The following content has been prepared for educational and informational purposes only. Because the content contains general information only, it may not reflect the current status of the law. This content is not legal advice or a legal opinion and should not be relied upon without consulting a tax advisor about your circumstances.
Generally the following tax treatment of oil and gas transactions apply. Working interest oil and gas participation, for tax purposes, is divided into three phases, the acquisition and exploration phase, the drilling and development phase, and the production phase.
Acquisition and Exploration
During this phase an “area of interest” is identified the operator feels could produce oil and gas in economic quantities. From this area of interest the operator identifies and contracts the mineral owner to obtain the right to drill for oil and gas. This mineral owner grants this right to operate in exchange for a cash consideration called a bonus and the primary lease term is typically three to five years as long there after as oil and gas is produced. The bonus is typically referred to as leasehold cost. Leasehold costs are capitalized for tax purposes and costs are recovered through either cost or percentage depletion whichever is greater.
Drilling and Development Phase
During this phase the actual drilling location on the leased acreage is identified and the oil or gas well is drilled. In recognition of the unique risks involved in drilling for oil and gas, special provisions in the Internal Revenue Code allow persons who bear those risks to elect to deduct certain expenditures that otherwise would be capitalized. These expenditures are designated as intangible drilling cost (IDC). An elect IDC is considered to have been made if on the first return filed, the taxpayer expenses the IDC incurred. Generally, intangible drilling cost, which in prior years could give rise to alternative minimum tax no longer applies to taxpayers who are dependent producers, (i.e. not integrated oil companies defined in section 291(b)(4). There is some risk of AMT, but it is greatly diminished under the current law. A complete discussion of AMT for this deduction is beyond the scope of this opinion. Generally speaking, expenditures are classified as IDC if they have, in themselves, no salvage value. Expenditures subject to the election include wages, fuel, repairs, hauling, supplies, etc., incurred in connection with the following operations, whether undertaken by the owner or through an outside contractor:
- Clearing of ground, draining, road making, surveying, and geological work necessary to prepare for drilling of wells.
- Drilling, shooting and cleaning wells, including the drilling of water wells to furnish water for drilling operations.
- Construction of derricks, tanks, pipelines, and other physical structures necessary for the drilling of wells and the preparation of wells for the production of oil and gas.
Intangible drilling cost typically constitute 80-85% of the cost to drill and complete an oil or gas well and are deducted in the year paid. The election to expense or capitalize IDC does not extend to expenditures for property ordinarily considered having salvage value, whether or not those items actually may be salvaged after they are installed. Examples of some items the cost of which must be capitalized and recovered through depreciation are (MACRS 7 year lives):
- Actual materials used in equipping the wells and structures that are constructed on the property, such as derricks, casing, tubing, tanks, Christmas trees, pumping units, flow lines, valves and other fittings, separators and compressors.
- Wages, fuel, repairs, hauling supplies, etc., in connection with the installing of equipment, facilities or structures not incident or necessary for the drilling of wells and the preparation of wells for the production of oil and gas, such as oil well pumps, separators, flow line, salt water disposal equipment, storage tanks, etc. Because these items are installed beyond the wellhead, the cost of installation constitute capital cost.
The Production Phase:
Subsequent to the completion of the well and the installation of all of the production equipment, “production operations” commence. During this phase the oil and gas is produced and sold. Generally, expenditures incurred during this phase are deducted as operating expense. Examples of some operating expenses are as follows:
- Contract pumping services, charts, lubricants, repairs, electric, insurance, supervision, etc.
The federal income tax concept of percentage depletion recognizes that substantial risks are involved in obtaining oil and gas production and that oil and gas properties are wasting assets that eventually will be exhausted through production. The allowance for depletion represents the higher of the results obtained from two alternative computations-cost depletion or percentage depletion. Cost depletion involves writing off the capitalized cost of mineral property (lease bonus or leasehold cost) over the life of the property on a pro-rata basis as the oil and gas is produced. Percentage depletion applicable to oil and gas produced is calculated at a statutory percentage of gross income from the property, but cannot exceed the taxable income from the property before the deduction for depletion. Both depletion methods must be calculated on a property-by-property basis. Percentage depletion for independent producers is limited to 1,000 equivalent barrels of production per day (equivalent barrel of oil = 6 MCF of natural gas). The percentage depletion deduction cannot exceed 65% of the net table income of the taxpayer. Cost depletion is computed using the leasehold cost and the estimated equivalent barrels of reserves. Unrecovered, depletable cost (leasehold cost) divided by the estimated recoverable equivalent barrels of reserves at beginning of the year all multiplied by equivalent barrels sold. Cost depletion can continue as long as there is an adjusted basis. It is important to remember that by statute, the depletion method used must be that method which results in the greatest deduction. Depletion begins with the first day of production and continues as long as the well is producing, and with respect to percentage depletion continues regardless of adjusted tax basis. The percentage generally applicable for percentage depletion is 15% of gross income from the property. Depletion in excess of adjusted basis could be as an adjustment in computing alternative minimum tax.
Leasehold costs: Capitalized.
- If a well is not drilled during the lease term, and the lease is allowed to terminate, the cost is deducted as leasehold abandonment.
- If a productive well is drilled the cost is recovered through cost or percentage depletion. Cost depletion is limited to the adjustment basis. Percentage depletion continues to be deducted although there is no depletable adjusted basis remaining.
- A “dry hole” (non-productive well) is drilled. The cost is expensed as a dry hole cost.
Intangible drilling cost: Deducted.
- If a productive well is drilled the cost are recovered through depreciation, generally MACRS, 7-year life.
- If a dry hole is drilled the equipment, if salvaged is sold and the proceeds credited to the equipment cost. To the extent that the equipment has no salvage, it is deducted as dry hold cost.
Prepaid intangible drilling cost: Depreciated.
Based on S. A. Keller, CA-8, 84-1USTC 9194, a taxpayer can take a deduction for prepaid intangible drilling costs if they are turnkey. Essentially the payment locked up the price of drilling the wells with no refund option.
Intangible Drilling Cost and Alternative Minimum Tax
Although there has been tax legislation that has somewhat mitigated the possibility of alternative minimum tax (AMT) as a result of deducting intangible drilling cost, there exists a narrow possibility that AMT could occur. Congress has provided relief from AMT in Code section 59(e). This section provides for capitalization of any portion of IDC and amortizing that amount ratably over 60 months, beginning with month in which the IDC was incurred. That portion of IDC capitalized is excluded from the AMT calculation.