Working Interest: Meaning, Overview, Advantages and Disadvantages

What Is Working Interest?

Working interest is a term for a type of investment in oil and gas drilling operations in which the investor is directly liable for a portion of the ongoing costs associated with exploration, drilling, and production. As part of the investment, working interest owners also fully participate in the profits of any successful wells. This stands in contrast to royalty interests, in which an investor's cost is usually limited to the initial investment, also resulting in a lower potential for large profits.

Understanding Working Interest

Working interest, also referred to as operating interest, provides investors with a percentage ownership of the drilling operation, functioning as a lease, providing the investor a right to participate in drilling activities and a right to the resources produced from that activity. Along with deriving an income from the production of the resource, the investors are also responsible for a percentage of the expenses related to its acquisition.

There are two types of working interest: operated and non-operated. Operated working interest has a designated operator that makes all operational decisions. The operator selects wells, determines drilling, and handles all the day to day operations.

A non-operated working interest member is not involved in daily operations but is consulted on production decisions. The well operator, after operating expenses have been covered, divides any additional funds between those holding a working interest, creating the source of income. Those holding a working interest may deduct certain costs, such as those associated with the depreciation of equipment.

Advantages and Disadvantages of Working Interest

With all types of investments, there are going to be advantages and disadvantages. Investing in a working interest related to oil and gas, the advantages and disadvantages are as follows:

Advantages

• The upside for financial gain is large. If wells prove successful, profits are sizable and can last for years.
• Tax benefits exist as losses are seen as active income and can be offset against other income.
• Tax incentives where certain costs are tax-deductible. Sometimes 65%-80% of the costs of a well's funding.
• An active investment where decision making is in your hands.

Disadvantages

• The upfront investment is extremely high as one is paying for the costs of production.
• There is a greater risk of loss as the costs of investing are high.
• Investors may be liable for on the job calamities, such as employee injuries or damage to the environment.

Tax Implications of Working Interest Income

Since most working interest income is treated as self-employment income because the investor is part of a partnership, it will generally be taxed as such, meaning that an investor will not be held to net investment income surtax but to Social Security and Medicare. Since regular income tax payments are not automatically withheld from these funds, investors are responsible for making estimated tax payments based on the current Internal Revenue Service (IRS) standards and rates. As of 2020, the self-employment tax rate is 15.3% in the United States.

Additionally, if the investor receives free resources, such as natural gas service to his property from the company with the associated leasing rights, these amounts may also qualify as income and may be taxed as such.

Investors with working interests are eligible for certain tax deductions based on the operating costs associated with the business. This can include business expenses of a tangible or intangible nature, such as equipment costs or utility payments.

Risks of Working Interest

As there is a potential downside for financial loss and other liabilities due to investing in a working interest, an individual should take steps to reduce that risk. It is recommended that when entering into a working interest investment, an individual sets up a limited liability company (LLC) or other tax partnerships. The main reason to do so is to be protected from any liability. An LLC can protect investors from risks incurred in the working interest. Conversely, it can protect the working interest from liabilities incurred by the investor.

On the other hand, individuals can look to investing in royalty interests that may provide an opportunity to participate in oil and gas investments with a lower level of risk than a working interest. While working interest investments require continuous input from investors in regards to expenses, risking larger losses if expenses outweigh income, royalty interests generally require no additional funding from those investors, making additional losses beyond the initial investment less likely.