Here is a top level overview of tax benefits that are advantageous for E & P companies and investors.
- Intangible Drilling Costs (IDC)- the intangible costs involved in drilling a well and include virtually everything except the actual drilling equipment. These costs include such things as labor, chemicals, mud, grease, supplies and anything else consumed or utilized in the drilling process. These costs generally make up 60%-80% of the expense involved in drilling a well and are 100% deductible in the year incurred. This deduction is available regardless of whether the well is productive or not. So long as the drilling operation is started by March 31 of the year following the deduction year, the deduction is available for the entire amount of intangible drilling costs spent or accrued in that deduction year. For example: IDCs of $100,000 are incurred in year 1 and drilling operations start prior to March 31 of year 2. The entire IDC of $100,000 is deductible in year 1. If an investor had invested $200,000 in the entire well project, he or she would be able to deduct $100,000 as IDC in year 1. This applies regarding of the eventual result of the exploratory well drilling operation.
- Intangible Completion Costs (ICC)- These are, in general, a second category of intangible costs for items consumed during the drillig process. These costs are more closely related to the completion of the drilling operation and include items such as labor, materials, fluids, supplies, rig-time, etc. These costs are also fully deductible in the year incurred.
- Tangible Drilling Costs (TDC)- These are the hard costs for the actual drilling equipment. These costs are depreciated over a seven year period with each year’s segment being fully deductible. In addition, because of new legislation signed by President Obama in 2010, certain equipment acquired after September 8, 2010, and placed in service before January 1, 2012, is eligible for 100% bonus depreciation which means the entire cost of such qualifying new equipment can be deducted in the year it is placed in service rather than being depreciated over the seven year period.
- Domestic Production Activity Deduction (DPD)- The Domestic Production Activity Deduction (DPD) is a special deduction enacted under Section 199 of the Internal Revenue Code that applies to organizations with domestic production activities. These activities include manufacturing, construction, engineering and architectural services and the generation or extraction of electricity, oil and gas resources or potable water.Property produced from such activity is called Qualified Production Property (QPP).Gross receipts associated with such activities are called domestic production gross receipts (DPGR). These gross receipts must be from the lease, rental, license, sale, exchange or other disposition of Qualified Production Property (QPP. )The DPD Section 199 deduction is a percentage deduction from Qualified Production Activities Income (QPAI), which is defined as domestic gross production receipts (DPGR) less cost of goods sold and other expenses, losses or deductions allocable to those receipts.
- Depletion Allowance- The Internal Revenue Code provides a deduction from gross revenues for oil and gas depletion. There are two methods of depletion: percentage depletion and cost depletion. Percentage depletion is more commonly used in the oil and gas industry and allows for a 15% deduction from gross revenues. Cost depletion is a more complex calculation but also allows for a deduction from gross revenues from oil and gas production. While the depletion allowance applies in general to working interests there is a special provision in the tax code for companies that produce or refine less than 50,000 barrels of oil per day. This provision is available for investors who own less than 1,000 barrels of oil per day or less than 6 million cubic feet of gas per day.
- Lease Costs- All of the costs for purchase of leases and mineral rights, lease operating costs and associated administrative costs are fully deductible in the year incurred.
- Completion Costs- Up to $17,000 of total completion costs per well can be fully deducted as a one-time charge in any given year before application of depletion allowance.
- Other Considerations- Intangible drilling costs are not considered a tax preference for purposes of computing an individual investor’s alternative minimum tax.
Disclaimer: As can be seen, there are numerous tax advantages associated with an investment in the oil and gas industry that are simply not available for other types of investment. These tax advantages are a direct result of our national energy policy and are expected to continue with little change for the foreseeable future. To determine how these tax benefits may impact your personal tax situation the investor is encouraged to consult his or her personal tax advisor.