The following general discussion is provided for background information only. Participants should consult with their own tax advisors.
The Tax Advantages of Oil & Gas Drilling
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 many tax advantages. These tax benefits enhance the economics of natural gas and oil projects.
Oil and gas projects are labor 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 participation of $25,000 could result in approximately $17,500 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 $7,500 of tangible costs may be deducted as depreciation over a seven year period. (See Section 263 of the Tax Code.)
Intangible Drilling Cost Tax Deduction
The 1990 Tax Act provided some special tax advantages for the typical participant 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 income from an oil and gas producing property to be tax free. (See Section 613A of the Tax Code.)
Small Producers Tax Exemption
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of "Passive" income and "Active" income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. 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(c)(3) of the Tax Code.)
Active vs. Passive Income
Prior to the 1992 Tax Act, working interest participants in oil and gas joint ventures were subject to the Alternative Minimum Tax to the extent that this tax exceeded their regular tax. The recent Tax Act exempted Intangible Drilling Cost as a Tax 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 taxation. 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.
Alternative Minimum Tax
The Intangible Drilling Cost (IDC) deductions and the depreciation of tangible equipment on a typical oil well allow a large income tax deduction of the investment in the first year (usually 65% to 80%). The tax consequences per a $25,000 participation can be approximated as follows:
Striving for American energy independance one well at a time!