7857 / How do individuals invest in oil and natural gas?

Because exploration for, and production of, oil and natural gas requires large amounts of capital and technical expertise and involves a high degree of risk, few individuals are willing to “go it alone” in an oil or gas project. As a result, the normal practice in an oil and gas project is for individuals, groups of individuals, and even corporations to combine efforts and capital in some type of joint organization. The forms of organization commonly used for this purpose are:

…corporations, including S corporations;

…trusts;

…partnerships;

…limited partnerships; and

…joint ventures.

Sometimes a combination of these forms is used, particularly where considerations apart from the actual exploration and production of oil or gas are important to some or all of the investing parties. (For example, an individual may more effectively be able to limit liability in an oil and gas venture by incorporating the individual’s interest and then having the corporation become a member of the oil and gas limited partnership.)

Traditionally, the most commonly used method available to individual investors for investing capital in an oil and gas venture has been the purchase of an interest in an oil and gas limited partnership. Such partnership interests were often tradable, if at all, only on informal secondary markets or to the partnership itself. In the 1980s there was a growth in partnerships that are traded on established securities markets or are readily tradable on a secondary market (or the substantial equivalent thereof), referred to in the IRC as publicly traded partnerships. A master limited partnership (MLP, see Q 7768) that is publicly traded would fall within this definition. However, in taxable years beginning after 1987, a publicly traded partnership is taxed as a corporation unless 90 percent of the partnership’s income is passive-type income. In general, “passive-type income” for this purpose includes income and gain from certain mineral or natural resource activities, as well as interest, dividends, real property rents, gain from the sale of real property, and gain from the sale of a capital or IRC Section1231 asset. A grandfather rule is in effect for tax years after 1997 for electing 1987 partnerships (that agree to a 3.5 percent tax on their gross income); such a partnership otherwise operates as a passthrough entity.¹ Taxation as a corporation would defeat the “passthrough” feature of a limited partnership. (See Q 7728 on publicly traded partnerships.) So long as investors are interested in limiting their liability and do not wish to materially participate in the oil and gas investment, limited partnerships that manage to avoid taxation as a corporation should remain popular. In general, there are now two types of passthrough limited partnerships: regular (see Q 7732) and electing large partnerships (note that the electing large partnership rules were repealed for tax years beginning after 2017, see Q 7733).