[Federal Register Volume 59, Number 246 (Friday, December 23, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31291]


[[Page Unknown]]

[Federal Register: December 23, 1994]


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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602

[T.D. 8578]

RIN 1545-AP23

 

Election Out of Subchapter K for Producers of Natural Gas

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that amend the 
regulations under section 761 of the Internal Revenue Code relating to 
the election out of subchapter K of chapter 1 of the Code. The final 
regulations contain certain requirements that must be met by co-
producers of natural gas subject to a joint operating agreement in 
order to make or maintain an election under section 761. The final 
regulations provide that the co-producers under a joint operating 
agreement must use one of two permissible methods described in the 
regulations in reporting income from gas sales and certain related 
deductions and credits.

EFFECTIVE DATE: January 1, 1995.

FOR FURTHER INFORMATION CONTACT: Grace Kim, 202-622-3060 (not a toll-
free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the requirements of the Paperwork Reduction Act (44 
U.S.C. 3504(h)) under control number 1545-1338. The estimated annual 
burden per respondent/recordkeeper varies from 15 minutes to 45 minutes 
depending on individual circumstances, with an estimated average of 30 
minutes.
    These estimates are approximations. They are based on such 
information as is available to the Internal Revenue Service. Individual 
respondents/recordkeepers may require more or less time, depending on 
their particular circumstances.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, 
D.C. 20224, and to the Office of Management and Budget, Attn: Desk 
Officer for the Department of the Treasury, Office of Information and 
Regulatory Affairs, Washington, D.C. 20503.

Background

    On September 16, 1992, a notice of proposed rulemaking (PS-103-90) 
was published in the Federal Register (57 FR 42712) proposing 
amendments to the Income Tax Regulations (26 CFR part 1, 602) under 
section 761 of the Internal Revenue Code (Code). A notice of hearing 
relating to the proposed regulations was published in that same issue 
(57 FR 42720), and a public hearing was held on November 17, 1992. 
After consideration of all written and oral comments regarding the 
proposed amendments, the proposed regulations are adopted as revised by 
this Treasury decision. These regulations are issued under the 
authority contained in sections 446(b), 761(a), and 7805.

Explanation of Provisions

In General

    Except for modifications in response to comments, these final 
regulations generally provide the same rules as the proposed 
regulations. Thus, the final regulations prescribe the methods of 
accounting for gas sales that may be used by co-producers of a gas 
producing property that seek to make or maintain an election under 
section 761(a) of the Code. Co-producers must use either the cumulative 
gas balancing method (cumulative method) or the annual gas balancing 
method (annual method). The final regulations require permission of the 
Commissioner to use the annual method. This is to ensure that the co-
producers (particularly those with different taxable year-ends) 
properly take income and deductions into account.

Changes to the Proposed Regulations in Response to Comments

I. Effective Date and Transitional Rules

    The proposed regulations apply to co-producers under an existing 
gas balancing agreement (GBA) or ``any agreement similar to a gas 
balancing agreement'' in effect on or after September 16, 1992, for 
taxable years beginning on or after that date. They also provide an 
automatic consent procedure for gas co-producers under existing GBAs to 
change their method of accounting and the rules for taking the related 
section 481(a) adjustments into account.
    Commentators have expressed uncertainty as to the meaning of ``an 
agreement similar to a gas balancing agreement,'' e.g., whether a joint 
operating agreement (JOA), without a formal GBA, is a similar 
agreement. Additionally, commentators asserted that the automatic 
consent procedure was overly burdensome and the section 481(a) 
adjustment rules were in some cases impractical. Some recommended that 
the regulations be entirely prospective and that the effective date be 
delayed.
    The final regulations are revised to remove the uncertainty 
concerning the meaning of ``an agreement similar to a gas balancing 
agreement,'' and are to apply to all gas co-producers operating under a 
JOA, without regard to whether a GBA exists. Additionally, the final 
regulations are revised to simplify the automatic consent procedure and 
to delay the effective date so as to apply to gas co-producers under 
JOAs in effect on or after the start of their first taxable year 
beginning after December 31, 1994. If, however, the co-producers under 
a JOA do not all have the same taxable year and they are changing to 
the annual method, the regulations apply on and after January 1, 1996, 
with respect to that JOA. Finally, although the final regulations 
maintain the six-year section 481(a) adjustment period, they are 
revised to add an election to take an aggregate section 481(a) 
adjustment for all JOAs, whether negative or positive, into account in 
the year of the change in method of accounting.

II. Entitlements Method as Elective Method

    A commentator suggested that the entitlements method be adopted as 
an elective method or as a replacement for the annual method. Under the 
entitlements method, a co-producer reports income currently only for 
its proportionate share of current production under the JOA.
    The final regulations do not adopt this suggestion because total 
income for tax purposes should be reported on the basis of the relative 
economics of current production, rather than entitlement under the JOA.

III. Consequences of Noncompliance

    Commentators indicated that the requirement of the proposed 
regulations that all co-producers under the same GBA use the same 
permissible gas balancing method might be construed as meaning that one 
co-producer's noncompliance would cause the section 761 election of all 
of the co-producers to be revoked.
    Accordingly, the final regulations are revised to require that all 
co-producers under a JOA use the cumulative method, unless the co-
producers are eligible to, and agree in writing, to use the annual 
method. The final regulations also clarify that the failure of a co-
producer to follow this rule will be treated as the use of an 
impermissible method of accounting, but will not cause the co-
producers' section 761 election to be revoked, unless the Commissioner 
determines that there was willful failure to comply.

IV. The Standard for Revoking a Section 761 Election Under the 
Cumulative Method

    The proposed regulations contain an anti-abuse rule under which the 
section 761 election of certain co-producers using the cumulative 
method could be revoked. The standard for applying the anti-abuse rule 
is a determination that ``a principal purpose'' of shifting income, 
deductions, or credits is to avoid tax. Commentators suggested 
replacing ``a principal purpose'' with ``the principal purpose.'' After 
careful consideration of the comments, the Service and Treasury have 
concluded that the standard contained in the proposed regulations is 
appropriate. Thus, the anti-abuse rule in the proposed regulations is 
finalized.

V. Requests for Clarification Under the Cumulative Method

    Commentators requested certain clarifying changes under the 
cumulative method relating to depletion deductions and the section 29 
credit for producing fuel from a nonconventional source. First, the 
rule that a taking co-producer's deduction for making a payment to a 
co-producer is reduced by the amount of any depletion deduction allowed 
on the related gas sales is revised to make it clear that the payment 
deduction is reduced only by the taking co-producer's percentage 
depletion deduction allowed on the related sales. The final regulations 
are not modified to clarify the section 29 credit issues because this 
project is not the appropriate one for addressing these issues.

Special Analyses

    It has been determined that these regulations are not major rules 
as defined in Executive Order 12291. Therefore, a Regulatory Impact 
Analysis is not required. It has also been determined that section 
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these 
regulations, and, therefore, a Regulatory Flexibility Analysis is not 
required. Pursuant to section 7805(f) of the Code, the notice of 
proposed rulemaking for the regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small business.

Drafting Information

    The principal author of these regulations is H. Grace Kim of the 
Office of Assistant Chief Counsel (Passthroughs and Special 
Industries), Internal Revenue Service. However, personnel from other 
offices of the Internal Revenue Service and Treasury Department 
participated in developing the regulations, both on matters of 
substance and style.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
the following citation:


    Authority: 26 U.S.C. 7805 * * *. Section 1.761-2 also issued 
under 26 U.S.C. 446(b) and 26 U.S.C. 761(a). * * *


    Par. 2. Section 1.761-2 is amended as follows:

    1. The section heading for Sec. 1.761-2 is revised.
    2. A sentence is added to the end of paragraph (a)(3) concluding 
text.
    3. Paragraph (d) is redesignated as paragraph (e).
    4. New paragraph (d) is added.
    5. The revised and added provisions read as follows:


Sec. 1.761-2  Exclusion of certain unincorporated organizations from 
the application of all or part of subchapter K of chapter 1 of the 
Internal Revenue Code.

    (a) * * *
    (3) * * *
* * * In addition, except as provided in paragraph (d)(2)(i) of this 
section, this paragraph (a)(3) does not apply to any unincorporated 
organization that produces natural gas under a joint operating 
agreement, unless all members of the unincorporated organization comply 
with paragraph (d) of this section.
* * * * *
    (d) Rules for gas producers that produce natural gas under joint 
operating agreements--(1) Joint operating agreements and gas balancing. 
Co-owners of a property producing natural gas enter into a joint 
operating agreement (JOA) to define the rights and obligations of each 
co- producer of the gas in place. The JOA determines, among other 
things, each co-producer's proportionate share of the natural gas as it 
is produced from the reservoir, together with the associated production 
expenses. A gas imbalance arises when a co-producer does not take its 
proportionate share of current gas production under the JOA 
(underproducer) and another co-producer takes more than its 
proportionate share of current production (overproducer). The co-
producers often enter into a gas balancing agreement (GBA) as an 
addendum to their JOA to establish their rights and obligations when a 
gas imbalance arises. A GBA typically allows the overproducer to take 
the amount of the gas imbalance (overproduced gas) and entitles the 
underproducer to recoup the overproduced gas either from the volume of 
the gas remaining in the reservoir or by a cash balancing payment.
    (2) Permissible gas balancing methods--(i) General requirement. All 
co-producers of natural gas operating under the same JOA must use the 
cumulative gas balancing method, as described in paragraph (d)(3) of 
this section, unless they use the annual gas balancing method described 
in paragraph (d)(4) of this section. A co-producer's failure to comply 
with the provisions of this paragraph (d)(2)(i) generally constitutes 
the use of an impermissible method of accounting, requiring a change to 
a permissible method under Sec. 1.4461(e)(3) with any terms and 
conditions as may be imposed by the Commissioner. The co-producers' 
election to be excluded from all or part of subchapter K will not be 
revoked, unless the Commissioner determines that there was willful 
failure to comply with the requirements of this paragraph (d)(2)(i).
    (ii) Change in method of accounting; adoption of method of 
accounting--(A) In general. The annual gas balancing method and the 
cumulative gas balancing method are methods of accounting. Accordingly, 
a change to or from either of these methods is a change in method of 
accounting that requires the consent of the Commissioner. See section 
446(e) and Sec. 1.446-1(e). For purposes of this section, each JOA is 
treated as a separate trade or business. Paragraph (d)(2)(ii)(B) of 
this section provides rules for adopting either permissible method of 
accounting. Paragraph (d)(2)(ii)(C) of this section provides rules on 
the timing of required changes to either permissible method during the 
transitional period, and paragraph (d)(5) of this section contains the 
procedural provisions for making a change in method of accounting 
required in paragraph (d)(2)(ii)(C) of this section.
    (B) Adoption of method of accounting. A co-producer must adopt a 
permissible method for each JOA entered into on or after the start of 
the co-producer's first taxable year beginning after December 31, 1994 
(or, in the case of the use of the annual gas balancing method by co-
producers not having the same taxable year, the start of the first 
taxable year beginning after December 31, 1994, of the co-producer 
whose taxable year begins latest in the calendar year). If a co-
producer is adopting the cumulative method, the co-producer may adopt 
the method by using the method on its timely filed return for the 
taxable year of adoption. A co-producer may adopt the annual gas 
balancing method with the permission of the Commissioner under 
guidelines set forth in paragraph (d)(4)(ii) of this section.
    (C) Required change in method of accounting for certain joint 
operating agreements. This paragraph (d)(2)(ii)(C) applies to certain 
JOAs entered into prior to 1996. Except in the case of a part-year 
change in method of accounting or in the case of the cessation of a JOA 
(both of which are described in this paragraph (d)(2)(ii)(C)), for each 
JOA entered into prior to a co-producer's first taxable year beginning 
after December 31, 1994, and in effect as of the beginning of that 
year, the co-producer must change its method of accounting for sales of 
gas and its treatment of certain related deductions and credits to a 
permissible method as of the start of its first taxable year beginning 
after December 31, 1994. In the case of a JOA of co-producers that do 
not all have the same taxable year and that choose the annual gas 
balancing method, if the JOA is entered into prior to the first taxable 
year beginning after December 31, 1994 of the co-producer whose taxable 
year begins latest in the calendar year and the JOA is in effect as of 
January 1, 1996, a change to the annual gas balancing method by each 
co-producer under that JOA is made as of January 1, 1996 (part-year 
change in method of accounting). If the co-producers would have made a 
part-year change to the annual gas balancing method but for the fact 
that their JOA ceased to be in effect before January 1, 1996 (cessation 
of a JOA), the co-producers do not change their method of accounting 
with respect to the JOA. Rather, for their taxable years in which the 
JOA ceases to be in effect, the co-producers use their current method 
of accounting with respect to that JOA.
    (3) Cumulative gas balancing method--(i) In general. The cumulative 
gas balancing method (cumulative method), solely for purposes of 
reporting income from gas sales and certain related deductions and 
credits, treats each co-producer under the same JOA as the sole owner 
of its percentage share of the total gas in the reservoir and 
disregards the ownership arrangement described in the JOA for gas as it 
is produced from the reservoir. Each co-producer is considered to be 
taking only its share of the total gas in the reservoir as long as the 
gas remaining in the reservoir is sufficient to satisfy the ownership 
rights of the co-producers in their percentage shares of the total gas 
in the reservoir. After a co-producer has taken its entire share of the 
total gas in the reservoir, any additional gas taken by that co-
producer (taking co-producer) is treated as having been taken from its 
other co-producers' shares of the total gas in the reservoir. The 
effect of being treated as a taking co-producer under the cumulative 
method is that the taking co-producer generally may not claim an 
allowance for depletion and a production credit on its sales of its 
other co-producers' percentage shares of the total gas in the 
reservoir.
    (ii) Requirements--(A) Reporting of income from sales of gas. Under 
the cumulative method, each co-producer must include in gross income 
under its overall method of accounting the amount of its sales from all 
gas produced from the reservoir, including sales of gas taken from 
another co-producer's share of the gas in the reservoir.
    (B) Reporting of deduction of taking co-producer. A taking co-
producer deducts the amount of a payment (in cash or property, other 
than gas produced under the JOA) made to another co-producer for sales 
of that co-producer's gas, but only for the taxable year in which the 
payment is made. Thus, an accrual method taking co-producer is not 
permitted a deduction for any obligation it has to pay another co-
producer for sales of that co-producer's gas until a payment is made. 
See paragraph (d)(3)(iii)(B) of this section for a rule requiring a 
reduction of the amount of the deduction described in this paragraph 
(d)(3)(ii)(B) if the taking co-producer had mistakenly claimed a 
depletion deduction relating to those sales.
    (C) Reporting of income by other co-producers. Any co-producer that 
is entitled to receive a payment from a taking co-producer must include 
the amount of the payment in gross income as proceeds from the sale of 
its gas only for the taxable year that the payment is actually 
received, regardless of its overall method of accounting.
    (D) Reporting of production expenses. Each co-producer deducts its 
proportionate share of production expenses, as provided in the JOA, 
under its regular method of accounting for the expenses.
    (iii) Special rules for production credits and depletion deductions 
under the cumulative method--(A) In general. Under the cumulative 
method, a co-producer's depletion allowance and production credit for a 
taxable year are based on its income from gas sales and production of 
gas from its percentage share of the total gas in the reservoir, and 
are not based on its current proportionate share of income and 
production as determined under the JOA. Thus, in general, a taking co-
producer is not allowed a production credit or an allowance for 
depletion on its sales of gas in excess of its percentage share of the 
total gas in the reservoir. However, the Service will not disallow 
depletion deductions or production credits claimed by a taking co-
producer on the gas of other co-producers if the taking co-producer had 
a reasonable but mistaken belief that the deductions or credits were 
claimed with respect to the taking co-producer's percentage share of 
total gas in the reservoir and the taking co-producer makes the 
appropriate reductions and additions to tax required in paragraphs 
(d)(3)(iii)(B) and (d)(3)(iii)(C) of this section. The reasonableness 
of the mistaken belief is determined at the time of filing the return 
claiming the deductions or credits. A co-producer receiving a payment 
for sales of its gas from a taking co-producer claims a production 
credit and an allowance for depletion relating to those sales only for 
the taxable year in which the amount of the payment is included in its 
gross income.
    (B) Reduction of taking co-producer's payment deduction for 
depletion claimed on another co-producer's gas. If a taking co-producer 
claims an allowance for depletion on another co-producer's gas, the 
taking co-producer must reduce its deduction claimed in a later year 
for making a payment to the other co-producer for sales of that co-
producer's gas by the amount of any percentage depletion deduction 
allowed on the gas sales to which the payment relates. If the 
percentage limitation of section 613A(d)(1) applied to disallow a 
depletion deduction for a previous year, the taking co-producer must 
reduce the amount of any carried over depletion deduction allowable in 
the year of the payment or in a future year by the portion of the 
carried over depletion deduction, if any, that relates to another co-
producer's gas.
    (C) Addition to tax of taking co-producer for production credit 
claimed on another co-producer's gas. If a taking co-producer claims a 
production credit on another co-producer's gas, the taking co-producer 
must add to its tax for the taxable year that it makes a payment to the 
other co-producer for sales of that co-producer's gas any production 
credit allowed in an earlier taxable year on the gas sales to which the 
payment relates, but only to the extent the credit allowed actually 
reduced the taking co- producer's tax in any earlier year. The taking 
co-producer also must reduce the amount of its minimum tax credit 
allowable by reason of section 53(d)(1)(B)(iii) in the year of the 
payment or in a future year by the portion of the credit, if any, that 
relates to another co-producer's gas.
    (iv) Anti-abuse rule. If the Commissioner determines that co-
producers using the cumulative method have arranged or altered their 
taking of production for a taxable year with a principal purpose of 
shifting the income, deductions, or credits relating to that production 
to avoid tax, the co- producers' election to be excluded from all or 
part of subchapter K will be revoked for that year and for subsequent 
years. In determining that a principal purpose was to avoid tax, the 
Commissioner will examine all the facts and circumstances surrounding 
the use of the cumulative method by the co-producers. See Examples 3 
and 4 of paragraph (d)(6) of this section.
    (4) Annual gas balancing method--(i) In general. The annual gas 
balancing method (annual method) takes into account each co-producer's 
ownership rights and obligations, as described in the JOA, with respect 
to the co-producer's current proportionate share of gas as it is 
produced from the reservoir. Under the annual method, gas imbalances 
relating to a JOA must be eliminated annually through a balancing 
payment, which may be in the form of cash, gas produced under the same 
JOA, or other property. If all the co-producers under a JOA have the 
same taxable year, any gas imbalance remaining at the end of a taxable 
year must be eliminated by a balancing payment from the overproducer to 
the underproducer by the due date of the overproducer's tax return for 
that taxable year (including extensions). If all the co-producers under 
a JOA do not have the same taxable year, any gas imbalance remaining at 
the end of a calendar year must be eliminated by a balancing payment 
from the overproducer to the underproducer by September 15 of the 
following calendar year. The annual method may be used only if the 
Commissioner's permission is obtained. Paragraph (d)(4)(ii) of this 
section provides guidelines for applying for this permission. The 
annual method is not available for a JOA with respect to which any co-
producer made an election under paragraph (d)(5)(i)(B)(3) of this 
section (to take an aggregate section 481(a) adjustment for all JOAs of 
a co-producer into account in the year of change).
    (ii) Obtaining the Commissioner's permission to use the annual 
method. A request for the Commissioner's permission to adopt the annual 
method for a new JOA must be in writing and must set forth the names of 
all the co-producers under the JOA and the respective taxable year of 
adoption. See paragraphs (d)(2)(ii) and (d)(5)(ii) of this section for 
the rules for a change in method of accounting to the annual method. In 
addition, the request must contain an explanation of how the co-
producers will report income from gas sales, the making or receiving of 
a balancing payment, production expenses, depletion deductions, and 
production credits. Permission will be granted under appropriate 
conditions, including, but not limited to, an agreement in writing by 
all co-producers to use the annual method and to eliminate any gas 
imbalances annually in accordance with paragraph (d)(4)(i) of this 
section.
    (5) Transitional rules for making a change in method of accounting 
required in paragraph (d)(2)(ii)(C) of this section--(i) Change in 
method of accounting to the cumulative method--(A) Automatic consent to 
change in method of accounting to the cumulative method. A co-producer 
changing to the cumulative method for any JOA entered into prior to its 
first taxable year beginning after December 31, 1994, and in effect as 
of the beginning of that year is granted the consent of the 
Commissioner to change its method of accounting with respect to each 
JOA to the cumulative method, provided the co-producer--
    (1) Makes the change on its timely filed return for its first 
taxable year beginning after December 31, 1994;
    (2) Attaches a completed and signed Form 3115 to the co-producer's 
tax return for the year of change, stating that, pursuant to 
Sec. 1.761-2(d)(2)(ii) of the regulations, the co-producer is changing 
its method of accounting for sales of gas and its treatment of certain 
related deductions and credits under each JOA to the cumulative method;
    (3) In the case of a co-producer making an election under paragraph 
(d)(5)(i)(B)(3) of this section to take the aggregate section 481(a) 
adjustment into account in the year of change, attaches the statement 
described in paragraph (d)(5)(i)(B)(3)(ii) of this section; and
    (4) In the case of a co-producer not making an election under 
paragraph (d)(5)(i)(B)(3) of this section, attaches a list of each JOA 
with respect to which there is a section 481(a) adjustment computed in 
accordance with paragraph (d)(5)(i)(B)(2)(i) of this section.
    (B) Section 481(a) adjustment--(1) Application of section 481(a). A 
change in method of accounting to the cumulative method under the 
automatic consent procedure in paragraph (d)(5)(i)(A) of this section 
is a change in method of accounting to which the provisions of section 
481(a) apply. Thus, a section 481(a) adjustment must be taken into 
account in the manner provided by this paragraph (d)(5)(i)(B) to 
prevent the omission or duplication of income. Paragraph 
(d)(5)(i)(B)(2) of this section provides the general rules for 
computing the amount of the section 481(a) adjustment of a co-producer 
relating to a particular JOA and for taking the section 481(a) 
adjustment into account. Paragraph (d)(5)(i)(B)(3) of this section 
provides rules for electing to take a co-producer's section 481(a) 
adjustment computed on an aggregate basis for all JOAs into account in 
the year of change. Paragraph (d)(5)(i)(C) of this section provides 
rules to coordinate the taking of a depletion deduction or a production 
credit with the inclusion of a section 481(a) adjustment arising from a 
change in method of accounting to the cumulative method under this 
paragraph (d)(5)(i).
    (2) Computation of the section 481(a) adjustment relating to a 
joint operating agreement--(i) In general. The section 481(a) 
adjustment of a co-producer relating to a JOA is computed as of the 
first day of the co-producer's year of change and is equal to the 
difference between the amount of income reported under the co-
producer's former method of accounting for all taxable years prior to 
the year of change and the amount of income that would have been 
reported if the co-producer's new method had been used in all those 
taxable years.
    (ii) Section 481(a) adjustment period. Except to the extent that 
paragraph (d)(5)(i)(B)(3) of this section applies, a co-producer's 
section 481(a) adjustment relating to a JOA, whether positive or 
negative, is taken into account in computing taxable income ratably 
over the 6-taxable-year period beginning with the year of change (the 
section 481(a) adjustment period). If the co-producer has been in 
existence less than 6 taxable years, the adjustment is taken into 
account over the number of years the co-producer has been in existence. 
If the co-producer ceases to engage in the trade or business that gave 
rise to the section 481(a) adjustment at any time during the section 
481(a) adjustment period, the entire remaining balance of the section 
481(a) adjustment relating to that trade or business must be taken into 
account in the year of the cessation. For purposes of this paragraph 
(d)(5)(i)(B)(2)(ii), production under each JOA is treated as a separate 
trade or business. The determination as to whether the co-producer 
ceases to engage in its trade or business is to be made under the 
principles of Sec. 1.446--1(e)(3)(ii) and its underlying administrative 
procedures. For example, the permanent cessation of production under a 
co-producer's JOA constitutes the cessation of a trade or business of 
the co-producer. Accordingly, for the year that production under a JOA 
permanently ceases, the remaining balance of the section 481(a) 
adjustment relating to the JOA must be taken into account.
    (3) Election to take aggregate section 481(a) adjustment for all 
joint operating agreements into account in the year of change--(i) In 
general. A co-producer may elect to take into account its section 
481(a) adjustment, computed on an aggregate basis for all of its JOAs, 
whether negative or positive, in the year of change, provided the co-
producer uses the cumulative method for all of its JOAs entered into 
prior to its first taxable year beginning after December 31, 1994, and 
in effect as of the beginning of that year. The aggregate section 
481(a) adjustment of a co-producer is equal to the difference between 
the amount of income reported under the co-producer's former method of 
accounting for all taxable years prior to the year of change and the 
amount of income that would have been reported if the co-producer's new 
method had been used in all of those taxable years for all JOAs for 
which the co-producer changes its method of accounting. An election 
made under this paragraph (d)(5)(i)(B)(3) is irrevocable. If any person 
who, together with another person, would be treated as a single 
taxpayer under section 41(f)(1) (A) or (B) makes an election under this 
paragraph (d)(5)(i)(B)(3), all persons within that single taxpayer 
group will be treated as if they had made an election under this 
paragraph (d)(5)(i)(B)(3) and, as such, will be irrevocably bound by 
that election. If a co-producer does not make an election under this 
paragraph, each JOA entered into prior to the start of its first 
taxable year beginning after December 31, 1994, and in effect as of the 
beginning of that year must be accounted for separately in computing 
the section 481(a) adjustment and taxable income of the co-producer for 
any year to which this paragraph (d) applies.
    (ii) Time and manner for making the election. An election under 
this paragraph (d)(5)(i)(B)(3) is made by attaching a statement to the 
co-producer's timely filed return for its year of change indicating 
that the co- producer is electing under Sec. 1.761-2(d)(5)(i)(B)(3) to 
take its aggregate section 481(a) adjustment into account in the year 
of change.
    (C) Treatment of section 481(a) adjustment as a sale for purposes 
of computing a production credit and as gross income from the property 
for purposes of depletion deductions. Any positive section 481(a) 
adjustment arising as a result of a change in method of accounting for 
gas imbalances under this paragraph (d)(5)(i) and taken into account in 
computing taxable income under paragraph (d)(5)(i)(B) of this section 
is considered a sale by the taxpayer for purposes of computing any 
production credit in the year that the adjustment is taken into 
account. Similarly, the positive section 481(a) adjustment is 
considered gross income from the property and taxable income from the 
property for purposes of computing depletion deductions in the year the 
adjustment is taken into account. Sales amounts used in computing any 
production credit in any year in which a negative section 481(a) 
adjustment is taken into account in computing taxable income under 
paragraph (d)(5)(i)(B) of this section must be reduced by the amount of 
the negative section 481(a) adjustment taken into account in that year. 
Similarly, gross income from the property and taxable income from the 
property used in computing any depletion deduction in any year in which 
the negative section 481(a) adjustment is taken into account must be 
reduced by the amount of the negative adjustment. For these purposes, 
any taxpayer that makes an aggregate section 481(a) adjustment election 
under paragraph (d)(5)(i)(B)(3) of this section must allocate the 
adjustment among its properties in any reasonable manner that prevents 
a duplication or omission of depletion deductions.
    (ii) Change in method of accounting to the annual method--(A) In 
general. A co-producer changing to the annual method in accordance with 
paragraph (d)(2)(ii) of this section must request a change under 
Sec. 1.446-1(e)(3) and will be subject to any terms and conditions as 
may be imposed by the Commissioner.
    (B) Section 481(a) adjustment. A change in method of accounting to 
the annual method is a change in method of accounting to which the 
provisions of section 481(a) apply. Thus, a section 481(a) adjustment 
must be taken into account to prevent the omission or duplication of 
income. If all the co-producers under a JOA have the same taxable year, 
the section 481(a) adjustment involved in a change to the annual method 
by a co-producer relating to the JOA is computed as of the first day of 
the co-producer's year of change. If the co-producers under a JOA do 
not all have the same taxable year (that is, in the case of a part-year 
change described in paragraph (d)(2)(ii)(C) of this section), the 
change in method of accounting occurs on January 1, 1996, and the 
section 481(a) adjustment is computed on that date.
    (iii) Untimely change in method of accounting to comply with this 
section. Unless a co-producer required by this section to change its 
method of accounting complies with the provisions of this paragraph 
(d)(5) for its first applicable taxable year within the time prescribed 
by this paragraph (d)(5), the co-producer must take the section 481(a) 
adjustment into account under the provisions of any applicable 
administrative procedure that is prescribed by the Commissioner 
specifically for purposes of complying with this section. Absent such 
an administrative procedure, a co-producer must request a change under 
Sec. 1.446-1(e)(3) and will be subject to any terms and conditions as 
may be imposed by the Commissioner.
    (6) Examples. The following examples illustrate the application of 
the cumulative method described in paragraph (d)(3) of this section.

    Example 1. Operation of the cumulative method. (i) L, a 
corporation using the cash receipts and disbursements method of 
accounting, and M, a corporation using an accrual method, file 
returns on a calendar year basis. On January 1, 1995, L and M enter 
into a JOA to produce natural gas as an unincorporated organization 
from a reservoir located in State Y. The JOA allocates reservoir 
production 60 percent to L and 40 percent to M. L and M enter into a 
GBA as an addendum to the JOA. L and M agree to use the cumulative 
method to account for gas sales from the reservoir and elect under 
section 761(a) and this section to exclude the organization from the 
application of subchapter K. Production from the reservoir is 
eligible for the section 29 credit for producing fuel from a 
nonconventional source. L and M produce and sell the following 
amounts of natural gas (in mmcf) until 2000 during which year 
production from the reservoir ceases:

------------------------------------------------------------------------
                                 1995   1996   1997   1998   1999   2000
------------------------------------------------------------------------
L.............................    720    480    600    -0-    -0-    -0-
M.............................    240     60    120    160     80     40
------------------------------------------------------------------------

    (ii) By the end of 1996, neither L nor M has fully produced its 
percentage share of the total gas in the reservoir. In 1997, L 
produces a total of 600 mmcf of gas at the rate of 50 mmcf per 
month. Prior to filing its return for 1997, L determines that it 
fully produced its percentage share of gas in the reservoir as of 
June 30, 1997. Pursuant to the GBA executed by L and M, L pays M at 
the end of 2000 for the 300 mmcf of M's gas (as determined under the 
cumulative method) that L sold in the last half of 1997.
    (iii) For 1995, L and M must include in their gross income the 
amounts relating to gas sales of 720 mmcf and 240 mmcf, 
respectively. For 1996, L and M must include the amounts relating to 
gas sales of 480 mmcf and 60 mmcf, respectively. For both 1995 and 
1996, L and M compute an allowance for depletion and a section 29 
credit based upon gas taken and sold by each from the reservoir for 
each taxable year.
    (iv) For 1997, L and M must include in gross income the amounts 
relating to their gas sales of 600 mmcf and 120 mmcf, respectively. 
Under paragraph (d)(3)(iii)(A) of this section, L computes an 
allowance for depletion and the section 29 credit based only on 
production from L's proportionate share of gas in the reservoir 
(that is, based on L's production through June 30, 1997). 
Accordingly, for 1997, L claims depletion and the section 29 credit 
only with respect to 300 mmcf of gas (50 mmcf per month x 6 months). 
For 1997, because M has not fully produced from its percentage share 
of the total gas in the reservoir as of the end of 1997, M claims 
depletion and the section 29 credit on the 120 mmcf that M produced 
in 1997.
    (v) In 1998 and 1999, M must include in gross income the amounts 
relating to M's sales of gas, that is, 160 mmcf for 1998 and 80 mmcf 
for 1999. For 2000, M must include in gross income the amount 
relating to sales of 340 mmcf of gas, which consists of its own 
sales of 40 mmcf plus the payment for 300 mmcf of gas that L made to 
M for having sold from M's share of the total gas in the reservoir 
during the last half of 1997. Because M produced from its percentage 
share of the total gas in the reservoir during 1998, 1999, and 2000, 
M claims a depletion deduction and a section 29 credit on its income 
and production for those years, that is, 160 mmcf for 1998, 80 mmcf 
for 1999, and 40 mmcf for 2000. Additionally, for 2000, M claims 
depletion and the section 29 credit relating to the payment that M 
received from L for the 300 mmcf of M's gas that L sold in the last 
half of 1997. Under paragraph (d)(3)(ii)(B) of this section, L's 
deduction for its payment to M for the 300 mmcf of M's gas that L 
sold in 1997 is allowable only for 2000.
    Example 2. Adjustments under the cumulative method for depletion 
deductions and production credits that were claimed for sales in 
excess of a co-producer's percentage share of total gas in the 
reservoir. (i) L, a corporation using the cash receipts and 
disbursements method of accounting, and M, a corporation using an 
accrual method, file returns on a calendar year basis. On January 1, 
1995, L and M enter into a JOA to produce natural gas as an 
unincorporated organization from a reservoir located in State Y. The 
JOA allocates reservoir production 60 percent to L and 40 percent to 
M. L and M enter into a GBA as an addendum to the JOA. L and M agree 
to use the cumulative method to account for gas sales from the 
reservoir and elect under section 761(a) and this section to exclude 
the organization from the application of subchapter K. Production 
from the reservoir is eligible for the section 29 credit for 
producing fuel from a nonconventional source. L and M produce and 
sell the following amounts of natural gas (in mmcf) until 2000 
during which year production from the reservoir ceases:

------------------------------------------------------------------------
                                 1995   1996   1997   1998   1999   2000
------------------------------------------------------------------------
L.............................    720    480    600     60     60    -0-
M.............................    240     60    120     60     60     40
------------------------------------------------------------------------

    (ii) In addition, L does not realize until December 31, 1999, 
that L fully produced its percentage share of the total gas in the 
reservoir as of June 30, 1997. At the time of filing its returns for 
1997 and 1998, L reasonably believes that during 1997 and 1998, 
respectively, it did not fully produce its percentage share of the 
total gas in the reservoir. Thus, L claims depletion and the section 
29 credit for its total sales of 600 mmcf in 1997 and 60 mmcf in 
1998. Pursuant to the GBA executed by L and M, L pays M at the end 
of 2000 for the 420 mmcf of M's gas (as determined under the 
cumulative method) that L sold (300 mmcf in the last half of 1997 
(assuming that production was at a rate of 50 mmcf per month), 60 
mmcf in 1998, and 60 mmcf in 1999).
    (iii) In 1997 and 1998, L and M include in gross income the 
amounts relating to their respective sales of gas, that is, for L 
600 mmcf for 1997 and 60 mmcf for 1998, and for M 120 mmcf for 1997 
and 60 mmcf for 1998.
    (iv) For 1999, L must include in gross income the amount of its 
sales of 60 mmcf, but may not claim depletion or the section 29 
credit on those sales. For 1999, M must include in gross income the 
amount of its sales of 60 mmcf and claims depletion and the section 
29 credit with respect to those 60 mmcf.
    (v) For 2000, M must include in gross income the amount relating 
to gas sales of 460 mmcf, that is, the amount of M's own gas sales 
of 40 mmcf and the amount of the payment received from L for the 420 
mmcf of M's gas that L sold (consisting of 300 mmcf in 1997, 60 mmcf 
in 1998, and 60 mmcf in 1999). Under paragraph (d)(3)(iii)(A) of 
this section, M computes a depletion deduction and a production 
credit relating to the amount of M's actual gas sales for 2000 and 
the payment received from L, that is, relating to a total of 460 
mmcf of gas (M's sales of 40 mmcf for 2000, plus L's payment for 420 
mmcf of gas). Under paragraph (d)(3)(ii)(B) of this section, L's 
deduction for making its payment to M for 420 mmcf of gas is 
allowable only for 2000. Under paragraph (d)(3)(iii)(B) of this 
section, L must reduce its deduction by the amount of any percentage 
depletion deductions allowed on its sales of M's gas, that is, 
relating to 360 mmcf of gas (300 mmcf for 1997 and 60 mmcf for 
1998). In addition, under paragraph (d)(3)(iii)(C) of this section, 
L must increase its tax for 2000 by the amount of any section 29 
credit L claimed on its sales of M's gas, but only to the extent 
that the credit claimed actually reduced L's tax in any earlier 
year.
    Example 3. Non-abusive altering of the taking of production for 
a taxable year. (i) C and D enter into a JOA and a GBA on December 
1, 1994, for gas production from a reservoir. The JOA allocates 
production at 50 percent to C and 50 percent to D. C and D agree in 
writing to use the cumulative method to account for gas sales. 
Additionally, C and D elect under section 761(a) and this section to 
exclude their organization from the application of subchapter K. C 
and D arrange to sell all their production under annually renewable 
contracts. In 1995, C and D each sell 480 mmcf of gas from the 
reservoir.
    (ii) In November 1995, D is notified that its contract with its 
purchaser will not be renewed for 1996. D is unable to find a new 
purchaser for its gas for 1996. In December 1995, D notifies C that 
it will not be taking production from the reservoir in 1996. 
Pursuant to the GBA, C then contracts with its current gas purchaser 
to sell an additional 20 mmcf per month in 1996. Accordingly, C 
sells 720 mmcf in 1996 (60 mmcf per month x 12 months). Under the 
facts described in this example, a principal purpose of altering the 
taking of production is not to avoid tax. Accordingly, the co-
producers' election under section 761(a) will not be revoked by 
reason of altering the taking of production.
    Example 4. Abusive altering of the taking of production for a 
taxable year. The facts are the same as in Example 3(i). For 1996, C 
anticipates that C's regular tax (reduced by the credits allowable 
under sections 27 and 28) will not exceed C's tentative minimum tax. 
Accordingly, under section 29(b)(6), C's credit allowed under 
section 29(a) for sales of its gas will be zero. For 1997, C 
anticipates that its credit allowed under section 29(a) will not be 
limited by section 29(b)(6). On the other hand, D anticipates that 
any credit it may claim under section 29(a) for 1996, even including 
a credit based on sales of C's share of current production under the 
JOA, will not be limited by section 29(b)(6). However, for 1997, D 
anticipates that its credit under section 29(a) will be limited by 
section 29(b)(6). On January 1, 1996, C and D agree that D will 
contract with its purchaser to sell the entire 960 mmcf produced 
from the reservoir in 1996 and that C will contract with its 
purchaser to sell the entire 960 mmcf produced from the reservoir in 
1997. Under these facts, a principal purpose of altering the taking 
of production is to avoid tax. Accordingly, the co-producers' 
election under section 761(a) will be revoked for 1996 and for 
subsequent years.

    (7) Effective date. Except in the case of a part-year change to the 
annual method or the cessation of a JOA, both of which are described in 
paragraph (d)(2)(ii)(C) of this section, the provisions of this 
paragraph (d) apply to all taxable years beginning after December 31, 
1994, of any producer that is a member of an unincorporated 
organization that produces natural gas under a JOA in effect on or 
after the start of the producer's first taxable year beginning after 
December 31, 1994. In the case of a part-year change, the provisions of 
this paragraph (d) apply on and after January 1, 1996. In the case of 
the cessation of a JOA, the co-producers use their current method of 
accounting with respect to that JOA until the JOA ceases to be in 
effect.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 3. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


Sec. 602.101  [Amended]

    Par. 4. In Sec. 602.101, paragraph (c) is amended by removing the 
existing entry for 1.761-2 and by adding the entry ``1.761-2 * * * 
1545-1338'' in numerical order to the table.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: December 12, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-31291 Filed 12-22-94; 8:45 am]
BILLING CODE 4830-01-U