• Congress allows tax breaks to individuals that are not available to large corporations
• Interests in wells can receive up to 100% in tax deductions of which 65%-80% can be written off in the first year as IDC’s (Intangible drilling costs)
• 15% of all income is tax free in accordance with the depletion allowance

THE FOLLOWING INFORMATION IS FOR GENERAL PURPOSES ONLY AND IS NOT TO BE CONSTRUED AS TAX ADVICE. EACH INDIVIDUAL MUST CONSULT THEIR OWN ACCOUNTANT, ATTORNEY OR FINANCIAL ADVISOR REGARDING THE SPECIFIC TAX IMPLICATIONS APPLICABLE TO THEIR OWN INDIVIDUAL FINANCIAL SITUATION.

INTANGIBLE DRILLING COSTS

A significant portion of the costs of drilling a well are referred to as Intangible Drilling Costs (IDC’s). These costs are deductible when incurred even though the well may have a productive life of many years. If the IDC’s are deducted in the year incurred, then it is offset against income from the wells and merged in with any other income and expenses of the taxpayer for that year. If the well is a dry hole, then an owner may deduct all the IDC’s as an ordinary loss in the year that the well is drilled. (Please note that an IDC can only be taken one time and only for the cash amount at risk) The Tax Reform Act of 1986 states that:

“When a taxpayer owns a working interest in an oil and gas property, the working interest is not treated as a passive activity, whether or not the taxpayer materially participates. Thus the losses and credits derived from such activity can be used to offset other income of the taxpayer without limitation under the passive rule.” (Senate Finance Committee report No. 99-313, May 29, 1986, Act Sec. 501)

This has been enacted as section 468 ( c ) (3), (4) of the Internal Revenue Code of 1986. This “Working Interest” exception allows an individual to deduct losses from investments in oil and gas against other “active” income (i.e., salaries, wages, interest income, etc.) Be aware that this does not apply to non-working interest or to any limited partnership or other forms which limits the liability of the taxpayer with respect to the interest.

A portion of the IDC’s are considered a preference item for alternative minimum tax purposes to the extent that the IDC’s exceed 65% of the net income from oil and gas properties. If any individual pays alternative minimum tax, a deduction for IDC’s will increase this tax. However, if the AMT is applicable, an individual may elect to capitalize IDC’s and amortize them over a ten-year period thus avoiding an increase in their AMT. The AMT is designed for persons in high-income situations with large preference items to pay a tax of at least 20-21% of the preferentially adjusted income.

The ownership of a working interest in an oil and gas well is regarded by tax laws as operating a business. As such, the income and expenses from the operations of those wells are reported with the specific method of reporting determined by the form of organization and method of accounting chosen for the interest. The taxpayer would report this on the Schedule C of the Form 1040. (Int.Rev.Code 446).

DEPRECIATION

The costs to drill a well that are not Intangible Drilling Costs or lease hold costs are generally expended for tangible costs such as; tubing, surface casing, and pumping equipment. All the tangible items for a well are then capitalized. Depreciation is taken as an ordinary expense, generally straight-line over a five to seven year period. The depreciation shall be calculated only for the pro rata share of ownership for each participant. The deduction also represents a “non-cash” expenditure that can partially shelter cash flow from the investment.

DEPLETION

Depletion is calculated independently by each individual attributed with an interest of any type in the property, or can be calculated independently even though held through a partnership of a subchapter S Corporation. This allows for amortization of the capital investment in oil and gas properties as the value of the property is decreased by production. Depletion can be calculated in two ways: (1) by applying the percentage of current production out of total reserves to the adjusted basis of the owner in the property, or (2) by taking the statutory percentage allowance (15% for primary production), up to a maximum number of barrels per day (1,000), up to 50% of the taxable income from the property of 65% of the individual’s total taxable income; and then the greater amount is taken as a deduction. Amounts excluded by the income limitation are carried over. Whatever part of the cost not deducted in IDC’s or depreciation will be recovered through depletion deductions, therefore allowing over time a 100% write-off. In addition, depletion deductions continue beyond the cost, since percentage depletion in excess of the taxpayer’s basis is a preference item subject to the alternative minimum tax.