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IRS: Petroleum Industry Overview Series

 

Direct Participation “Tax Benefits"

Direct participation oil and gas investments generate several tax benefits. These benefits range from large up-front deductions for IDC's, to tax credits for the development of certain types of tight formations. Deductions are generated from the costs of non-salvageable equipment or services conducted during the drilling phase, testing, and/or completion of the well. The following is a synopsis of the tax benefits generated by direct participation in gas and oil investments.

IDC (Intangible Drilling Cost)

These costs which are considered intangible include everything but the actual drilling equipment. Labor, chemicals, mud, grease, and any other miscellaneous items necessary for drilling. These expenses generally constitute 65-80% of the total cost of drilling a well and are 100% deductible in the year incurred. For example, if it cost $500,000 to drill a well, and if it was determined that 80% of that cost was considered IDC's, the investors would receive a current deduction of $420,000. Furthermore, it doesn't matter whether the well actually produces or even strikes a productive zone; as long as the operations are started by March 31 of the following year, the entire deductions apply.

ICC (Intangible Completion Costs)

As with IDC's, these costs are generally related to non-salvageable completion costs, such as labor, completion materials, completion rig-time, fluids etc. Intangible completion costs are also generally deductible in the year they occur, and usually amount to about 15% of the total.

TDC (Tangible Drilling Cost)

Tangible costs pertain to the actual direct cost of the drilling equipment. These expense are also 100% deductible, but must be depreciated over a 7 year period. Therefore, in the above example, the remaining $80,000 could be written of according to a seven-year schedule.

DPAD (Domestic Production Activity Deduction)

Section 199 DPAD is a special deduction that applies to organizations with domestic production activities, including those in manufacturing, software production, film production, print media, construction, engineering, and power generation such as electricity, oil and natural gas.

Qualified projects for Sec. 199 deduction, taxpayer must have qualified production activities income (QPAI), which is defined as domestic production gross receipts (DPGR) for a tax year minus cost of goods sold and other expenses, losses, or deductions allocable or properly attributable to those receipts. DPGR comprises receipts obtained from leases, rental, license, sale, exchange, or other disposition of qualified production property (QPP). DPAD offers 9% deduction for qualified projects.

Sec. 199 defines "oil-related qualified production activities income" as the QPAI attributable to the production, refining, processing, transportation, or distribution of oil, natural gas, or any primary product derived from these substances. If a taxpayer has oil-related QPAI, Sec. 199 deduction is reduced by 3%.

Example: in 2010, A Corp. has taxable income of $210,000, QPAI of $145,000, and DPGR wages of $26,000.

The Sec. 199 deduction would be $13,000. ($145,000 x 9% = $13,050, limited by $26,000 x 50% = $13,000).

Small Production Tax Exemption

This is perhaps one of the more exciting tax breaks for small producers and investors. This incentive, which is commonly know as "depletion allowance", excludes from taxation of 15% of all gross income from gas and oil wells. This special advantage is limited solely to small companies and investors. Any company that produces or refines more than 50,000 barrels of oil per day is ineligible. Entities that own more than 1,000 barrels of oil per day, or 6 million cubic feet of gas per day are excluded.

Lease Costs

These include the purchase of the leases and mineral rights, lease operating cost, and all administration, legal and accounting expenses. These expenses are 100% deductible in the year they are incurred.

Completion Costs

Up to $17,000 of total completion costs per well can be written off as a one time charge in any given year with the remaining balance depleted (deducted) over a period of 7 years reducing income tax expense paid to tax authorities.

Depletion Allowance

All revenues from oil and natural gas exploration along with development projects are subject to a depletion allowance benefit from the US government. Working interest holders will pay taxes on 80-85% of total oil and gas income.

Depreciation

As opposed to services and materials that offer no salvage value, equipment used in the completion and production of the well is generally salvageable. Items such as these are usually depreciated over a 7 year period, utilizing the MACRS (Modified Accelerated Cost Recovery System). Equipment in this category would include casing, tanks, well heads and tree, pumping units, etc. Equipment and tangible completion expenses generally account for 25-40% of the total well cost.

Marginal Well Tax Credit

The US Senate and the House of Representatives have passed a tax incentive bill to help small oil and gas producers. This bill provides a tax credit of up to $9 per well per day for "marginal wells". A typical "marginal well" pumps 15 barrels of crude oil or 90 thousand cubic feet of gas per day. There are 650,000 "marginal" or "stripper" oil and gas wells in the USA. Marginal wells provide as much as 25 percent of the nations' crude supply and about 10 percent of gas stocks.

The tax credit phases-in if the average crude price for a year is less than $18 a barrel or $2 per thousand cubic feet of gas. The maximum credit is $3 a barrel for the first three barrels of crude oil produced if prices plunge below $15 a barrel and 59 cents per thousand cubic feet if gas prices average less than $1.67 per thousand cubic feet. Crude oil is now above $70 per barrel and natural gas is currently above $4 per thousand cubic feet.

AMT (Alternative Minimum Tax)

Historically the tax benefits from oil and natural gas production could present the possibility for taxation under the Alternative Minimum Tax (AMT). In the early 1900's; however, Congress provided some tax relief for "independent producers". An independent producer was defined as an individual or company with production of 1,000 barrels per day or less.

This Tax Act specifically 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 well thereon.

Developing Energy Infrastructure

The above extensive list of tax benefits effectively illustrate how serious the U.S. government is about developing the domestic energy infrastructure. Perhaps most telling is the fact that there are no "income" or "net worth" limitations of any kind for any of them other than what is listed above (i.e. small producer limit). Therefore, even the wealthiest investors could invest directly into oil and natural gas projects and receive all of the benefits listed above, as long as they limit their ownership to 1,000 barrels of oil per day or 6 million cubic feet of natural gas per day.

No other investment category in America can compete with the smorgasbord of tax benefits that are available to the oil and gas industry!

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American's Natural Energy
Phone: (909) 214-2002   Email: info@americasnatural.com

THIS MATERIAL IS DESIGNED FOR MARKETING PURPOSES ONLY. The information on these pages is intended solely for the benefit of participants in the oil and natural gas exploration and production industry, developers, other persons interested in operating relationships with America's Natural Energy, or persons who have pre-existing relationships with American's Natural Energy. The natural gas and oil interests are owned by limited partnerships located in Delaware.