7865 / How do the “passive loss” rules affect investment in an oil and gas program?

Application of the passive loss rules to an investment in an oil or gas program depends on the form in which the investment is made and the level of participation of the investor in the activity.¹ Investment in an oil or gas activity of a C corporation, other than a personal service corporation or closely held corporation, is not subject to the passive loss rules. Apparently, a publicly traded partnership taxed as a C corporation is also not a taxpayer subject to the passive loss rules.² (However, investment in a C corporation does not permit items of income and deductions to flow through to the shareholder-investor.) Also, a working interest in an oil or gas property that the investor owns directly or through any entity that does not limit the liability of the investor with respect to the interest is not a passive activity (see below).³ Otherwise, an oil or gas program will be subject to the passive loss rules, unless the investor materially participates in the program.⁴ Thus, an investor who wants the tax benefits of an oil or gas investment to flow through to him or her, but does not wish the oil and gas investment to be passive, must either forgo limited liability or materially participate in the venture. As a result, the typical investor in an oil or gas program will be subject to the passive loss rules (see Q 8010, Q 8011).

For purposes of the working interest exception, an entity is considered to limit liability if the taxpayer’s interest is in the form of (1) a limited partnership interest (unless the taxpayer is also a general partner), (2) stock in a corporation, or (3) any other interest in which the potential liability of a holder of such an interest is limited under state law to a determinable fixed amount, such as the taxpayer’s capital contribution. However, the following protections against loss are not taken into consideration in determining whether the entity limits liability: (1) an indemnification agreement, (2) a stop loss arrangement, (3) insurance, (4) any similar arrangement, or (5) any combination of (1) through (4).⁵ Two spouses are treated as separate taxpayers for purposes of the working interest in an oil or gas property exception.⁶

In general, the passive loss rules limit the amount of the taxpayer’s aggregate deductions from all passive activities to the amount of the taxpayer’s aggregate income from all passive activities; passive credits can be taken only against tax attributable to passive activities. The rules are applied separately in the case of a publicly traded partnership; aggregation is permitted only within the partnership.⁷ The rules are intended to prevent taxpayers from offsetting income in the form of salaries, interest, and dividends with losses from passive activities. However, the benefit of the disallowed passive losses and credits is generally not lost forever, but rather is postponed until such time as the taxpayer has additional passive income or disposes of the activity (see Q 8010 to Q 8021).

With respect to the working interest exception above, gross income from an oil or gas property is not treated as income from a passive activity if any loss from such property in a prior taxable year beginning after 1986 was treated as other than a passive loss solely by reason of the working interest exception, and not by reason of the taxpayer’s material participation in the activity.⁸

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1.  IRC § 469.