A GENERAL DESCRIPTION OF THE TAX ADVANTAGES OF OIL AND GAS DRILLING

The examples below are for general information only and are not intended to be individual tax advice. Consult your personal tax advisor concerning the applicability and effect on your personal tax situation. Oil and gas is a very specific market it would be advisable to seek the counsel of an oil and gas tax attorney. Tax laws change from time to time and there can be no guarantee of the interpretation of the tax laws. The following general discussion is provided for background information only. Participants should consult with their own tax advisors.

Congressional Incentives

The exploration and development of domestic oil and natural gas reserves helps to make our country more energy self-sufficient by reducing our dependence on foreign imports. Congress has provided special tax incentives to stimulate domestic oil and natural gas exploration, development and production financed by private sources.

Intangible Drilling Cost Tax Deduction

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 $24,000 could result in approximately $15,600 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 $8,400 of tangible costs may be deducted as depreciation over a seven year period. (See Section 263 of the Tax Code)

Small Producers Tax Exemption

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)

Active Vs. Passive Income

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).

Alternative Minimum Tax

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.

Tax Example

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 for a $24,000 investment can be approximated as follows:

Intangible Costs