When it comes to tax-advantaged investments for wealthy or sophisticated partners, one investment class continues to stand alone above all others: oil. With the U.S. government’s backing, domestic energy production has created a litany of tax incentives for both investors and small producers.
Several major tax benefits are available for oil and gas investors that are found nowhere else in the tax code. Read on, as we cover the benefits of these investments and how you can use them to fire up your portfolio.
- Intangible Drilling Deductions:
These include everything but the actual drilling equipment. Labor, chemicals, mud, grease and other miscellaneous items necessary for drilling are considered intangible. These expenses generally constitute 65-80% of the total cost of drilling a well and are 100% deductible in the year incurred. For example, if it costs $300,000 to drill a well, and if it was determined that 75% of that cost would be considered intangible, the investor would receive a current deduction of $225,000. Furthermore, it doesn’t matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 31 of the following year, the deductions will be allowed.
- Tangible Drilling Deductions:
Tangible costs pertain to the actual direct cost of the drilling equipment. These expenses are also 100% deductible but must be depreciated over seven years. Therefore, in the example above, the remaining $75,000 could be written off according to a seven-year schedule.
- Active vs. Passive Income:
The tax code specifies that a working interest (as opposed to a royalty interest) in an oil and gas well is not considered to be a passive activity. This means that all net losses are active income incurred in conjunction with well-head production and can be offset against other forms of income such as wages, interest and capital gains.
- Lease Costs
Lease costs (purchase of leases, minerals, etc.), sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are also 100% tax deductible through cost depletion.
- Alternative Minimum Tax
Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This Tax Act specifically exempted Intangible Drilling Cost as a Tax Preference Item. “Alternative Minimum Taxable Income” generally consists of adjusted gross income, minus allowable Alternative Minimum Tax itemized deduction, plus the sum of tax preference items and adjustments. “Tax preference items” are preferences existing in the Code to greatly reduce or eliminate regular income taxation. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon.
- Small Producers Tax Exemption
The 1990 Tax Act provided some special tax advantages for small companies and individuals. This tax incentive, known as the “Percentage Depletion Allowance”, is specifically intended to encourage participation in oil and gas drilling. This tax benefit is not available to large oil companies, retail petroleum marketers, or refiners that process more than 50,000 barrels per day. It is also not available for entities owning more than 1,000 barrels of oil (or 6,000,000 cubic feet of gas) average daily production. The “Small Producers Exemption” allows 15% of the Gross Income (not Net Income) from an oil and gas producing property to be tax-free.
The tax benefits generated in oil and/or natural gas are substantial. The immediate deduction of the intangible drilling costs or IDCs is very significant, and by taking this up front deduction, the risk capital is effectively subsidized by the government by reducing the Federal, and possibly State income tax. Each individual should consult with their tax advisor to maximize their tax advantages of oil and natural gas.
The basic tax considerations involved in oil and gas investments
1. INTANGIBLE DRILLING COSTS:
Approximately 80% of the investment, amount constitutes what are known as Intangible Drilling Costs (IDC), and are deductible against active, passive or portfolio income in the first year incurred. This includes all labor related costs for the prospect well. Including, but not limited to, drilling contractors, professional services, and others. The total amount of IDC is reported to each participant at the end of the year. Please consult with your tax advisor for further details.
2. TANGIBLE DRILLING COSTS:
Approximately 20% of the amount of costs to drill the well constitutes Tangible Drilling Costs (TDC). This includes, but is not limited to, all good equipment, piping, storage tanks, wellhead equipment, lease expenses and others. The exact amount will be determined after the well is drilled. This portion of an investment is depreciated over a seven-year period. Please consult with your tax advisor for further details.
Intangible Drilling Costs (estimate)
1st year deductions of intangible drilling costs (estimate)
1st year depreciation deduction (estimate) (37,000 x .20 divided by 7 years)
TOTAL FIRST YEAR TAX DEDUCTIONS(estimate)
Total Deduction (estimate)
Maximum Income Tax Bracket
TOTAL FIRST YEAR CASH VALUE OF DEDUCTIONS (estimate)
Actual Cash Savings from Tax Deductions (estimate)
AFTER-TAX CASH INVESTMENT (estimate)
*These tax calculatios are for illustration purposes only, they do not constitute any partnership participation under Sofí Exploration.
3. DEPLETION ALLOWANCE
Currently, the depletion allowance is 15%. This means that fifteen cents of every dollar are tax-free. Please consult with your tax advisor for further details.
4. STATE INCOME TAXES
State income taxes could add substantial additional savings, however, they may vary from state to state. Please consult with your tax advisor for further details.
1974. Oil, gas and geothermal deposits percentage depletion.
Percentage depletion applies to oil and gas and geothermal deposits only as follows:
Crude oil and natural gas production of independent producers and royalty owners. 15%depletion is allowed a taxpayer who isn't a retailer or refiner for so much of his “average daily production” of domestic crude oil and domestic natural gas as doesn't exceed his “depletable oil quantity” or “depletable natural gas quantity.” “Marginal production” may qualify for a higher percentage depletion rate (not to exceed 25%) if the price of domestic crude oil is below $20 per barrel for the calendar year preceding the calendar year in which the tax year in question begins.