What Is Working Interest?

What Is Working Interest?

Let me explain working interest to you directly—it's a form of investment in oil and gas drilling where you, as the investor, take on direct liability for a share of the ongoing costs tied to exploration, drilling, and production. In return, you get to fully participate in the profits if the wells succeed. This differs from royalty interests, where your costs are mostly limited to the initial outlay, which also caps your potential for big profits.

Key Takeaways

You need to know that working interest is specifically an investment in oil and gas operations. As an investor, you're on the hook for ongoing project costs but you also get a cut of any production profits. Keep in mind that both the costs and risks here are extremely high. On the plus side, there are tax benefits linked to those costs and any losses you incur.

Understanding Working Interest

Working interest, sometimes called operating interest, gives you a percentage ownership in the drilling operation—think of it as a lease that lets you join in the drilling and claim rights to the resources produced. Along with earning income from that production, you're responsible for a matching percentage of the acquisition expenses. You'll encounter two types: operated and non-operated. In an operated working interest, there's a designated operator handling all decisions—they pick the wells, manage drilling, and oversee daily operations.

If you're in a non-operated working interest, you're not involved in the day-to-day, but you do get consulted on production decisions. After covering operating expenses, the well operator splits any leftover funds among working interest holders—that's your income source. You can also deduct costs like equipment depreciation.

Advantages and Disadvantages of Working Interest

Every investment has its ups and downs, and working interest in oil and gas is no exception—I'll lay them out for you plainly. On the advantages side, the potential for financial gain is huge; successful wells can deliver sizable profits that last for years. You get tax benefits since losses count as active income and can offset other earnings, plus incentives where 65% to 80% of well funding costs might be tax-deductible. It's an active investment, so you have a say in decisions.

Now, the disadvantages: the initial investment is massive because you're covering production costs upfront. There's a high risk of loss with those steep costs, and you could be liable for on-site issues like employee injuries or environmental damage.

Tax Implications of Working Interest Income

Most working interest income is treated as self-employment income since you're essentially in a partnership, so it's taxed accordingly—you avoid the net investment income surtax but face Social Security and Medicare taxes. No automatic withholding happens, so you must make estimated tax payments based on current IRS rules. As of 2020, the self-employment tax rate in the US is 15.3%. If you get free resources like natural gas service from the leasing company, that could count as taxable income too. On the deduction side, you're eligible for write-offs on operating costs, whether tangible like equipment or intangible like utilities.

Risks of Working Interest

Given the potential for financial loss and other liabilities in working interest, you should take steps to minimize risks. I recommend setting up a limited liability company (LLC) or similar tax partnership when entering this kind of investment—it's mainly to shield yourself from liability. An LLC protects you from risks in the operation and vice versa. Alternatively, if you want lower risk, consider royalty interests instead; they let you participate in oil and gas with less exposure than working interest. With royalty interests, you usually don't need to fund beyond the initial investment, reducing the chance of further losses if expenses exceed income.