TD 8578 Election Out of Subchapter K for Producers of Natural Gas

Page 1

Treasury Decisions
Copyright 2007 LexisNexis Group, All Rights Reserved
Rules and Regulations
DEPARTMENT OF THE TREASURY
Internal Revenue Service (IRS)
26 CFR Parts 1 and 602
59 FR 66181; RIN 1545-AP23
Election Out of Subchapter K for Producers of Natural Gas
T.D. 8578
DATE: December 23, 1994
ACTION: Final regu lations.
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

Page 2
T.D. 8578

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

Page 3
T.D. 8578

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

Page 4
T.D. 8578

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 § 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:
§ 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

Page 5
T.D. 8578

(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 § 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 § 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),

Page 6
T.D. 8578

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.

Page 7
T.D. 8578

(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 § 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;

Page 8
T.D. 8578

(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 § 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

Page 9
T.D. 8578

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 § 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 § 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 § 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

Page 10
T.D. 8578

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

L

720

480

600

M

240

60

120

1998

1999

2000

L

-0-

-0-

-0-

M

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.

Page 11
T.D. 8578

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

L

720

480

600

M

240

60

120

1998

1999

2000

L

60

60

-0-

M

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

Page 12
T.D. 8578

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.
§ 602.101 -- [Amended]
Par. 4. In § 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,

Page 13
T.D. 8578

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

11059F
********** Print Completed **********
Time of Request: Wednesday, September 18, 2013
Print Number:
2825:427955600
Number of Lines: 481
Number of Pages: 13

Send To:

DENNIS, KERRY
IRS - HEADQUARTERS OPERATIONS
1111 CONSTITUTION AVE NW RM 2116IR
WASHINGTON, DC 20224-0002

09:16:18 EST