Tax Information
There may be significant tax advantages associated with participation in privately held domestic oil and gas drilling and production in the U.S. today. The Internal Revenue Code of 1986, as amended (the “Code”) currently provides tax advantages for certain types of direct participation in oil and gas drilling and production in order to encourage investment in oil and gas exploration within the United States. However, in order to benefit from these tax incentives participants must meet certain requirements – not all oil and gas ventures generate the same types of tax advantages.
This overview sets forth some of the tax benefits associated with participating in private oil and gas ventures within the United States. It is applicable only to participation in private companies – investing in a publicly traded stock does not generate the same types of tax advantages. Of course, you are encouraged to consult with your tax advisor regarding how any specific participation will be treated given your particular circumstances.
Intangible Drilling and Completion Costs (“IDCs”) generate significant deductions during the 1st year of participation.
IDC costs comprise a substantial portion of the expense associated with drilling and developing a well, and include drilling expenses, such as site preparation, rig costs and the expensive, high-pressure fracturing of rock formations. A substantial portion (approximately 65 to 80%) of a direct investment in a domestic oil and gas venture may constitute IDC and be deductible in the taxable year of the participation. This is even true for some investments made late in a year, in which the drilling doesn’t begin until the beginning of the following year. For example, if a participant were to purchase a portion of a U.S. working interest in December 2007, the IDC for that well generally could be deducted in 2007 as long as drilling begins prior to April 2008. For a participant in the 35% federal marginal tax bracket who has the ability to use the full write-off, this means a tax savings in the first year equal to 22.75% to 28% of the initial investment. As an illustration, if the IDC for a well amounted to 75.0% of a participant’s $100,000 investment, the participant could receive up to a $75,000 deduction. This would save the participant (at a 35% federal marginal rate) $26,250 on his or her taxes in the year of the investment. These tax benefits could be even more significant in states where there is a state income tax or for self-employed participants who could benefit from reduced self-employment taxes as a result of IDC deductions.
Participation in oil and gas ventures allows participants to offset other “Active” income.
The Code classifies participation in joint ventures formed to purchase working interests in oil and gas properties as an “active” business activity. This is beneficial because it allows individuals to offset losses stemming from oil and gas joint ventures against other income from “active” businesses. This classification allows participants to use deductions from certain oil and gas ventures against income from salaries, businesses in which they invest, stock dividends and stock trades. The same benefits are not associated with “passive” investments, such as investment in stock in corporations or limited partnership interests in limited partnerships formed to purchase oil and gas properties.
Participation may also generate depreciation deductions over time.
Equipment including pipe, well casings, tubing, storage tanks, pumping units and other items that remain with the well after its completion are considered depreciable. These additional expenses may generally be depreciated over a seven-year period.
Participants in domestic independent oil and gas ventures are entitled to a percentage depletion allowance.
The owner of an economic interest in an U.S. oil and gas property is generally entitled to claim the greater of “percentage depletion” or “cost depletion.” Percentage depletion is generally available only to the domestic oil and gas production of “independent producers.” To qualify as an independent producer, the taxpayer, either directly or through related parties, may not be involved in the refining of more than 50,000 barrels of oil (or equivalent of gas) on any day during the taxable year or in the retail marketing of oil and gas products exceeding a total of $5 million per year. Although it could be higher, generally a percentage depletion allowance of 15% is used. In contrast, cost depletion for any year is determined by multiplying the cost basis of the mineral interest by a fraction, the numerator of which is the number of barrels of oil (or Mcf of gas) sold during the year, and the denominator of which is the estimated recoverable units of reserves available at the beginning of the depletion period. In no event may the cost depletion exceed the adjusted basis of the property to which it relates.
The impact of the depletion allowance is to generally make 15% to 25% of the gross income from a direct participation in an oil and gas property tax-free. One important limitation on the depletion allowance is that the deduction in any tax year may not exceed 65% of the taxpayer’s taxable income from all sources. Typically, any excess depletion allowance may be carried forward.
Consult your personal tax advisor.
The above examples are for general information only and are not intended as individual tax advice. Federal and state tax laws are complex. Consult your personal tax advisor concerning the applicability and effect participation in oil and gas ventures on your personal tax situation and, more specifically, whether or not participation in an oil and gas venture would produce favorable tax advantages in your tax situation. This information was current as of September 2007. However, tax laws change from time to time, and there can be no guarantee of the interpretation of the tax laws.
