- 0.1 Intangible Drilling Costs
- 0.2 Tangible Drilling Costs
- 0.3 Active, Passive, and Non-Passive Income
- 0.4 Lease Costs
- 0.5 Alternative Minimum Tax
- 0.6 Small Producer Tax Exemptions
- 0.7 Enhanced Recovery Credit
- 1 How to Participate in Oil and Gas Investments
- 2 Net Revenue Interest
- 3 Conclusion
Numerous tax benefits of Oil investment attract savvy, sophisticated, or accredited investors. The tax incentives are unique and unavailable anywhere else in the tax code. For instance, an investor can get a 100% tax-deductible intangible drilling cost to reduce the risk of capital. Other tax deductions are available for oil and gas companies, some of which are below.
Intangible Drilling Costs
Intangible drilling costs include every aspect of the drilling exercise except equipment. Examples include labor, grease, chemicals, and mud, among other miscellaneous elements that seem insignificant but make up 60% to 80% of the total drilling cost. The costs attract 100% tax deductions in the first year. For instance, if the total amount for drilling a well is $400,000 and intangible completion costs make up 70% of that, the tax deduction would be $280,000. The tax breaks remain effective whether you hit oil or not that first year, but you must start operating before March 31st of the following year.
Intangible completion costs are also available, allowing tax relief on non-salvageable goods and services or goods with no salvage value, like completion materials, fluids, and completion rig regime. They can give tax relief of up to 15% of the total cost.
Note: federal taxes categories contribute to the amount you save.
Tangible Drilling Costs
Tangible drilling costs refer to all direct expenses related to the actual drilling equipment. Pump jacks, casing, tanks, and well heads are some assets considered tangible drilling costs.
The tangible costs are 100% tax-free, but the oil and gas assets must be depreciated within seven years utilizing the Modified Accelerated Cost Recovery system.
Active, Passive, and Non-Passive Income
The income tax reform act introduced a tax code that does not allow offsetting losses from passive income against active income.
The tax code specifically states that working interest on an oil and gas well does not qualify as a passive activity. Other forms of business income, like capital gains, investment interests, and wages can offset all net losses associated with wellhead production.
Lease operating expenses include the purchase of leases and minerals, administrative costs, legal fees, and accounting expenses.
Lease operating costs become tax deductible after capitalization in the year you incur them. The tax reprieve includes re-entry or re-work costs in an existing well.
Alternative Minimum Tax
The 1992 tax act provided tax incentives by exempting intangible drilling costs from tax preference items. Before that, working interest participants were subject to the tax such that it exceeded their regular tax. The intention was to ensure taxpayers paid their fair share of taxes – the income tax owed plus specific preferential tax deductions.
Alternative minimum taxable income consists of adjusted gross income without the allowable itemized deduction.
Small Producer Tax Exemptions
The tax exemption is sometimes called percentage depletion allowance, and it excludes 15% of all gross income from oil and gas wells proceeds from taxation. The tax advantage is not for large oil companies – only small investors who want to protect a portion of the gross income derived from oil or gas sales.
You can choose one of the two depletion allowance options below.
- Cost depletion refers to the relationship between current production as a percentage of all recoverable reserves.
- Statutory depletion is the percentage depletion that shields the 15% mentioned above.
Note: oil and gas companies that produce more than 50,000 oil barrels daily, businesses that own over 1000 oil barrels daily, or those that process more than a million cubic feet of gas daily do not qualify for the tax incentive.
Enhanced Recovery Credit
Enhanced recovery credit is a less popular tax benefit – one of the special tax advantages. It can give you up to 15% deductions when drilling reduces the oil quantity in a well. Extraction can be more challenging when oil and gas reserves reach specific levels and pressure reduces. The tax advantage encourages investors to keep extracting even at low levels.
How to Participate in Oil and Gas Investments
Investors in the oil and gas industry can use various avenues to capitalize on all the several major tax benefits listed above. They are in four major categories that we highlight below.
Several oil and gas investments can fall under partnerships, the most popular being limited joint ventures that limit the liability of producing projects to investing partner’s total amount. The investment must be securities registered with the Securities Exchange Commission, after which the partner gets Form K-1 to highlight the details of their expenses and income.
Even the wealthiest investors sometimes need less risky investment opportunities like mutual funds. Despite the safety you get, the investment does not provide the major tax benefits mentioned above. You will pay capital gains and dividends the same way you would with other investment opportunities.
Oil and gas investors who prefer a more hands-on option can choose working interest or operational interest investments, which are riskier. You get a percentage of ownership and participate in oil and gas drilling activities but do not require a license to sell. The operations are similar to a general partnership because each investor has unlimited liability. The buying and selling can be an unwritten agreement with the partner.
The option falls under the self-employment tax category because of the nature of the income, but most investors exceed the taxable wage base brackets for social security.
Investors who own the gas-producing property where drilling takes place but do not participate in the mining process can get royalty compensation. You can have between 12% and 20% of the gross production as a land owner with the additional benefit of non-liability to the wells or leases. Royalty investment makes you ineligible to work or partnership interests. You can fill in all the details about the investment in Schedule E of Form 1040.
Net Revenue Interest
The overall tax burden for oil and gas investment involves gross and net incomes. Gross revenue refers to the number of oil barrels or cubic feet of gas produced daily. Net revenue is the remaining amount after issuing royalties to the land owner and severance tax on minerals where applicable.
Tax laws in domestic energy production have several tax benefits associated with oil and natural gas investment. However, tax considerations and limitations in oil and gas investments, such as an interest in another entity with limited potential liability and stock in a corporation, exist. Your tax advisor can help you weigh all your options accordingly to enjoy the big tax breaks.