Oil and Gas Tax Deductions- Tax Shelters For High Income Earners
The immediate deduction of the intangible drilling costs or IDCs alone is very significant. By taking this up-front deduction, the risk capital is effectively subsidized by the government by reducing the participant’s federal, and possibly state income tax, also. This, in turn, creates a tax shelter for high income earners.
You will learn about several other kinds of deductions that are available to the Small Producer of oil and gas. All told, the COGJV investor enjoys roughly 180%* of their initial capital investment in deductions through payback and ~80% of distributed earnings thereafter are tax-free.
The greatest benefit of the generous tax deductions associated with oil and gas investing is the potentially huge increase in realized profits. A top-margin Accredited Investor could see his COGJV after-tax annual yields through payback increase by up to 76.8% once tax avoidance credits are factored in!
*Including the new 20% Qualified Business Income (QBI) for pass-through income that starts in tax year 2018.
Note: This Information is for General Educational Purposes only. Consult your CPA professional for direct impact on your financial picture.
Simplified Example of 1st-Year Tax Deduction for Oil & Gas:
The Intangible Drilling Cost (IDC) deductions and the depreciation of tangible equipment on a typical oil or natural gas well allow a large income tax deduction of the investment (usually 65% to 80%) for the first year of activity. The tax consequences for a $100,000 capital expenditure can be approximated as follows:
|Intangible Drilling Costs||x 65%|
|Intangible Expenses Deduction||$65,000|
|Tangible Equipment Costs||x 35%|
|Depreciated over 7 years||÷ 7|
|First year Tangible Depreciation Deduction||$5,000|
First year reduction in Taxable Income $70,000
What Does $70,000 of 1st Year Deductions Actually Mean?
A Virginia Accredited Investor getting $70,000 of additional deductions would realize an incredible in-pocket tax credit of up to nearly $30,000. 100% free and clear.
The potential for a $70,000 tax deduction could deliver a huge 1st year after-tax yield of up to 34.2%. That’s up to $34,200 of tax-free income.
TAX CONSIDERATIONS of Oil & Gas Investing – The Basics
■ Congressional Incentives
Natural gas and oil development from domestic reserves helps to make our country more energy self-sufficient by reducing our dependence on foreign imports. In light of this, Congress has provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. Natural gas and oil drilling projects offer numerous tax advantages. These tax benefits enhance the economics of natural gas and oil projects.
■ Intangible Drilling Cost (IDC) Tax Deduction
Oil and gas projects are labor, services, and non-salvageable materials intensive, so a significant portion of the expenditure is considered Intangible Drilling Cost (IDC), which is 100% deductible during the first year. For example, a capital expenditure of $100,000 could result in approximately $70,000 in tax deductions for IDC even if the well does not start drilling until March 31 of the year following the contribution of capital. The remaining $30,000 of tangible costs may be deducted as depreciation over a 7-year period. (See Section 263 of the Tax Code).
■ Depreciation Tax Deduction
As opposed to services and materials that offer no salvage value, equipment and other tangible materials used in the completion and production of a well is generally salvageable. Items such as these are depreciated over a 7-year period, utilizing either the Straight-line Method or the Modified Accelerated Cost Recovery System or MACRS. Equipment in this category would include casing, tanks, well head and tree, pumping units etc. Equipment and tangible completion expenses generally account for 20 to 40% of the total well cost.
■ Small Producer’s Tax Exemption- Depletion Allowance
Once a well is in production, the participants or well owners are allowed to shelter some of the gross income derived from the sale of the oil and/or gas through a depletion deduction. The 1990 Tax Act provided some special tax advantages for the typical Small Producer in oil and gas drilling projects. 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, or taxpayers who sell oil or natural gas through retail outlets, or those who engage in refining crude oil with runs of more than 50,000 barrels per day. It is also not available for entities owning more than 1,000 barrels of oil (or 6,000,000 cubic feet of gas) average daily production.
The “Small Producers Exemption” specifically allows 15% of the gross Working Interest income from an oil and gas producing property to be tax-free. (See Section 613A of the Tax Code).
■ Active, or Non-passive vs. Passive Income
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” or “Non-passive” income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. However, the new Tax Code specifically states that a Working Interest in an oil and gas well is not a “Passive” activity, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. (See Section 469©(3) of the Tax Code).
■ Alternative Minimum Tax (AMT)
Prior to 1992, Working Interest participants or “Independent Producers**” in oil and gas joint ventures were subject to the Alternative Minimum Tax to the extent that this tax exceeded their regular tax. However, Congress provided some tax relief through the 1992 Tax Act, which exempted Intangible Drilling Cost as a tax Preference Item. Although there is still the potential for AMT taxation for excess IDCs, percentage or statutory depletion is no longer considered a preference item.
“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 existing in the Code to greatly reduce or eliminate regular income tax deductions. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon (Standard Cost Depletion).
**An Independent Producer also called Small Producer is defined as an individual or company with production of 1,000 barrels (or 6,000,000 cubic feet of gas) per day or less.
TAX CONSIDERATIONS – Small Producer’s Perspective
Investment in the oil and gas industry provides very significant tax advantages for the Small Producer. Although the Tax \ Reform Act of 1986 eliminated many traditional “tax shelters,” the tax advantages associated with participation in domestic drilling programs remained in place. A properly structured program can provide an excellent means of stretching one’s investment dollar.
■ Tax Benefits for the Small Producer – a Recap:
- In the case of a successful oil and gas investment, the IRS allows for a tax write-off from one’s taxable earned income of approximately 65% – 80% of the investment amount in the year of investment. The remaining amount of the investment is depreciated over a period of seven years.
- Even in the case of an unsuccessful oil and gas investment, the IRS allows almost 100% of the investment to be written off against one’s taxable earned income unlike stock investments where the investor may only write-off a small portion of the loss (subject to certain limitations).
- The IRS currently allows 15% of one’s gross Working Interest income from the sale of oil and/or gas to be derived “tax free” (this is referred to as a “depletion allowance”).
- Net income from a producing oil and/or gas wells is received on a monthly basis. [Energy Partners Fund distributes income earnings quarterly.] Each check, in effect, serves to reduce the amount initially invested. This differs from stock investments where most of one’s profitable income is derived from the one-time sale of stock.
- Most importantly, if one’s tax liability is substantial (Accredited Investors generally have the highest margin Federal tax rates.), investment in a multiplicity of oil and gas projects can greatly reduce one’s tax liability, while providing long-term, investment income.
- Investment in oil and gas exploration and/or field enhancement has the potential to lower one’s taxable income bracket in the following ways:
- Approximately 65% to 80% of the initial investment is classified as “Intangible Drilling Costs” (IDC’s) and may be deducted from one’s income in the year the investment is made, subject to certain limitations (see pages 28-29 in IRS publication 535, catalog 15065z).
- Approximately 20% to 35% of the amount of one’s investment is allocated to “Tangible Drilling and Completion Costs” (TDC’s) and may be deducted from one’s income over a 7-year period.
- Lease operating expenses (LOE) covers the day to day costs involved with the operation of a well. Also included in LOE are any costs of re-entry or re-work of an existing producing well. Lease operating expenses are generally deductible in the year incurred, without any AMT consequences.
- Oil and gas income earned by Small Producers is subject to the 15% statutory depletion allowance.
- If the well is unsuccessful and/or abandoned all the P & A costs may be deducted from one’s income in the year of that occurrence, subject to certain limitations.
CEFM’s Practice Concerning Partner’s K-1s
CEFM as Managing General Partner has always made it a practice to distribute the Partner’s K-1s and supporting documentation usually by mid-February. We have found that this provides enough time for the partner to process the information and file his/her tax return by April 15.
Along with the 1065 K-1 there are up to three (3) supporting documents, or reports that are provided. Some of the information provided:
- Distributed Well Revenue & Depletion Allowance – The Partner’s share of Gross WI income, the Net Income Received, and the 15% Depletion Allowance calculations for all wells in the Energy Partner Fund portfolio are provided.
- 1st Year IDC & Depreciation Deductions – This document summarizes the Partner’s share of all capital that was paid out during tax year. Shown is the total amount of intangible expenses from each Partnership well investment that the partner may deduct for the tax year. In addition, the first-year allowable depreciation for each well is calculated in this spreadsheet. A 7-year straight-line depreciation schedule is used.
- Business Capital Activities Worksheet – The Partner’s share of operational capital expenses and retained earnings of the Partnership. Also shown are the specific, proportioned dollar amounts that apply to their account for such things as the Total Re-invested Capital Contributed, Previous Years Allowable Depreciation Expenses, and Interest Inco