4 Reasons to Consider Oil and Gas Investments for Tax Savings - Part 3

Reason 3 - Common Pitfalls in Pass-Through Tax Reporting

Pass-through entities, such as partnerships, LLCs, and publicly traded partnerships (PTPs), can be powerful investment vehicles for individuals seeking to benefit from the tax advantages available in the oil & gas industry.

However, when reporting becomes messy, mistakes can be costly. As someone who works with these filings regularly, I see the same issues repeatedly, even with experienced tax preparers who are unfamiliar with this specialized area of the tax code.

 Passive vs. Non-Passive Mismatch

• Why it matters: Misclassifying income as passive when it should be non-passive (or vice versa) changes how and when losses can be deducted, whether the self-employment tax applies, and whether the Net Investment Income Tax (NIIT) is applicable.

• The mistake: Many investors assume all K‑1 income is passive. In reality, working interest ownership is inherently non-passive, which is a unique feature of oil and gas taxation. Missteps here can mean lost deductions or unexpected tax bills.

Net Investment Income Tax (NIIT) Surprises

• Passive income is subject to the 3.8% NIIT if you’re above the income threshold.

• Misreporting can lead to either overpaying or underpaying if you aren’t planning with a tax specialist who has experience in the oil & gas industry.

• The IRS closely monitors passive and non-passive income bucketing, so accuracy is crucial.

Missing State Filing Obligations

• Oil & gas, as well as other multi-state partnerships, allocate income across multiple states.

• Many investors ignore the state schedules attached to their K‑1s, missing required nonresident filings.

• Even small allocations can trigger filing obligations, and states are aggressive in pursuing nonresident compliance.

• Remember: even if the partnership or investment says they file a return on your behalf, this is typically not permitted for certain types of trusts that are investors. This is a common misconception I often encounter.

Misunderstanding Depletion Schedules

• Complex depletion schedules attached to K-1s are often overlooked or misunderstood, potentially resulting in lost additional tax benefits.

• Misunderstanding the schedule can affect basis tracking, suspended loss calculations, and future deductions.

• These schedules are not standardized, so investors and preparers must carefully review them.

 Non-Standardized K‑1 Statements

• Not all K‑1s look the same. Supplemental statements vary widely by partnership.

• Investors often miss critical footnotes about state sourcing, special credits, or withholding.

• Failing to read beyond the “main” K‑1 page leads to incomplete reporting. This is a very common area where I see mistakes.

Takeaway

Pass-through reporting is full of traps: passive vs. non-passive mismatches, NIIT exposure, overlooked state filings, misunderstood depletion schedules, and non-standard K‑1 reporting. These mistakes aren’t rare; I see them constantly. Careful review and professional guidance are essential to avoid penalties, lost deductions, and unnecessary tax bills.

Pro Tips for Investors

• Always confirm whether your K‑1 income is passive or non-passive based on the type of interest in the oil and gas properties.

• Review NIIT exposure early if your income is near or above the threshold.

• Don’t ignore state schedules. Work with your CPA to determine if you should file nonresident returns even for small allocations.

• Reconcile depletion schedules carefully to protect basis and future deductions.

• Read supplemental K‑1 statements thoroughly; footnotes often contain critical tax details.

Meliora Consulting PLLC | tax advisory