The Internal Revenue Service Takes a New Look at the ABC Transaction
Authors: Bullion J.W. 
Published: December 2007

BULLION, J.W., THOMPSON, KNIGHT, WRIGHT AND SIMMONS, DALLAS, TEX.

Mechanics of the ABC Method
The death knell of the ABC transaction was almost sounded during the past year. In fact its extinction, insofar as rulings of the Internal Revenue Service (IRS) are concerned, came so close that one practitioner was constrained to remark that "the sexton's hands were on the rope".In an ABC transaction, A sells the working interest in properties to C for a consideration of, say $250,000; in the assignment to C he reserves unto himself, out of a specified percentage of the production, a production payment in the principal sum of, say, $750,000 plus certain additional amounts, one of which is an amount equal to interest on the unliquidated balance of said principal sum at the rate of 6 1/2 per cent/annum. A, at the same closing and following the sale to C, sells the production payment to B for the sum of $750,000. B secures the $750,000 with which to purchase the payment by a borrowing at 6 per cent interest from a lending institution, and secures that loan by a mortgage and deed of trust on and an assignment of the runs and deliveries accruing to the production payment.

Past IRS Rulings
This is the classic ABC transaction. Until the past year the IRS found no difficulty whatsoever in ruling that A, if he had owned the properties for more than six months, was entitled to long-term capital gain treatment on both the proceeds of the sale of the working interest to C and the sale of the reserved production payment to B. In so ruling, it reasoned that long-term capital gain treatment was proper because A had forever parted with all of his interest in the properties. The IRS also ruled that, inasmuch as A in reserving the production payment had retained an economic interest in the properties, C was not taxable on the proceeds of the sale of production accruing to the payment. As to B, the Service ruled that he had acquired an economic interest in the properties from A, that he was taxable on the proceeds of the sale of production accruing to the payment and that he could deduct from such proceeds, for purpose of determining his taxable income, cost depletion computed on the basis of the price he had paid for the production payment. As a matter of fact, the first ruling on an ABC transaction was made about 20 years ago. The transaction did not come into vogue, however, until after the end of World War II. Largely, independents first acquired properties on the basis of the ABC method. The method was gradually adopted by the majors and, during the past several years, all purchases of consequence have been conditioned upon the consummation of the purchase on the ABC method. Thus, during the past year and without action on the part of Congress, the IRS was considering administratively changing a policy that it had been following for 20 years a policy of which the Congress was aware.

Carved-Out Production Payments
At one time the IRS ruled that the seller of a carved-out production payment was entitled to long-term capital gain treatment on the proceeds of the sale if he had owned the properties out of which it was carved for more than six months. A carved-out production payment is a payment assigned out of a larger depletable interest in oil and gas properties. In such a situation A, the owner of working interests, sells to B a production payment and retains the leasehold estates out of which the payment has been assigned. In 1946 the IRS changed its position on carved-out payments and ruled that the proceeds of the sale of a short-lived carved-out production payment constituted ordinary income subject to the deduction for depletion. This position was taken by a ruling published in 1950 made applicable to all carved-out payments, except payments which were assigned either for materials or services, or both, to be used in connection with the development of the property out of which it was carved or which were sold for cash with the proceeds of such sale being pledged to the development of the property out of which it was carved. Notwithstanding the issuance of these rulings, some operators continued to sell carved-out payments and claim capital gain treatment with respect to the sales proceeds. Happily, the great majority of the industry did not so endeavor to convert ordinary income into capital gain. There is something wrong about being able to sell one or several years' production at capital gain rates. Capital gain should flow from a capital conversion.
P. 825^