Last Updated on Since 1926, the Oil and Gas Depletion Deduction for small producers has been a part of the United States Federal tax code. Depletion represents a form of depreciation for mineral resources. It enables a deduction from taxable income, which can reflect the reducing oil or gas well production over a specific time.
To explain more, this guide will examine what depletion allowance is and its relevance for oil and natural gas producers. So, don’t stop reading!
What is a Depletion Allowance in Oil and Gas?
The percentage/cost depletion allowance is available through the IRS code. It ensures that an owner can account for the reduction of reserves during the production and sale of oil and natural gas.
In other words, the depletion allowance is an oil and gas deduction from gross income that is allowed, reflecting the depletion of mineral deposits. The cost depletion deduction applied is based on the fact that investors should be incentivized to engage in high-risk investments such as oil and natural gas production.
In the United States, anyone can claim the oil depletion allowance if they hold an economic interest in a mineral deposit, for example, natural gas reserves. The depletion deductions follow a principle that states the asset represents a capital investment, a wasting asset. As a result, depreciation can be considered an offset – or a capital loss – against asset-generated income.
This allowance has become a subject of much interest. After all, there is a strong relationship between the government and the oil industry.
Besides this, a method of claiming the allowance (percentage depletion) ensures that it is possible to write off more than the entire capital cost of the asset.
Who Can Claim a Depletion Allowance?
If a party expresses an economic interest in a mineral property, they can take a deduction for depletion. Economic interest exists once the following conditions apply:
- By investment, there is an acquisition of an interest in mineral deposits.
- There is a legal right to income from the extraction of minerals, which is depended on as a return on capital investment.
How To Calculate Depletion?
The depletion allowance ensures that oil and gas have become one of the most available tax-advantaged investments. For financial and accounting reporting purposes, the depletion calculation will help identify the value of assets on the balance sheet. It will also help record expenses at the right time on the income statement.
The two methods of calculating depletion: percentage depletion and cost depletion, are discussed in the section below.
Percentage depletion oil and gas allowance
Percentage depletion is only allowed for independent producers and royalty owners. It measures the amount of depletion associated with the extraction of non-renewable resources. Royalty owners and independent producers apply the percentage depletion allowance to the taxable gross income of a productive well’s property.
How do you calculate this?
Percentage depletion allowance is calculated by multiplying the gross income received in a tax year. The IRS determines the percentage for each resource.
In the case of oil and gas royalty owners, the percentage depletion is often estimated by using the 15% rate for gross income. It depends on the average daily production of crude oil, up to the depletable quantity of oil or natural gas.
For net income that is not up to 15% of gross income, the percentage depletion deduction is restricted to 100% of net income.
Cost Depletion oil and gas allowance
Cost depletion makes it possible for a taxpayer to recover the actual capital investment throughout the period of income production. This type of depletion is easier to estimate. The cost depletion allowance oil and gas producers use forms a part of the depreciation and amortization line of a natural resource company’s income statement. It is worth noting that depletion can only be used for natural resources.
How do you calculate it?
There is a simple formula to calculate cost depletion:
CD = (APV÷TR) × U
Where
- CD = Cost Depletion
- APV = Adjusted Property Value
- TR = Total Reserves
- U = Extracted units in a specific period
The adjusted property value is estimated by the formula:
APV = IC + DC – SV
For example, the investment cost of a natural resource asset is $3 billion. The development costs over the specific period were $45 million.
The salvage value is $300 million.
The calculated number of resource units for the property is 800 million.
The company extracts and sells 20 million units, and the depletion expense, as estimated under the cost depletion method, is determined by:
[($3 billion + $45 million – $300 million) ÷ 800 million] × 20 million = $68.625 million
Which is the right method to use?
According to the IRS, a landowner is required to compare the two methods when determining the depletion deduction. And the method that provides the largest deduction should then be employed.
Usually, companies that engage in mining or extracting determine their depletion expense method. They comment on period expenses in the management discussion and analysis sections of their quarterly and yearly financial filings.
What Is The Benefit of Depletion Allowance?
As mentioned earlier, investments in oil and gas wells have emerged as one of the most tax-advantaged investments currently available in the United States. This is primarily due to the depletion allowance.
Again, it should be stressed that about 15% of gross income from oil and gas is free of tax, especially for independent oil and gas producers and small investors.
The total amount of depletion that can be deducted from income from non-renewable resources has no dollar limits. Yet, percentage depletion can only apply to oil and gas properties with net income.
In cases where a property registers a net loss in a specific tax year, it is impossible to apply percentage depletion. Usually, percentage depletion is restricted to 50% of net income.
Do Depletion Rates Vary?
Depletion rates are set by the IRS and cover various natural resources. The most common rates are listed as follows:
- Oil and gas: 15% percent
- Borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone, and carbon dioxide originating from wells: 14%
- Sand, gravel, and crushed stone: 5%
- Sulfur and uranium: 23%
- Copper, iron ore, gold, silver, and some oil shale desposits: 15%
Is there a Taxable Income Limit?
A taxable income limit exists for royalty owners of oil and gas. Usually, the annual deduction for percentage deduction is limited to the smaller of:
- 100% of the taxable income originating from the property, figured without any depletion deduction.
- 65% of the taxable income from all sources, figured without the depletion allowance.
Conclusion
According to U.S. tax law, anyone may benefit from the oil depletion allowance if they have an economic interest in a mineral deposit.
The allowance is a significant subsidy for corporations. The accumulated value of the oil depletion allowance is estimated to be $470 billion to the petrochemical industry.
The calculation of oil depletion allowance can be achieved by considering two different methods: percentage depletion and cost depletion.
A percentage depletion deduction is limited to 100% of net income if the net income is not up to 15% of gross income.
A benefit of the oil depletion allowance is that it promotes a tax-advantaged investment for investors in the United States. Furthermore, the depletion allowance for different natural resources varies. In addition, it should be stressed that royalty owners in oil and gas can enjoy a taxable income limit.
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