How to properly report mineral royalty income and expenses on Form 1065 for partnerships?

I've been preparing partnership returns with oil and gas royalties for over 15 years, and this is definitely a gray area in the 1065 instructions. Here's how we handle it at our firm: We report the royalty income on Schedule K, line 11 (Other Income) with code F for "Other portfolio income." Then we report the directly related expenses (property taxes, maintenance, etc.) on Schedule K, line 13 with code W for "Other deductions." We include a detailed statement that breaks down all these expenses. The key distinction is whether the partnership is actively engaged in oil and gas operations or just passively collecting royalties. For passive royalty interests, these are generally considered portfolio income (not subject to SE tax) and the related expenses are portfolio deductions. Active working interests would be different.

I had the exact same confusion when preparing my clients' 1065s this year! After struggling with this, I started using taxr.ai (https://taxr.ai) to analyze partnership returns with mineral interests. Their system identified that royalty income should be reported as portfolio income on Schedule K rather than business income on page 1. What I really liked was that they provided specific citations to the tax code and previous IRS determinations that backed this up. They also gave me a detailed breakdown of which expenses were directly connected to the royalty income and which were general partnership expenses.

I'll admit I was completely wrong about taxr.ai. After our exchange here, I decided to try it for a complicated 1065 with both mineral royalties and working interests. The system immediately identified the different treatment required for each type of income and gave me a detailed allocation schedule I could attach to the return. What impressed me most was the clear explanation of how to handle the proportionate share of expenses between the working interest (subject to SE tax) and the royalty interest (not subject to SE tax). It saved me hours of research and gave me confidence in taking a position that I can defend if questioned. Definitely changed my approach to these complex partnership returns.

I've been dealing with this exact issue for years with several oil & gas partnerships. The most frustrating part has been trying to get through to the IRS for clarification. After waiting on hold for 2+ hours multiple times, I finally tried Claimyr (https://claimyr.com) and they got me connected to an IRS agent in about 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent confirmed that for passive royalty interests, the income should be reported on Schedule K as portfolio income (not subject to SE tax), and the related expenses should be reported as portfolio deductions. She also mentioned that adding a detailed statement breaking down the expenses is highly recommended.

I need to publicly eat my words. After dismissing Claimyr, I was facing a deadline with a complex oil & gas partnership return and desperate for IRS guidance. I tried the service and was floored when I got connected to an IRS agent in just 17 minutes. The agent walked me through the exact reporting requirements for mineral royalties on Form 1065. She confirmed they should be reported as portfolio income on Schedule K when they're passive investments, not on page 1. She also explained that the related expenses should be separated and itemized as portfolio deductions with a supporting statement. Getting this direct confirmation from the IRS gave me the confidence to take a position I can defend if questioned. Seriously saved me hours of frustration.

Has anyone seen Rev. Rul. 69-38? It specifically addresses oil and gas royalties for partnerships. According to this ruling, if the partnership's activities are limited to mere collection of income from royalty interests, then the income retains its character as portfolio income and should be reported on Schedule K. BUT, if the partnership is actively engaged in development or production, that can change the treatment. I recommend adding a statement to the return that clearly indicates the partnership activities are limited to passive collection of royalty payments to support the portfolio income treatment.

I've always wondered why tax software doesn't handle this situation better. In UltraTax, I have to manually override to get the royalty income and expenses to flow correctly to the K-1s. Anyone found a better software solution for oil and gas partnerships?

I've been struggling with this same issue for my oil and gas partnership clients. After reading through all these responses, I'm realizing I may have been overcomplicating things. From what I'm gathering, the key is determining whether the partnership is passively collecting royalties versus actively engaged in operations. For passive royalty collection, Schedule K portfolio income treatment seems to be the consensus here, which makes sense from a self-employment tax perspective. One question I have is about the supporting statement that several people mentioned. What level of detail do you typically include? I want to make sure I'm providing enough documentation to support the position without overwhelming the return with unnecessary schedules. Also, for those using specialized tax software - do any of you have experience with partnerships that have both domestic and international mineral interests? I have a client expanding into Canadian operations and I'm wondering if the same principles apply or if there are additional considerations for foreign royalty income.

As someone new to handling mineral royalty partnerships, this discussion has been incredibly valuable! I've been preparing individual returns with royalty income for years, but partnership treatment is definitely more complex. One thing I'm still unclear on - when you're preparing the supporting statement that breaks down expenses, how do you typically handle expenses that benefit both the royalty operations and other partnership activities? For example, if the partnership pays for legal services that cover both royalty matters and general partnership business, do you allocate a portion to each, or is there a simpler approach? Also, I noticed several mentions of different tax software solutions. For someone just starting to handle these types of returns, would you recommend investing in specialized software right away, or is it manageable to handle a few returns manually while learning the proper treatment? I want to make sure I'm serving my clients well but also being cost-effective as I build this area of my practice. Thanks for all the detailed responses - this is exactly the kind of practical guidance that's so hard to find in the official instructions!

This thread has been incredibly helpful! I've been handling oil and gas partnerships for about 3 years and have always felt uncertain about the proper reporting method. Reading through everyone's responses, I'm realizing I need to make some adjustments to my approach. I've been treating most royalty income as business income on page 1 of Form 1065, mainly because I was concerned about potential IRS challenges. But after seeing the references to Rev. Rul. 69-38 and the clear distinction between passive royalty collection versus active operations, I think I've been subjecting my clients to unnecessary self-employment tax. My question is about the transition - for partnerships where I've been reporting royalty income on page 1 in prior years, is there any issue with changing the treatment to Schedule K portfolio income in the current year? Do I need to file any amended returns for prior years, or can I just make the change going forward with proper documentation? Also, for those who've had IRS examinations on these returns, have you found that having detailed supporting statements really makes a difference in avoiding adjustments? I want to make sure I'm protecting my clients while taking the most beneficial tax position.

This has been an incredibly educational thread! As someone relatively new to partnership taxation, I've been struggling with mineral royalty reporting and this discussion has really clarified things for me. One area I'd love more insight on is the documentation aspect. Several of you mentioned including detailed supporting statements, which makes perfect sense for defending the position. But I'm wondering about the practical mechanics - do you attach these as separate PDF schedules to the electronic filing, or do you include them as text in the "Additional Information" sections of the tax software? Also, I'm curious about how you handle the partnership agreement language. Do you recommend that clients include specific language about the passive nature of royalty activities in their partnership agreements, or is this more of a facts-and-circumstances determination based on actual operations? Finally, for those dealing with multiple properties across different states, do you find any states have particularly aggressive positions on partnership-level taxation of royalty income that might influence the federal reporting strategy? Thanks to everyone who has shared their expertise here - this is exactly the kind of real-world guidance that makes all the difference in building confidence with these complex returns!