Severance Tax Related to Oil & Gas Royalties
Whether you’re an oil or gas well producer or you earn mineral royalties, knowing everything about taxes is important. Taxes are often complicated, especially if you have money coming in from different sources. As an oil and gas royalties earner, you’ll also be liable to pay severance pay and taxes.
The severance tax is collected on a state level. So, you’d be paying this tax to the state the minerals are located in. This includes even if you don’t really live in that state. But why do you need to pay this tax if you’re already paying income tax on your royalties? Let’s find out.
Severance Tax In-depth Definition
A severance tax is imposed by the state on the extraction of non-renewable resources. This includes such as crude oil, natural gas, uranium, timber, and coal. This tax is imposed to make up for the loss (severance) of the resources from the surface and ground of the state.
Since it’s a state-level tax, the rules vary by state. There’s no severance tax in the federal tax system, but you do pay income tax on your royalties or earnings from the extraction of these resources.
This tax may be charged to any party with an interest in the extraction of the minerals from below the ground or even the surface. Now, that means the tax is not only applicable to the companies extracting and selling the minerals but also to the owners who may be earning royalties from those minerals.
How is Severance Tax Calculated?
A severance tax is collected by the state, and each state has its own rules. You would have to check with the state tax collection agency to see how exactly the tax is calculated.
The tax is typically based on the value of the resources or the number of minerals extracted from the wells. Some states use a combination of both to determine how much tax is owed in severance pay.
Some states don’t even charge this tax to the companies or owners of the minerals.
Pennsylvania, which is the largest producer of natural gas in the US, does not levy this tax on companies or royalties earners. However, it does charge an impact tax, which is similar to the severance tax. It’s a one-time tax the companies pay for drilling unusual wells and is not based on resources.
Other states that don’t charge severance include Iowa and New York.
The good news is that most states only charge severance on wells that produce over a certain amount of oil or gas. This encourages oil and gas producers not to abandon less productive wells in those states. So, essentially, you only pay this tax when the well is actually producing resources in abundance.
How much of this tax each party pays is calculated on a pro-rata basis. For instance, those earning royalties from oil and gas wells will have severance tax deducted from their monthly royalty payments. The company paying you the royalties will already deduct this tax, so you don’t really have to pay it separately to the state.
Is Severance Tax a Deductible?
Oil and gas companies can use the severance tax as a deductible for federal taxes. It can be a deductible from the corporate income to reduce federal income taxes. However, companies and royalties earners are still subject to pay federal and state income tax on their earnings.
Normally, companies and even royalties earners still have to pay considerable income tax on their earnings from the oil and gas well, despite paying severance taxes to their respective states. As a result, the deduction may not always have a big impact on the final income tax you have to pay.
Now, what about states that do not collect income tax like Texas? Well, severance tax is different from income tax. So even states that do not collect income tax on your royalties may ask for severance taxes. Since Texas doesn’t charge income tax to its residents, severance taxes is one of the ways it generates tax revenue.
Why Do States Charge With this Tax?
The whole idea of severance pay and taxes is that the resources that are extracted from the wells may not be replenished. They have been severed from the ground, so you have to pay for that loss. In essence, it’s just another type of income tax levied based on the resources.
While state government earnings can be high from severance pays and taxes, but rarely do these taxes make up a big part of the overall state tax revenue. However, in states with big oil and gas industries and perhaps relatively smaller populations, severance tax can be a major part of the revenue (for example, Wyoming).
Some states have also created severance endowments that have grown to be worth billions of dollars. Those endowments help states to make more money and improve infrastructure and facilities.
Severance Tax by State
Currently, there are 34 states that have some form of this tax or fee in place for oil and gas income. These are largely states that have considerable production of oil and gas, like in the South and the North.
You can find the exact tax rates by each state on this interactive map developed by the National Conference of State Legislatures. You’ll see that most states charge on the value of the resource.
This value is commonly based on per barrel for oil and cubic feet production for gas. However, calculating that value is not such a simple process.
You can also see where this tax revenue goes for each state. If you’re a royalties earner, you can get a rough idea as to how much tax is owed by the company paying you royalties.
The severance tax is an important way for states to collect taxes and revenue on resources that are naturally present there. The good thing is that you can use these state taxes as deductibles for federal income tax.
Often states also offer rebates and incentives to keep the companies drilling and extracting. Of course, very high taxes would be discouraging for both companies and mineral owners.
If you have further question about this tax, reach out to us here.