Oil and Gas Tax Benefits
Direct participation in oil and natural gas well production generates several tax benefits. These range from large, up front tax deductions for intangible drilling costs (IDC), to tax credits for the development of certain types of tight sand formations. For investors seeking to leverage even greater tax advantages, Beacon Energy Partners offers investments of a higher risk profile, available for more aggressive exploratory drilling programs. Deductions of this type are generated mainly from the cost of non-salvageable equipment, or, from services conducted during the drilling phase, the testing, and/or completion of the well. Beacon Energy Partners has compiled a synopsis of tax benefits created by direct participation in oil and natural gas investments:
1.Intangible Drilling Costs (IDC):
When an oil or gas well is drilled, several expenses may be deducted immediately. These write-offs qualify as deductible expenses because they possess no salvage value, regardless of whether or not a well is subsequently declared dry. Examples of these types of expenses are labor, drilling rig time, drilling fluids, etc. IDCs usually represent 60 to 80% of the well cost. For those investors who seek a higher risk/ reward profile, the investor puts up the drilling portion of their investment before drilling operations commence. This investor’s portion of the IDC are generally taken as a deduction in the tax year for which the intangible drilling costs are incurred. The accounting method adopted by the investor, however, ultimately affects the deduction period.
2. Intangible Completion Costs:
As with IDCs, these costs are generally related to non-salvageable completion costs, such as labor, completion materials, completion rig time, fluids, etc. Intangible completion costs are deductible in the year they occur, and usually amount to 15% of the total expenditure.
3. Depreciation:
Contrary to services and materials that offer no salvage value, equipment used in the completion and production of a well are generally deemed salvageable. These items are depreciated over a seven year period, utilizing the Modified Accelerated Cost Recovery System (MACRS). Equipment in this category include casings, tanks, well head and tree, pumping units, etc. Equipment and tangible completion expenses account for 25 to 40% of the total well cost.
4. Depletion Allowance:
Once a well is in production, participants in the well are permitted to shelter some of the gross income derived from the sale of the oil and/or gas through a depletion deduction. There are two types of depletion deductions: cost, and statutory (statutory is also referred to as “percentage depletion”). Cost depletion is calculated from the relationship between current production as a percentage of total recoverable reserves. Percentage depletion is subject to several qualifications and limitations. Depletion allowance will generally shelter 15% of the well’s annual production from income tax. For “stripper production” (wells producing 15 barrels/day or less), the depletion percentage can be as large as 20%.
5. Tax Credits:
Congress has enacted several tax credits for oil and natural gas production. The enhanced oil recovery credit is applied to certain project costs that enhance a well’s oil or natural gas production. This credit is up to 15% of costs incurred for production enhancement. There also is a fuel credit for non conventional sources (tight sand formations, etc.) that provide for the equivalent of a $3 per barrel credit for the production of qualified fuels. Qualified fuels include oil shale, tight formation gas, and certain synthetic fuels produced from coal.
6. The Alternative Minimum Tax (AMT):
Historically, the tax benefits from oil and natural gas production presented the possibility of taxation under the Alternative Minimum Tax (AMT). In the early 1990s, however, Congress provided tax relief for “independent producers”, defined as individuals or companies with production of 1,000 barrels of oil per day or less. Although there still exists AMT taxation for excess IDCs, percentage depletion is no longer considered a preference item.
7. Lease Operating Expense:
This expense covers the day-to-day costs of the operation of a well. The lease operating expense also covers the cost of re-entry or re-work of a producing well, and is deductible for the year incurred, without AMT consequences.
More Information
In conclusion, tax benefits generated by direct participation in oil and/or natural gas are substantial. The immediate deduction of the intangible drilling costs (IDC) is very significant. When the IDC is taken as an up front deduction, the risk capital is effectively subsidized by the government. This reduces the investor’s federal and, in some cases, state, income tax liability. Each participant should, of course, consult with their tax advisor.