Oil and Gas Tax Benefits
Direct participation in oil and gas can generate several tax benefits. These benefits range from large upfront deductions for intangible drilling costs (IDC) to tax credits for the development of certain types of tight formations. Deductions are primarily generated from the cost of non-salvageable equipment or services used during the drilling phase, testing and/or completion of the well.
1. Intangible Drilling Costs (IDC): Several expenses may be deducted immediately when an oil or gas well is drilled. These expenses are deductible because they offer no salvage value whether or not the well is subsequently declared to be dry. Examples include labor, drilling rig time, drilling fluids, etc. IDCs usually represent 60 to 80 percent of the well cost. Investors generally put up the drilling portion of their investment before drilling operations begin. The investor’s portion of the intangible drilling costs is generally taken as a deduction in the tax year in which the intangible costs occurred. However, the accounting method adopted could affect the deduction period.
2. Intangible Completion Costs: As with IDCs, these costs are generally related to non-salvageable completion costs, which include labor, completion materials, completion rig time, fluids, etc. Intangible completion costs are also generally deductible in the year they occur and usually amount to about 15 percent of the total.
3. Depreciation: As opposed to services and materials that offer no salvage value, equipment used in the completion and production of a well is generally salvageable. These salvageable items are usually depreciated over a seven-year period using the Modified Accelerated Cost Recovery System, or MACRS. Equipment in this category includes casings, tanks, wellhead and tree equipment, pumping units, etc. Equipment and tangible completion expenses generally account for 25 to 40 percent of the total well cost.
4. Depletion Allowance: Once a well is in production, the participants in the well are allowed to shelter some of the gross income derived from the sale of the oil and/or gas through a depletion deduction. Two types of depletion are available -- cost and statutory, which is also referred to as percentage depletion. Cost depletion is calculated based on the relationship between current production as a percentage of total recoverable reserves. Statutory, or percentage depletion, is subject to several qualifications and limitations. This deduction will generally shelter 15 percent of the well’s annual production from income tax. For stripper production, wells producing 15 barrels a day or less, the depletion percentage can be up to 20 percent.
5. Tax Credits: Congress has enacted several tax credits in relation to oil or natural gas production. The enhanced oil recovery credit is applied to certain project costs incurred to enhance a well’s oil or natural gas production. This credit is up to 15 percent of the costs incurred to enhance production. The non-conventional source fuel credit provides a $3 per barrel of oil equivalent credit for production from so-called 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 could potentially present the possibility for taxation under the Alternative Minimum Tax (AMT). In the early 1990s, however, Congress provided some tax relief for independent producers, which are individuals or companies with production of 1,000 barrels per day or less. Although there is still the potential for AMT taxation for excess IDCs, percentage or statutory depletion is no longer considered a preference item.
7. Lease Operating Expense: This expense covers the day-to-day costs involved with the operation of a well. The expense also covers the costs associated with re-entry or re-work of an existing producing well. Lease operating expenses are generally deductible in the year incurred without any AMT consequences.
8. 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 that own more than 1,000 barrels of oil -- or 6,000,000 cubic feet of gas – in average daily production. The Small Producers Exemption allows 15 percent of the gross income – as opposed to net income -- from an oil and gas producing property to be tax-free.
Obviously, the tax benefits generated by direct participation in oil and/or natural gas are substantial. The immediate deduction of the intangible drilling costs, or IDCs, is significant. By taking this upfront deduction, the risk capital is effectively subsidized by the government by reducing the participant's federal and possibly state income tax. Each individual participant, of course, should consult with his or her tax advisor.