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Fracking Income Is Qualified Income Under IRC 7704

In Private Letter Ruling 201227002, the IRS ruled that income derived by a publicly traded partnership from the removal, treatment, recycling, and disposal of fracturing flowback and produced water generated by oil and gas wells during the fracking process is qualifying income under Internal Revenue Code Section 7704(d)(1)(E). Additionally, the IRS ruled that income from the non-retail marketing and distributing of crude oil that is salvaged from the fracking process is also qualifying income.

Generally, a publicly traded partnership (PTP) is treated as a corporation for tax purposes - meaning that income to the partnership is subject to the dreaded corporate "double tax." However, a PTP will not be treated as a corporation if at least 90% of its gross income for the tax year is "qualifying income" and certain other requirements are met.

"Qualifying income" is made up specific types of passive income including, among other things, interest, dividends, rents, capital gains, investment income, and, relevant here, income and gains from the exploration or development of any mineral or natural resource, including oil and gas.

The classification of the type of fracking income discussed in the ruling is unclear because legislative history for IRC 7704 indicates that, "oil, gas or products thereof" are not intended to include products that require additional processing beyond that of petroleum refineries or field facilities, and that income from retail marketing of petroleum products is not "qualifying income" for the purposes of IRC 7704.

The ruling is significant because it expands the types of income that a PTP can generate without subjecting itself to corporate tax rules. However, it's important to know that private letter rulings (PLRs) are not the same as a court decision or statute. The IRS position stated within the ruling applies only to the taxpayer to whom the letter is specifically addressed and may not be relied on by other taxpayers. Nevertheless, PLRs generally provide valuable insight into the Service's policy towards an issue and can be very useful during the initial stages of an audit or other tax controversy.

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