuals who earn income through self-employment rather than as traditional employees. It consists of Social Security and Medicare taxes, similar to payroll taxes withheld from employee wages. The current self-employment tax rate is 15.3%, split between Social Security (12.4%) and Medicare (2.9%) (IRC §1401).
How Self-Employment Tax Applies to Oil and Gas Partnerships
Typically, investors in partnerships are classified as limited partners, meaning they are not subject to self-employment tax on their share of the partnership’s income (IRC §1402(a)(13)). However, in oil and gas partnerships, a working interest significantly changes the tax treatment.
- Working Interest vs. Limited Partner Interest
- To qualify for key tax benefits, an investor must hold a working interest in the oil and gas partnership (Treas. Reg. §1.469-1T(e)(4)).
- A working interest means the investor has unlimited liability, making them a general partner instead of a limited partner.
- Because the taxpayer’s working interest in the partnership is operating a trade or business, their share of income is subject to self-employment tax (Cokes v. Commissioner, 91 T.C. 222 (1988)).
This distinction is important because while a working interest allows an investor to deduct intangible drilling costs (IDCs) immediately and take advantage of nonpassive loss treatment, it also subjects their earnings to self-employment tax.
Potential Tax Benefits in the Early Years
In the initial years of the investment, an oil and gas working interest can generate large deductible losses due to IDCs. These losses can be used to offset other nonpassive income, reducing overall taxable income.
For investors who usually owe significant self-employment tax, these losses can create substantial tax savings. The impact is especially beneficial if the investor’s usual self-employment earnings are below the Social Security wage base since the losses may help eliminate self-employment tax liability for the year.
Reporting Issues on Schedule SE
Investors should be aware of how IDCs are reported on tax returns:
- IDCs are not included in Box 14a on Partnership K-1s, which may create confusion (Instructions for Schedule K-1 (Form 1065)).
- Adjustments must be made on Schedule SE to reflect self-employment income properly. This means that in the tax software, tax professionals will have to manually override the Box 14a entry for NESE to be reduced by the deductible amount of IDCs. (IRS Reg §1.1402(a)-1 [note that in 1979 IRC §702(a)(9) was changed to (a)(8) and the 1402 regs have not changed], IRS Reg §1.702-1(a)(8)(i))
Changing from General Partner (GP) to Limited Partner (LP)
Some oil and gas investments transition general partners to a limited partner after a few years. This raises questions about whether income remains subject to self-employment tax:
- Limited partners are generally exempt from self-employment tax under IRC §1402(a)(13).
- However, simply changing the title from GP to LP may not be enough—the IRS looks at the investor’s actual role and level of participation (Soroban Capital Partners, L.P., 161 TC No. 12, 2023).
- If a taxpayer is truly passive in the business after the transition, their income may no longer be subject to self-employment tax.
Conclusion
Investors in oil and gas partnerships must carefully navigate self-employment tax rules. While holding a working interest can unlock valuable deductions and tax benefits, it also comes with the responsibility of paying self-employment tax. Understanding how to structure the investment and properly report income and deductions is key to maximizing tax advantages while staying compliant with IRS rules.
If you have questions about working interest in oil and gas partnerships, contact us.