Tax Considerations for Investing in Oil and Gas

Tax Code Provisions Regarding Oil & Gas

The Independent Producer

America’s determination to increase domestic reserves and be free of OPEC dependency has placed a tremendous need for capital on oil and gas companies. The burden is particularly heavy for independent producers whose funds are more limited than those of major oil and gas companies which fund their drilling activities with the sale of stock. Most independent operators, which drill the majority of the nation’s wells, are able to provide investors with cash flow and tax advantages through direct participation in oil and gas programs, thus avoiding the major oil companies’ corporate overhead.

Oil and Gas Investing Tax Treatment

The Tax Reform act (Act), enacted in 1986, made significant changes to the tax laws as they pertain to oil and gas investment. The Act attempted, for the most part, to shift more of the tax burden from individuals to corporations. The Act affected the ability of taxpayers to shelter income.

Intangible Developmental Costs:

The act allows domestic intangible development costs to be expensed or capitalized at the discretion of the taxpayer. Furthermore, intangible costs may be deducted by the taxpayer in the year the well is drilled.

Tangible Developmental Costs:

Currently, the drilling of an oil and/or gas well is considered production of an asset. The tangible well costs are capitalized and amortized over a seven (7) year period, beginning with the month in which they are paid.

Depletion:

Independent producers and royalty owners can claim percentage depletion of 15% on domestic production. Depletion costs may be recovered using whichever of two (2) methods provides a higher deduction, cost depletion or percentage depletion.
Percentage depletion for oil and gas properties is limited to independent producers and royalty owners for daily production up to 1,000 barrels of crude oil or an equivalent amount of natural gas. However, percentage depletion cannot exceed 65% of overall income.

Breakdown of Deductions*

Cost Classification	Tax Treatment	% Estimtated
Intangible Developmental	Expensed year incurred	50%
Tangible Developmental	Depreciated over 7 years	25%
Leashold	Depreciated over life of well	10%
Organization & Due Diligence	Amortized over 60 months	5%
Commissions	Amortized over 60 months	10%

*Tax advantages will vary with each program

Investing in Oil

Although there is principal risk associated with investing in oil and gas programs, there are substantial benefits. In addition to the aforementioned tax benefits, informed and selective investors have the potential to recover their initial investment and continue to receive cash distributions.