When it comes to tax-advantaged investments for investors, oil and gas investments produce significant tax benefits with the backing of the U.S. Government. Domestic energy production offers a litany of tax benefits for investors who can offset “ordinary” or “passive” income sources.
Intangible Drilling Costs
These costs include everything but the actual well equipment. Labor, chemicals, mud, grease and other miscellaneous items necessary for drilling are considered intangible. 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 costs $300,000 to drill a well, and if it was determined that 75% of that cost would be considered intangible, the investor would receive a current deduction of $225,000. Furthermore, it doesn’t matter whether the well actually produces or even strikes oil.
Tangible Drilling Costs
Tangible costs pertain to the actual direct cost of the equipment installed in and around the well, and it would appear that under the Tax Cuts and Jobs Act, most types of these tangible equipment are 100% depreciable in the year placed in service.
Active vs. Passive Income
The tax code specifies that a working interest in an oil and gas well is not considered to be a passive activity as long as you do not invest through an entity that limits your liability. This means that net losses can be offset against other forms of income, such as wages, interest, capital gains, etc. provided you have not limited your liability.
Small Producer Tax Exemptions
This is perhaps the most enticing tax break for small producers and investors. This incentive, which is commonly known as the “depletion allowance”, excludes from taxation 15% of all gross income from oil and gas wells, subject to the following limitations. The percentage depletion deduction is generally limited to the lesser of 65% of the taxable income before the depletion allowance (Code Sec. 613A(d)(1)) or 100% of the taxable income from the property before the depletion allowance. 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 as well.
Lease Operating Costs
These include lease operating costs, administrative, legal and accounting expenses. These expenses are 100% deductible in the year they are incurred.
Alternative Minimum Tax
All excess intangible drilling costs have been specifically exempted as a “preference item” for those classified as an independent producer on the alternative minimum tax return. (Generally defined as an individual or entity whose proportionate share is less than 1,000 barrels of oil per day and/or six million cubic feet of gas per day.) Their AMTI, however, may not be reduced by more than 40 percent of the AMTI that would otherwise be determined if the taxpayer were subject to this intangible drilling cost preference and did not compute an alternative tax net operating loss deduction.
Developing Energy Infrastructure
This list of tax breaks effectively illustrates 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. the small producer limit.) Therefore, even the wealthiest investors could invest directly in oil and gas and receive all of the benefits listed above, as long as they limit their ownership to 1,000 barrels of oil per day. No other investment category in America can compete with the smorgasbord of tax breaks that are available to the oil and gas industry.
There are several different avenues available for oil and gas investors. These can be broken down into four major categories: mutual funds, partnerships, royalty interests and working interests. Each has a different level of risk and separate rules for taxation. Mutual Funds While this method of investment contains the least amount of risk for the investor, it also does not provide any of the tax benefits listed above. Investors will pay tax on all dividends and capital gains, just as they would with other funds.
There are several forms of partnerships that can be used for oil and gas investments. Limited partnerships are the most common, as they limit the liability of the limited partner to the amount of the limited partner’s investment A limited partnership can be structured to provide partners the choice of whether to be a limited partner (subject to the passive loss rules) or a general partner wherein a partner could deduct losses against ordinary income. The aforementioned tax incentives are available on a pass-through basis. The partner will receive a K-1 form each year detailing his or her share of the revenue and expenses.
This is the compensation received by those who own the minerals where oil and gas wells are drilled. This income comes “off the top” of the gross revenue generated from the wells. Mineral owners typically receive anywhere from 12-25% of the gross production. Furthermore, mineral owners assume no liability of any kind relating to the leases or wells. However, mineral owners also are not eligible for any of the tax benefits enjoyed by those who own working or partnership interests, other than the depletion allowance. All royalty income is reportable on Schedule E of the 1040.
This is by far the riskiest and most involved way to participate in an oil and gas investment. All income received in this form is reportable on Schedule C of the 1040. Although it is considered self-employment income and is subject to self-employment tax, most investors who participate in this capacity already have incomes that exceed the taxable wage base for Social Security. This type of arrangement is similar to a general partnership in that each participant has unlimited liability.
From a tax perspective, oil and gas investments have never looked better.
Of course, they are not suitable for everyone, as drilling for oil and gas can be a risky proposition.
Therefore, the SEC requires that the investors for many oil and gas partnerships be accredited, which means they must meet certain income and net worth requirements.
For those who qualify, participation in an independent oil and gas project can give them just what they are looking for.
This information has been prepared by Harris Energy Group, LLC. IRS regulations require that we inform you as follows: Any tax advice contained in this communication (including any attachments) is not intended to be used and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending to another party any transaction or tax-related matter[s]. Nothing in this communication should be construed as an offer to sell or the solicitation of an offer to buy any investment, or as the provision of investment advice.