Oil and Gas Tax in a Nutshell – Part 1

This title may sound like an oxymoron … after all, entire courses are given on the topic of oil and gas tax. However, with a basic overview, you can have a starting point for a client coming to you with oil and gas information.

Depletion is what makes oil and gas unique. What’s that?

IRS Pub 535 states that “depletion is the using up of natural resources by mining, drilling, quarrying stone or cutting timber. The depletion deduction allows an owner or operator to account for the reduction of a product’s reserves.”

Oil and gas rules say that you generally capitalize the costs to acquire, explore and develop oil and gas producing properties. These costs are usually referred to as capitalized leasehold costs.

Depletion is how those capitalized costs are claimed as a deduction, when the oil or gas well begins production, and is calculated and maintained on a property-by-property basis. The term ”property” can mean each separate interest in each separate well. See IRC Sec. 614 for more details.

Who can claim the depletion deduction? Whoever holds an “economic interest” in the property, or the right to income from the extraction of the minerals from the property.

How is it calculated? There are two methods of depletion:

1. Cost depletion is calculated from the capitalized costs, and is taken as the oil or gas is extracted from the property.
2. Percentage depletion gets its name from the fact that the deduction is based on a percentage (usually 15 percent) of gross income from the property (see limitations below). Because the starting point isn’t capitalized on leasehold costs, you can get a percentage depletion even after capitalized costs have been recovered!

Which method of depletion should I use?

If your client is an “independent producer” [IRC Sec. 613A(d)] or royalty owner, the best part of oil and gas is that you can use the better of both! You can deduct the higher of cost depletion or percentage depletion for each property. Because percentage depletion can be an amazing deduction, and rather complicated, let’s explain percentage depletion.

Calculating percentage depletion

Percentage depletion is calculated based on a percentage of gross income from the property, but it can only be taken on a property that has net income. It’s important to note that percentage depletion uses the following definition of net income: Oil and gas gross revenue, less:

• lease operating expenses,
• production taxes,
• intangible drilling costs,
• dry hole costs,
• depreciation from tangible drilling cost,
• overhead expenses, and
• other expenses.

Be careful to allocate depreciation expense to the correct property, as it is used to calculate net income for that property. For each property, the allowable statutory percentage depletion deduction is the lesser of net income, or 15 percent of gross income. Intuit® ProConnect™ Lacerte® will automatically do the calculation for you.

Percentage depletion also has other limitations:

1. A taxpayer’s total percentage depletion deduction for the year from all oil and gas properties cannot exceed 65 percent of taxable income, computed without deducting percentage depletion, the domestic production activities deduction, NOL carrybacks and capital loss carrybacks (if a corporation).
2. If the average daily production exceeds 1,000 barrels, then the quantity limitation rate must be calculated.
3. Percentage depletion is not allowed for foreign oil and gas producers, domestic retailers, and domestic refiners.

Please read the second post in this oil and gas taxation series, which covers cost depletion and other related topics.

Editor’s note: For more information, read “Basic Tax Reporting of Oil- and Gas-Related Activities” on the Intuit ProConnect Tax Pro Center as well as the IRS Oil and Gas Handbook.