Tax Aspects

I. NORMAL TAX FOR TAXPAYERS

A. Percentage Depletion.
Independent producers and royalty owners (that is, taxpayers who are not retailers or refiners, as discussed below) are entitled to a percentage depletion allowance of 15% of the gross income from so much of the taxpayer’s average daily production of domestic crude oil as does not exceed the taxpayer’s "depletable oil quantity" and so much of the taxpayer’s average daily production of natural gas as does not exceed the taxpayer’s "depletable natural gas quantity." A taxpayer’s average daily production of domestic crude oil or natural gas for any taxable year is determined by dividing the taxpayer’s aggregate production of oil or gas during the year by the number of days in that year. If a taxpayer holds a partial interest in the production from any property (including an interest held in a partnership), the taxpayer’s average daily production is determined by multiplying the total production from that property by the taxpayer’s percentage participation in the revenues from the property.

A taxpayer has an annual depletable oil quantity of 1,000 barrels (reduced by the taxpayer’s average daily marginal production for the taxable year). The taxpayer can elect annually to use all or some of that amount to determine its depletable natural gas quantity by using a conversion factor of 6,000 cubic feet of gas per barrel.

If the taxpayer’s average daily production of domestic crude oil or natural gas exceeds its depletable oil or natural gas quantity, the depletion allowance with respect to production from each property is the amount that bears the same ratio to the amount of depletion that would have been allowable for all of the taxpayer’s oil or gas in the absence of a limitation as its depletable oil or natural gas quantity bears to the aggregate quantity representing the average daily production of domestic crude oil or natural gas of the taxpayer for the taxable year. In other words, the depletion allowance allowable for any property would be reduced based upon the ratio that 1,000 barrels of depletable oil quantity bears to the average daily production from all oil and gas properties.

The percentage depletion for domestic oil and gas production from marginal producers is 15% plus 1% point for each whole dollar by which $20 exceeds the reference price for crude oil for the calendar year preceding the calendar year in which the taxable year begins. The reference price is determine pursuant to Section 45K(d)(2)(C). The term marginal production means domestic crude oil or natural gas which is produced during the year from a property which is a stripper well or is a property substantially all of the production of which during such calendar year is heavy oil. Stripper well property is defined as property for which during the calendar year the average daily production of domestic crude oil and natural gas from the producing wells on the property does not exceed 15 barrel equivalents. If the taxpayer owns a partial interest in the property, it first must determine if the entire property, not just the taxpayer’s portion, is a stripper well property.

Independent producers and royalty owners (hereinafter called "independent producers") are entitled to a percentage depletion allowance unless they are retailers or refiners. A "retailer" is a taxpayer who directly or through a related party sells all their natural gas (excluding bulk sales of oil or natural gas before it has been manufactured or converted into a refined product to commercial or industrial users) or any product derived from oil or natural gas (excluding bulk sales of aviation fuels to the Department of Defense) (1) through any retail outlet operated by the taxpayer or related person or (2) to any person obligated to use a trademark in marketing or distributing oil or gas or (3) given authority to occupy any retail outlet owned, leased or in any way controlled by the taxpayer. There are exceptions to retailers with aggregate sales of oil and gas that do not exceed $5,000,000 bulk sales of oil or natural gas to commercial or industrial users and certain foreign sales.

An independent producer excludes a refiner. A "refiner" is a taxpayer or related person who engages in the refining of crude oil where the average daily refinery runs of the taxpayer and any related party for the year exceeds 75,000 barrels (meaning more than 75,000 barrels per diem on the average).

Percentage depletion allowance is based on a percentage of the gross income received from the oil or gas property during the taxable year (excluding any royalties paid or incurred). With respect to any take or pay contracts, any prepayment or advance payment made without regard to the production is not considered gross income from the property for purposes of percentage depletion. Additionally, any "make up" gas deliveries are disregarded in determining percentage depletion. However, a producer would be entitled to cost depletion on the entire payment when received.

Percentage depletion for oil and gas is limited to 100% of the taxable income from the property, computed without depletion allowance, and without the Section 199 deduction for domestic production activities. This limitation is computed for each separate property. Proper deductions include all operating expenses.

The depletion allowance for independent producers under the independent producer and royalty owner exemption cannot exceed 65% of the taxpayer’s taxable income for the taxable year. This is computed without considering any depletion on production that is subject to the exemption, any net operating loss carry back to the taxable year, any capital loss carry back to the taxable year, and in the case of a trust, any distributions to beneficiaries. Any depletion allowance that is disallowed due to such limitations may be carried forward and allowed as a deduction for the following year subject to the 65% of taxable income limitation applied for that year.

Depletion is computed separately by the partners (and not the partnership) so that each partner can determine on its own whether it meets the test for percentage depletion. The partnership allocates to each partner a proportionate share of the partnership’s adjusted basis in each oil and gas property and each partner makes it own determination of whether cost or percentage depletion is applicable.

B. Cost Depletion.
Cost depletion allows the taxpayer deduction costs that are allocable to the mineral property sold or otherwise used in producing the income for the taxable year. Such deduction is generally equal to that portion of the mineral property which has been sold during the year; in other words, that portion of the reserves of the property which have been produced and sold during the taxable year. The base of the mineral property for cost depletion purposes generally is equal to the adjusted basis of the property and includes any oil and gas, drilling and development costs that have been capitalized. Basis however does not include amounts allowable through depreciation (depreciable equipment), amounts allowable through deferred expenses, salvage value of the land and improvements, and expense deductions other than depletion.

Since depletion deductions reduce the taxpayer’s basis in the mineral properties, cost depletion is no longer available once the taxpayer’s basis has been reduced to zero.

C. IDC’s
Generally an operator in the development of oil and gas properties may either capitalize or deduct currently intangible drilling and development costs (IDCs). An "operator" is a person who holds a working or operating interest in any tract or parcel of land either as a fee owner or under a lease or any other form of contract granting working or operating rights.

II. ALTERNATIVE TAX TREATMENT FOR TAXPAYERS
A taxpayer’s tax preference items is added to his or her taxable income in calculating the alternative minimum taxable income. Taxpayers take into account preferences for: (1) depletion and (2) intangible drilling costs; Section 56(a)(1) and (2). A corporate taxpayer’s alternative minimum taxable income is increased by 75% of the excess of adjusted current earnings over its alternative minimum taxable income, computed disregarding the alternative tax net operating loss deduction. For this purpose the corporate taxpayer’s adjusted current earnings are adjusted for IDCs and percentage depletion except for independent producers of oil and gas wells; Section 56(g)(4)(D) and (F).

A. Percentage Depletion
The excess of depletion deduction allowable over the property’s adjusted basis at the end of the year, disregarding the current year’s depletion deduction, is an item of tax preference. Where total percentage depletion exceeds a property’s adjusted basis, the property has experienced "excess percentage depletion."

The excess of the depletion deduction allowable over the property’s adjusted basis is computed on each separate property. The preference is measured on a cumulative basis. Depletion will not be considered an item of tax preference until the total depletion deductions have exceeded the adjusted basis of the property. Then, the entire amount of the percentage depletion in excess of that basis will be considered an item of tax preference.

Independent producers are excluded from this item of tax preference. Section 57(a)(1) provides that for years beginning after December 31, 1992, depletion preference is not applicable to any deduction for depletion computed in accordance with Section 613A(c) which is the provisions permitting percentage depletion deduction for independent oil and gas producers and royalty owners.

B. Intangible Drilling Costs
The tax preference for intangible drilling costs is equal to the excess of a taxpayer’s IDCs for the taxable year over 65% of the taxpayer’s Net Income, as defined below, from oil and gas properties for that taxable year. The IDC tax preference amount is computed separately for each oil and gas property. For purposes of computing the IDC tax preference, excess IDCs are defined as the excess of the amount of IDCs paid or incurred on oil and gas properties that are allowable in the taxable year over the amount that would be allowed for the taxable year if the costs had been capitalized and amortized under one of the following two methods:

(1) A ratable amortization over 120 month period beginning with the first month in which production begins, or

(2) At the election of the taxpayer, any method permitted for determining cost depletion on a well.

The Net Income from oil and gas properties is defined as the "gross income from all the taxpayer’s oil and gas properties less any deductions allocable to these properties reduced by the excess IDCs."

An independent producer, being a taxpayer that is not an integrated oil company, may exclude excess IDCs as a preference item to a limited extent. Section 57(a)(2)(E)(i) provides that for calendar years after 1992 the preference item for intangible drilling costs is limited to any taxpayer other than an integrated oil company as defined in Section 291(b)(4). Under that subsection the term integrated oil company means any producer of crude oil who is not entitled to a percentage depletion allowance under Section 613A(c) by reason of being a retailer or refiner under Section 613A(d)(2) or (4), as described above. Under Section 57(a)(2)(E)(ii), in the case of an independent producer, if the IDC tax preference amount exceeds 40% of the taxpayer’s alternative minimum taxable income, the preference amount shall be limited to the excess, if any, that the total IDC tax preference amount exceeds 40% of the alternative minimum taxable income determined by disregarding the limitation on the IDC preference and the AMT net operating loss. If the IDC tax preference amount is 40% or less of the taxpayer’s alternative minimum taxable income, then there is no tax preference for an independent producer.
Some taxpayers use a strategy of electing to deduct some IDCs currently and capitalize the others and then elect to amortize the capitalized IDCs pursuant to Section 59(e) over a 120 month period. The portion of the IDCs that are expensed are limited to those amounts so that the excess IDCs will not exceed 40% of the taxpayer’s AMTI disregarding the IDC preference and AMT net operating loss.

III. CONCLUSION
In summary, independent producers (the owners of working interests who are not retailers or refiners) are entitled to percentage depletion deductions as determined in accordance with Section 613A(c) of the Code and are not preferences for alternative minimum tax. Independent producers can expense IDCs under Section 263(c) and may exclude IDC tax preference items (the excess IDCs over 65% of taxable income on a per property basis) so long as such exclusion does not exceed 40% of the taxpayer’s AMTI, disregarding the limitation on the IDC preference and the AMT net operating loss. Additionally, corporate taxpayers other than independent producers may have excess adjusted current earnings as a result of IDCs and percentage depletion, which could result in additional alternative minimum taxable income.

IV. SPECIAL RULE APPLICABLE TO WORKING INTEREST OWNERS THAT HAVE LIMITED LIABILITY
The foregoing discussion with respect to normal taxable income and preference items assumes that the working interest in an oil and gas property is owned by the taxpayer, either directly or through an entity which does not limit the liability of the taxpayer with respect to such interest. Section 58(b) provides that Section 469 shall apply in computing the alternative minimum taxable income of the taxpayer. Section 469(c)(3) provides that a passive activity loss is not allowed for an individual, a closely held C corporation, and any personal service corporation (that owns a working interest in an oil and gas property), unless such taxpayer holds such property directly or through an entity which does not limit the liability of the taxpayer with respect to such interest. Furthermore, if any taxpayer has a loss from the working interest in an oil and gas property that he holds directly or through an entity which does not limit his liability for any taxable year, then income in any subsequent taxable year with respect to such property shall be treated in the same manner as not being from a "passive activity."

In the event, that a taxpayer indirectly owns a non-operating working interest through an entity which limits his liability, then any losses from such operations will not be deductible under Section 469 in computing his taxable income, as well as in computing his alternative minimum taxable income. However, if the taxpayer has a loss in a year in which he did own the property directly or through an entity in which he had personal liability, any subsequent income would be considered to be treated as income which is not from a passive activity for both regular income tax purposes and the alternative minimum tax purposes.