Last Updated on Oil and natural gas projects generate substantial tax benefits. Oil represents one of the exceptional tax-advantaged investments for big investors. It promises to stand alone above other commodities.
As the United States government maintains its backing, the production of domestic energy has produced a catalog of tax incentives that both small producers and big investors can enjoy. This also includes oil.
This guide will discuss what oil and gas tax deductions are and how they work.
Are there tax deductions available for oil and gas companies?
Yes, oil and gas investors will find numerous major tax benefits available. These cannot be found anywhere else in the tax code.
Besides this, one of the most important questions for investors is: Are oil and gas investments tax deductible for investors?
It is worth noting that these costs are totally (100%) deductible in the year incurred. This is even true irrespective of whether or not the well produced.
Accredited investors can enjoy significant tax deduction potential in their oil and gas investments.
What type of Oil and Gas Tax Benefits are Out There and How Do They Work?
Some tax benefits that are available to investors are discussed in this section.
Working Interest
A working interest represents an ownership interest in an oil and gas well or lease, which ensures that investors can enjoy a right to a specific share of production income once the royalty income investors have been paid. It requires the investor to share in the operation and development costs of the well.
- The working interest is also known as the operating interest.
- According to the tax code, the working interest in oil and gas cannot be classified as a passive activity.
- This is considered the riskiest involvement in an oil and gas investment.
- A percentage of the ownership ensures that investors can participate in drilling activities.
Intangible Drilling Costs (IDC)
Intangible drilling costs include everything but the actual drilling equipment. Many items essential to carry out drilling activities are considered to be intangible. These include grease, labor, mud, and chemicals.
- The partners may choose to amortize as a form of alternative.
- Generally, these expenses account for between 60% and 80% of the total drilling cost of a well.
- They are also totally deductible in the year incurred.
- Intangible drilling costs in oil and gas represent one of the most substantial tax breaks that are available for oil companies
- It is now possible for independent natural gas producers to choose to immediately deduct all of their intangible drilling costs.
Intangible Completion Costs (ICCs)
These costs cannot be recovered upon the completion of an oil and gas well.
- They are 100% deductible in the year that the costs are incurred.
Tangible Drilling Costs (TDC)
These costs relate to the actual direct costs that are associated with the drilling equipment. These include drilling rigs, tractors, trailers, tandem trucks, dozers, and excavators.
- These expenses are also 100% deductible but must be depreciated over seven years.
- Between 20% and 35% of the amount of one’s investment accounts for “Tangible Drilling and Completion Costs” (TDCs).
- This may be deducted from one’s income over a 7-year period.
Loss limitations
According to IRC Section 469, losses are generally disallowed from all passive activities.
- Determining whether or not a working interest investor depends on the Section 469 loss limitation rules is based on the type of entity in which the interest is held by the investor.
Qualified business income deduction
Under Section 199A, It is also possible for individual investors to choose to deduct income from a working interest in an oil and gas asset.
- This ensures that taxpayers can deduct up to 20 percent of qualified business income.
DEPLETION ALLOWANCE (Small Producer Tax Exemptions)
The 1990 Tax Act allows certain entities to exempt 15% of their gross income from federal taxes to help support smaller oil companies and direct investors. This is perhaps the most enticing tax break for small producers and investors. Depletion allowance (Small Producer’s Tax Exemption) excludes from taxation 15% of all gross income from oil and gas wells.
- This is also known as a small producer tax exemption.
- The allowance is based on the fact that investors should be encouraged for participating in high-risk investments.
- Oil and gas income earned by Small Producers is subject to the 15% statutory depletion allowance.
- This special advantage can be enjoyed only by small companies and investors.
- Any company that produces or refines at least 50,000 barrels of oil daily is excluded.
- Any company that owns more than 1,000 barrels of oil daily, or 6 million cubic feet of gas per day, is ineligible as well.
Active vs. Passive Income
According to the tax code, unlike a royalty interest, a working interest cannot be considered a passive activity. After all, investors are charged with the responsibility of taking an active role in their oil and gas investment.
- All net losses are active income incurred in conjunction with well-head production
- They can be offset against other forms of income such as wages, interest, and capital gains.
Lease Costs
Lease costs involve the purchase of lease and mineral rights, lease operating costs, and all legal, administrative, and accounting expenses.
- These expenses must be capitalized and deducted over the life of the lease via the depletion allowance.
- These expenses are also completely deductible, without any consequences related to Alternative Minimum Tax (AMT).
Alternative Minimum Tax (AMT)
A preference item is a term used to specifically describe any excess intangible drilling costs. This is exempted from the Alternative Minimum Tax (AMT) return.
- Alternative Minimum Tax (AMT) was set up to enable taxpayers to pay their fair share of taxes.
- This is done by recalculating the amount of income tax owed and adding back specific preferential tax deductions or items.
- Before 1992, working interest investors or independent producers (these are small producers are companies with 1,000 barrels daily) in oil and gas joint ventures were subject to the Alternative Minimum Tax. This is to an extent that this tax surpassed their regular tax.
- 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 that exist in the Code to significantly minimize regular income tax deductions.
Depreciation tax deduction
Unlike products and services that present no salvage value, tangible equipment that is adopted in the completion and production of a well is typically regarded as salvageable.
- These items generally depreciate over a 7-year period. These follow either the Straight-line Method or the Modified Accelerated Cost Recovery System.
- Many pieces of equipment found in this category include casing, tanks, wellheads and trees, pumping units, and many more. Generally, equipment and tangible completion expenses make up 20 to 40% of the total well cost.
TAX DEDUCTIONS EXAMPLE
In the calculation of depletion tax deduction, the cost depletion method is often adopted. This method is associated with the landowner’s basis in the property. An example will explain better how this method can tackle depletion tax deduction.
Let’s imagine that a landowner inherited about 500 acres of property from his father Upon his father’s death, the value of the land received a stepped-up basis to its fair market value of $4,000 per acre. This ensures that the total value of the land is $2,000,000.
As drilling of oil and gas in Ohio increased recently, he reserved a specific portion of the land’s basis for the mineral rights. The basis he establishes in the mineral rights is fixed as $100,000. A geological survey that was conducted revealed that there are about 5,000 million cubic feet (Mmcf) of natural gas reserves. The first year includes the well producing 500 million cubic feet (Mmcf)
To calculate the cost depletion, the first step to take is to estimate the value of the depletion units. This calculation is done by dividing the adjusted basis of the reserves by the total reserve units.
For the sake of this example, the landowner must divide $100,000 by 5,000 Mmcf. The result of this is $20 per Mmcf (or $0.02 per Mcf). 500 Mmcf of gas were sold in the first year. The cost depletion value for this amount is estimated by the formula:
500 Mmcf × $ 20/Mmcf
This gives $10,000. This figure is significantly less than his cost basis of $100,000. Then, he can deduct $10,000 for his cost depletion.
Then, his adjusted basis for the next tax year will be ($100,000 – $10,000 =) $90,000.
Percentage depletion is another popular method that can be adopted in estimating depletion tax deductions. Another example will illustrate better how this works.
A farmer receives a royalty income of $20,000. This represents the only income he receives from his real estate. Other sources generate a taxable income of $60,000. In order to estimate his percentage depletion, the farmer must first multiply the royalty income of $20,000 by a certain specified percentage of 15%.
By multiplying both together, he gets $3,000. He must determine if the deduction will be restricted by the 65% taxable rule. If so, he must then multiply the taxable income of $60,000 by 65%. This gives $39,000. Since $3,000 is less than $39,000, his deletion won’t be limited. The depletion tax deduction would then be $3,000. This would be placed on line 18 of Schedule E.
Are there Taxable Limitations?
Just like many other tax laws, limitations exist on the liability of a taxpayer for their oil and gas investment. There are many ways through which oil and gas investors’ liability may be reduced. These include the following:
- A limited partnership that does not involve the taxpayer being a general partner
- Any interest in another entity that can limit potential liability.
- Stock in a corporation
What are The Benefits of Oil and gas tax deductions?
Oil and gas investors can enjoy numerous returns on their investments. Many investors consider the returns they can enjoy from production and sales. Yet, greater value can also be enjoyed from tax deductions.
Despite this, it is worth understanding what kind of tax liability and what kind of expenses are deductible. This enables you to adhere to the relevant tax code properly while maximizing your returns.
Conclusion
Considering taxes, oil and gas investments offer so much promise. However, it must be said that it is not meant for everyone. After all, the risk involved in drilling for oil and gas can be daunting. For this reason, the SEC makes it compulsory for oil and gas partnerships to be accredited.
What this implies is that certain net worth and income requirements must be satisfied. For all eligible investors, engaging in an independent oil and gas project can offer significant returns, especially on a tax-advantaged basis.
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