O&G exploration is still highly speculative, even with the advanced technologies available today. The unique tax benefits to this industry — designed as incentives for O&G development — can include a large direct deduction of all costs associated with development in the year they occurred. No other industry allows that timing of cost recovery. MLPs, for example, can deduct 70-80 percent of their costs to develop a drilling site, regardless of how successful it is. If it ends up being a dry hole, they can deduct 100 percent of the costs, but of course they’ve lost a lot of money on the investment.
The other unique tax benefit for O&G investment derives from the statutory concept of depletion. Every time you take oil or gas reserves out of the ground, you deplete the value of the asset.
When it comes to tax benefits for oil and gas investing, benefits vary by investment type. The most significant benefits apply mainly to direct working interest investments and to certain drilling partnerships. Direct investments in royalty interests receive a more limited benefit, as do Master Limited Partnerships (MLPs). Investors in O&G publicly traded stocks don’t receive a tax benefit directly, but may receive income taxed at long term capital gain rates via dividends or stock buy backs.
The following are the primary tax benefits that apply to direct working interest investments and partnerships (to a degree). CPAs like myself who are knowledgeable about tax compliance and reporting of O&G investment income can determine if your particular investments are eligible for these deductions.
Intangible drilling and completion costs (“IDC”)
IDCs include all the expenses incurred by the operator of the well related to the drilling and preparing the well for production. Such expenses may include the cost of the drilling contractor, wages paid to employees to oversee the project, survey work, site preparation, fuel, etc. IDC also includes the cost of casing and tubing in addition to certain other tangible items, so the term “intangible” can be a bit misleading. The costs of pumping equipment, flow lines, storage tanks, separators, salt water disposal equipment, and other production facilities or equipment is not classified as IDC and is required to be capitalized and depreciated.
With the exception of integrated oil companies and drilling projects situated outside of the United States, IDC can be fully deducted in the year in which they occurred. You must make the election to deduct IDC on the first return in which IDC is incurred by either deducting or affirmatively electing.
- For cash basis taxpayers, if the contract with the operator requires the costs to be prepaid, IDC is fully deductible when paid, even if the actual costs are incurred by the operator in the following year.
- Taxpayers can elect to capitalize and amortize over 60 months straight line (if IDC incurred on non-domestic oil and gas properties, it must be capitalized and amortized over 10 years – not eligible to be expensed).
In assessing the potential tax benefits available from a potential oil and gas investment, the investor should consider their alternative minimum tax (“AMT”) position. IDC is partially deductible for AMT purposes. Excess IDC (difference between IDC deducted and the amount that would have been amortized during the tax year had the election to capitalize and amortize been made) is added to AMT income and multiplied by 40 percent. All excess IDC above the product is considered preference IDC and is not deductible for AMT. For example:
- Assume AMT income before any IDC preference add back is $500,000 and Excess IDC is $400,000; AMTI including Excess IDC = $900,000 x 40% = $360,000 amount deductible from AMT
- $40,000 is the preference IDC add back, thus, taxable AMT is $540,000
The IDC deduction applies to working interests, either owned through drilling partnerships or direct working interests. It also applies to MLPs, but passive activity and publicly traded partnership tax rules limit its utility.
Investors compute cost depletion and statutory depletion (also known as percentage depletion), then deduct the larger of the two amounts. Depletion is calculated on a property-by-property basis.
- Cost depletion is computed by the units of production method (total volume produced during the year / total expected remaining volumes to be ultimately produced at the beginning of the tax year multiplied by leasehold cost.
- No income limitations apply
- Once all leasehold costs are fully recovered through depletion, cost depletion is zero
- Percentage depletion is calculated by multiplying gross sales for the property for the year by 15%
- Allowable depletion is limited to taxable income for the property, thus, percentage depletion can reduce taxable income on a property to zero, but may not create a tax loss for the property.
- Overall income limit – 65% of taxable income; any allowable percentage depletion above the overall limit is carried over to future years
- Not limited to leasehold cost – thus may continue to deduct percentage depletion after all leasehold costs are fully recovered
This is the 100,000-foot view of O&G investing for the potential investor looking to diversify a portfolio while prices are low. To explore if these opportunities may be right for you, consult with your investment advisor. Cornwell Jackson can assist potential investors with analyzing the potential tax impacts of oil and gas investments and with the complexity of tax filing each year. Contact us with any questions.
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients.
Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.