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Beginning in 1977, there was an explosion in the use of the partnership as a form for the joint development of oil and gas properties. A first cause of this explosion was the promulgation by the Internal Revenue Service of Rev. Rul. 77-176, 1977-1 CB. 77. Rev. Rul. 77-176 misaligned the tax consequences of joint development with the economic arrangements among parties which followed "first principles" that developed primarily under the "pool of capital doctrine." Partnerships were used by practitioners to re-align tax consequences with economic consequences of joint development.
First Principles: Risk Sharing and Tax Alignment
First principles of both tax planning and economic arrangements for the joint development of oil and gas properties are based on risk sharing. Generally speaking the agreements follow the maxim "If a party bears the cost of an aspect of development, that party should enjoy the tax consequences and the economic consequences of that cost." For example, the party that pays for the lease expects to bear the economic burden of depletion and worthlessness and to be allocated the tax deductions associated with these economic consequences. On the other hand, the party that pays for the cost of drilling the well expects to bear the economic risk of a dry hole and to deduct the intangible drilling and development costs. Each party expects the allocation of economic benefits and burdens agreed to in the joint operating agreement to be respected for tax purposes.
Pool of Capital Doctrine (POC)
The pool of capital doctrine was summarized by the IRS in G.C.M. 22730, 1941-1 CB. 214 and described the way oil and gas property development had evolved over time. To oversimplify, under the POC, the property owner contributed the mineral rights, a drilling party drilled the well, an attorney drafted the necessary documents, and a geologist picked a well site. Everyone's profit depended upon the success of the well. But everyone's loss depended on the capital he had contributed to the pool of capital required to develop the property. In the broadest sense, this resembles the formation of a partnership.
First Principles: Risk Sharing and Tax Planning
Development of mineral properties is all about risk sharing. Enormous amounts of capital are required to explore for oil and gas. In...