In oil and gas ownership, there are two fundamentally different types of interest: working interest and royalty interest. Most inherited mineral rights holders have a royalty interest and never think about the distinction. But if you've ever been offered a chance to "participate" in a well, or if your tax return shows mineral income on Schedule C instead of Schedule E, the difference is important.

Royalty Interest

A royalty interest entitles you to a percentage of production revenue with no obligation to pay any of the costs. You receive checks. You don't pay for drilling, completing, operating, or plugging the well.

This is what most individual mineral owners have. You own the minerals, you lease them to an operator, and you collect a royalty (typically 1/8 to 1/5 of production revenue).

Tax treatment: Royalty income is reported on Schedule E and is not subject to self-employment tax.

Working Interest

A working interest carries both the right to revenue and the obligation to pay a share of the costs. If you own a 5% working interest in a well, you receive 5% of the revenue but you also pay 5% of the drilling costs, operating expenses, and eventually the plugging costs.

Working interests are held by operators and investors who choose to participate financially in a well. The potential upside is larger (you keep more of the revenue because there's no royalty carved out of your share), but the risk is also larger (a dry hole or an expensive completion can cost you money).

Tax treatment: Working interest income may be reported on Schedule C and is generally subject to self-employment tax. Working interest holders can also deduct intangible drilling costs (IDCs) in the year they're incurred, which is a significant tax benefit for active participants.

Why the Distinction Matters

Cost exposure. If you have a working interest and the operator sends you a bill for your share of a $2 million well completion, you owe it. Royalty interest holders never receive those bills.

Cash flow risk. Working interest holders can have months where costs exceed revenue, especially during drilling and completion. Royalty interest holders always receive positive cash flow (as long as the well is producing).

Tax obligations. The tax treatment is different. Royalty interest income on Schedule E is passive income. Working interest income on Schedule C may trigger self-employment tax and has different deduction rules.

Liability. Working interest holders may have environmental and operational liability associated with the well. Royalty interest holders generally do not.

How to Tell Which You Have

If you inherited mineral rights and you've only ever received royalty checks without paying any costs, you have a royalty interest. That's the case for the vast majority of individual mineral owners.

Signs you might have a working interest:

Electing to Participate

When a new well is proposed on a pooled unit, unleased mineral owners sometimes receive an option to participate as a working interest owner instead of being pooled at a royalty rate. This means you'd pay your share of well costs in exchange for a larger share of revenue.

For most individual mineral owners, this is a bad idea. Well costs can run into the millions, and there's no guarantee the well will be profitable. The royalty interest option gives you income with zero cost and zero risk. Unless you have industry experience and the financial resources to absorb a potential loss, take the royalty.

In Your Records

Note the interest type for every property in MinRight. Most of your interests will be "RI" (royalty interest). If you discover you have a working interest in any well, pay close attention to the cost statements and make sure your tax preparer knows, because the reporting requirements are different.

For more on interest types, see our comparison of overriding royalty vs. royalty interests.