Oil & Gas Investing > Tax Benefits to Oil and Gas Investing

Congressional Incentives Encourage Domestic Petroleum Development

Oil and natural gas drilling is a capital intensive business which requires the use of, and creates demand for, a wide range of equipment, supplies and personnel; accordingly, the national economy is stimulated when the energy business is very active. Oil and natural gas from domestic sources helps to make our country more energy self-sufficient and reduces our dependence on foreign imports. In light of this, Congress has provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. Drilling projects offer many tax advantages and these benefits greatly enhance the economics. Investment returns are improved and financial risks are reduced by the implementation of these tax code provisions. These incentives are not "Loop Holes" -- they were placed in the Tax Code by Congress to make participation in oil and gas ventures perhaps the best tax advantaged investment available and are designed to create investment attributes that will stimulate investment in the energy sector by individual investors, partnerships, trusts, and corporations.

Now that the top federal income tax rate for individuals has been hiked to 39.6%—and notwithstanding changes in commodity prices—the producer incentives contained in the Energy Policy Act of 1992 and the Revenue Reconciliation Act of 1990 have taken on added importance for investors.

With state income taxes in California and New York now above 10%, for example, some taxpayers are looking at more than 50% of their earnings going to taxes. Given these higher marginal tax rates and a smaller alternative minimum tax burden; drilling investments that provide current tax deductions (IDC and depletion allowance), which offset other sources of income, become extremely attractive. Further, when a successful well is drilled, the investor has a better chance of recouping the investment faster through the depletion deduction, which is no longer a tax preference for purposes of computing the alternative minimum tax (AMT).

The following is a generalized summary of certain items in the U.S. Internal Revenue Code relating to oil and gas exploration. It is neither exhaustive nor detailed. Each individual should understand how these items will impact them personally. In addition, other items unique to the individual may also be relevant. Investors should contact their professional tax consultants for a complete explanation of the benefits of investing in oil and gas.  

Intangible Drilling and Development Costs (IDC)

With a proper election, intangible drilling and development costs may be deducted as an expense for federal income tax purposes. These costs in general are those expenditures incurred in connection with the drilling and completion of oil and gas wells and which have no salvage value. Examples of such expenditures are amounts paid for labor, services, fuel, repairs, hauling and supplies which are used in the (1) drilling, shooting and cleaning out of wells, (2) in the clearing of ground, draining, road making, surveying and geological work as are necessary in preparation for the drilling of wells and (3) in the construction of such derricks, tanks, pipelines and other physical structures as are necessary for the drilling and preparation of wells for the production of oil or gas. Prepayment of intangible drilling expenses is generally allowed only if economic performance occurs within 90 days after the close of the taxable year in which payments are made.
(See IRS Code, Section 263)

For example, a $100,000 investment could yield $70,000 to $80,000 in tax deductions against active income (salary, investment portfolio income, business income, interest and rental income) during the first year of the venture. These deductions are available in the year the money was invested, even if the well does not start drilling until March 31 of the year following the contribution of capital.

Tangible Equipment Costs (L & W, Lease and Well Equipment)

The cost of capital equipment utilized in the completion and preparation for production of oil and gas wells generally must be capitalized and recovered through cost recovery deductions. Cost recovery deductions can either be accelerated depreciation schedules with time formulas or units of production. Upon the sale or other disposition of depreciable equipment, all or a portion of the cost recovery deductions previously claimed may be subject to recapture and taxable as ordinary income.
(See IRS Code, Section 263)

Typically, the total amount invested in Lease and Well Equipment is 100% tax deductible as depreciation usually on a accelerated seven year declining schedule, providing approximately 60% of the write-off in the first three years. Alternately, this tangible equipment cost may be written off 100% in the first year under IRS section 179 if the investor has sufficient excess income.

Property Acquisition Costs (Leasehold, Oil and Gas Mineral Lease)

Leasehold costs incurred in connection with the acquisition of oil and gas property must be capitalized and recovered through depletion deductions over the producing life of such property, through loss deductions in the year such property is determined to be worthless or is abandoned, or as an offset against the amount realized upon the sale or exchange of such property. Leasehold costs include the amounts paid in connection with the acquisition of an oil and gas lease, including title insurance or examination costs, broker's commissions, filing fees, recording costs, transfer taxes, certain geological and geophysical costs, and professional fees, such as accounting or legal fees, related to the acquisition. Property acquired as a result of a drilling commitment that provides for a complete payback of drilling costs before reversion generally requires no capitalization of imputed leasehold value. The leasehold capital costs remain with the originating entity.

Rules for recovery of Leasehold costs through depletion allow the investor to calculate both cost and percentage depletion methods each tax year and utilize the method with the most favorable result. Percentage depletion allowance ranges from fifteen (15%) to twenty five (25%) percent and can fluctuate annually driven by the market price of crude oil; as the market price goes up, the percentage depletion goes down and vice versa.

Depletion Allowance (Cost or Percentage Depletion)

The owner of an economic interest in an oil and gas property is generally entitled to a deduction for depletion with respect to the income derived from the production of oil and gas. The depletion for any year with respect to any specific property is equal to the greater of cost depletion or percentage depletion. Cost depletion for any year is determined by dividing the adjusted basis for the property by the estimated total recoverable units at the beginning of the year to determine the per-unit allowance by the number of units sold during the year. Percentage depletion for oil and gas is allowable only to small producers and is generally limited to an average daily production of up to 1,000 equivalent barrels and can vary from 15-25% based on the market price of crude oil. (S ee IRS Code Section 611(a) Regulation 1.611-1(a)(1)) Percentage depletion, where applicable, is not limited by the cost basis in the property, but is subject to various tests that have the result of reducing the amount of depletion. The deduction in any tax year may not exceed 65% of the tax payer's taxable income from all sources. (See IRS Code, Section 613A)

IRS Section 179 Expensing (Write – Off)

A business owner (or in this case, the oil and gas investor) may make an election to expense (write-off) certain lease and well equipment (income producing tangible goods) which are purchased and placed into service in the tax year. This write off is subject to certain limitations and tests. This is a direct write off as opposed to depreciating purchased equipment over time. As a stimulus to the national economy, the expense limits were dramatically increased in 2003 and for several subsequent years. The expense limit for calendar year 2006 is $108,000.00 Operating Income (Production Income, Production “Net” after Royalties)

The income from oil and gas operations will be taxed at ordinary individual rates. Lease operating expenses (LOE) will be deductible as an ordinary business expense from the income derived from the sale of oil and gas. Production income is reported on IRS Form 1099 as miscellaneous income. The 1099 Form is required to show the gross, total sum of production value “at the wellhead”, prior to deductions for state severance taxes and lease operating expenses.

Limitations on Deductions and Credits from Passive Activities

Deductions from or credits attributable to passive trade or business activities and certain passive investments to the extent that they exceed income from all passive activities, generally may not be deducted from or offset against the income tax attributable to other income such as salary, active business income or portfolio income. A passive activity generally includes the conduct of any trade or business in which the taxpayer does not materially participate throughout the year. Special rules provide, however, that a passive activity will not, in certain circumstances, include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such working interest.
(See IRS Code, Section 469(c )(3))

The Tax Code provides that joint venture working interests is not a “Passive Activity”, therefore, deductions can be used to offset income from salary, interest, portfolio investment income, and business income.

At Risk Limitations

The federal tax code prohibits individual taxpayers from taking current deductions for losses incurred in connection with business and investment activities, except to the extent that the taxpayer is at risk with respect to these activities. A taxpayer is not considered to be at risk to the extent that he is protected against loss through non-recourse financing, dollar guarantees, stop loss agreements or other similar activities. Each oil and gas property constitutes a separate activity with respect to which the amount at risk must be determined. Deductions from an activity which are not allowable for that year because they exceed the taxpayers amount at risk may be carried forward.

Alternate Minimum Tax

To prevent taxpayers from totally escaping federal income taxation, the Code provides for an alternate method of calculating tax liability. Items that are normally deductible can be classified as tax preference items for the alternate minimum calculation. Prior to the 1992 Tax Act working interest participants in oil and gas ventures were subject to normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. The 1992 Act specifically exempted Intangible Drilling Cost and percentage depletion as tax preference items, but retained “excess” IDC as a tax preference item. Alternative minimum tax (‘AMT') liability is a highly specialized area and the use of a qualified tax professional is advised.

IRS Circular 230 Disclosure

To ensure compliance with U.S.Treasury Regulations governing tax practice, we inform you that any U.S. Federal tax advice contained in this communication, including any appendices, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under U.S. Federal tax law, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

The information herein is not to be construed as legal or tax advice. SPXCO recommends that any prospective investor consult with qualified, professional legal and/or tax advisors prior to consummating any investment.