The Tax Benefits of Domestic Oil & Gas Production

Congressional Created Incentives to Encourage Domestic Petroleum Production

Congress recognized oil and Natural gas from domestic reserves help to make our country more energy self-reliant by reducing our dependence on foreign imports. So Congress provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. Drilling projects offer some of the best tax advantages and these benefits greatly enhance the the overall economy. These are incentives not "Loop Holes" – they were placed in the Tax Code by Congress to make participation in oil and gas ventures one of the most attractive tax advantages available.

Drilling Cost Tax Deduction (Intangible)

The intangible expenditures (labor, chemicals, mud, grease, etc.) are usually about (75 to 80%) of the cost of drilling a well. These expenditures are considered "Intangible Drilling Cost (IDC)", which is 100% deductible during the first year. For example, a $100,000 investment would yield up to $75,000 to $80,000 in tax deductions during the first year of the venture. These deductions are available in the year the money was invested, even if the well does not start drilling until March 31 of the year following the contribution of capital. (See Section 263 of the Tax Code.)

Drilling Cost Tax Deduction (Tangible)

The total amount of the investment allocated to the equipment "Tangible Drilling Costs (TDC)" are 100% tax deductible. The remaining tangible costs may be deducted as depreciation over a seven-year period. (See Section 263 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 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).

Small Producers Tax Exemption

The 1990 Tax Act provided some special tax advantages for small companies and individuals. 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, retail petroleum marketers, or refiners that process 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" allows 15% of the gross Income from an oil and gas producing property to be tax-free. It is possible for small investors to structure their investments so that 100% of their net income is tax-free! (See Section 613A of the Tax Code.)

Lease Costs

Lease costs (purchase of leases, minerals, etc.), sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are all also 100% tax deductible through cost depletion.

Alternative Minimum Tax

Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This Tax Act specifically 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.

This content is provided for informational purposes only. Information on this website is not intended to be a solicitation of any kind. Nothing herein shall be construed as tax, legal or accounting advice. Investing in oil and gas is highly speculative and could result in substantial losses. Potential investors should consult their attorney, accountant and financial advisors before investing in oil and gas. Past performance is not a guarantee of future performance or returns.