As the leaves start to change colors this fall, we have many things to look forward to, including the rest of the football season, daylight savings time, apple picking, and of course…..reviewing oil and gas drilling programs! The primary reason that oil and gas drilling programs are so prevalent near the end of the calendar (read: tax) year is that they offer multiple tax benefits, chief of which is the ability to deduct intangible drilling costs as a current business expense.
IDCs are the key
Intangible drilling costs, or IDCs, are expenses that are necessary to drilling and preparing oil and gas wells for production, but have no salvageable value. IDCs include such expenses as labor, fuel, repairs, hauling, supplies, chemicals, surveys, and installation costs. IDCs do not include expenses for tangible equipment that has salvage value, leasehold costs, or costs unrelated to drilling, such as well operating costs.
The tax code provides that working interest owners in an oil and gas well can elect to recover IDCs in one of two ways. One is to capitalize the IDCs and recover them through depreciation over a 60 month period starting in the month they’re incurred. The other way is to elect to deduct 100% of the IDCs as a current business expense in the first year eligible costs are incurred, which the majority of investors elect to do.
If an oil and gas drilling partnership pays its IDCs to an operator, without recourse, such amounts are deductible in the tax year they’re paid as long as the wells associated with those IDCs are spudded (i.e., drilling begins) in that year or within the first 90 days of the following year. Because IDCs must be prepaid before the end of the taxable year, the investment entity and investors will be unsecured creditors of the operator until the prepaid costs are deployed for drilling.
Limited partnerships, (un)limited offsets
One of the most common drilling program structures is a limited partnership where the general partners and limited partners take on very different levels of risk (and reward):
- General partner interests—expose investors to unlimited personal liability associated with drilling
- Limited partner interests—generally limit investor liability to the amount of their capital contribution.
You’re probably asking yourself, why would any investor choose general partner interests and expose themselves to unlimited personal liability?
Asked and answered: the reason that many investors purchase general partners interests is that passive activity loss limitations in the tax code and individual investor circumstances alter the timing as to when a taxpayer can deduct their proportionate share of IDCs. The tax code generally prevents taxpayers from taking deductions from passive activity to offset active income, such as wages. However, a working interest in oil and gas wells is not considered passive activity if the taxpayer’s interest is owned directly or through an entity that doesn’t limit the taxpayer’s liability with respect to the drilling. In the limited partnership structure, general partners are allowed to use their share of IDCs to offset both active and passive income, while limited partners can only use their share of IDCs to offset passive income, but may carry forward unused amounts to offset passive income in the following year.
Allocations for maximum benefit
IDCs typically comprise approximately 60% to 80% of the drilling costs; however, the amount of the deduction will vary based on the program’s strategy and allocation of IDCs among working interest owners. For example, a partnership may maximize the IDCs that are allocated to investors by allocating offering costs, tangible equipment costs, and leasehold costs to a manager’s working interest or by allocating borrowing proceeds to certain costs other than IDCs. Limited partnerships may also allocate IDCs differently between general and limited partners in order to maximize the write off for general partners, who can offset their active income as previously discussed. While drilling programs often provide IDC deductions greater than 70% of an investor’s investment, some programs that combine drilling and other oil and gas related activities may provide a lower, or nominal, IDC deduction.
Other tax considerations
The IDC deduction is a significant tax benefit; however, potential investors need to be aware of other tax considerations associated with the deduction, including:
- Investors may have to recapture a portion of their previously deducted IDCs at ordinary income rates if the property associated with the IDCs is later sold.
- The IDC deduction cannot reduce the alternative minimum taxable income by more than 40% for many investors.
- Drilling programs that are structured to maximize tax benefits may not necessarily be structured to maximize economic returns. While tax-related benefits are important considerations for oil and gas investors, it’s important to identify the investment’s profit motive, because without one, the program could be deemed abusive and investors could be subject to tax and/or legal consequences
While oil and natural gas prices have remained suppressed over the last couple of years, tax benefits associated with drilling programs, and specifically the IDC deduction, may make these programs attractive options for certain investors. As investors take a break from raking the leaves or watching their favorite team on Sunday afternoon to consider a drilling program investment this fall, they should consult their tax advisors regarding the tax considerations associated with investment and their individual circumstances.
Please see the FactRight password protected Report Center, which is available for FINRA-member broker dealers and registered investment advisors, for due diligence reports on oil and gas programs that FactRight has previously reviewed, which include discussion of the IDCs associated with those specific programs.
