By: Steve Drake PhD, CPA, CFP®, CGMA
The Oil and Gas (O&G) Industry has probably more specialty tax deductions than most any industry. It is not just knowing that these deductions exist but maximizing their benefits. With federal income and employment taxes often being 50% or more, even without State taxes, the stakes are high indeed.
As an example, a very successful O&G operation had a long-time public accountant of many years that was completely forgetting to take percentage depletion and production credits until we reviewed the situation and filed for large refunds in all available years. The accountant had mistakenly thought that only cost depletion was available when in fact percentage depletion was the way to go. There is a lot of professional misunderstanding of how to handle the tax details to maximize allowable deductions. In this case, it added up to be hundreds of thousands of dollars that was overpaid. Fortunately, the owner got back timely refunds and was better informed going forward.
Here is a checklist of key O&G deductions often available:
1/ Tangible drilling costs/Machinery/Equipment used:
There are large upfront depreciation deductions available in this category and anything still left to depreciate will be generally be written off over 3-7 years.
Example: Assume $1,000,000 in new machinery and equipment (M&E) is purchased in year 2013. The first $500,000 can be written off (expensed) in the year of purchase under Section 179, then another $250,000 can be written off with an additional 50% depreciation calculation. The balance of $250,000 (still undepreciated balance left of the $1,000,000) is written off over typically, 7 years. So, there are large upfront depreciation deductions for new M&E. Not quite as much depreciation is allowed for used M&E. Note that the Section 179 depreciation may revert to as little as $25,000 in 2014 from the $500,000 allowed in 2013 unless these laws are extended by Congress.
2/ Intangible Drilling Costs (IDC):
This is all of the costs for drilling such as labor, fuel, outside contractors, chemicals, payroll costs, etc. This is typically all deductible. There are other considerations and limitations here, but for simplicity, that is the explanation. With 70-85% of typical costs in a well consisting of IDC, this represents a large tax deduction in year 1.
Generally, percentage depletion is most often used and as long as the definition of a small producer is met then the deduction is equal to 15% of all gross income from the wells. For royalty recipients, this can include you. A small producer is 1,000 barrels per day or less. 6,000,000 cubic feet of gas or less is also a small producer. There are other rules with this that give plenty of room for planning on the daily calculations. There is also “cost depletion” but this is often not as beneficial as “percentage depletion”.
4/ Domestic Production Activity Deduction:
There is an extra tax deduction available for US operators equal to 6% (9% for non-oil and gas operations) of net income from operations. There can be several limitations on this including one based on a calculation of wages paid and overall income limitations. But, there is a lot of planning that can happen here to maximize the deduction. A simple example: $500,000 is earned in net income for oil and gas operations x 6% is a $30,000 extra deduction allowable in addition to IDC, depletion etc.
There is no cost or obligation for us to see if we can help or to give you some initial, confidential guidance. See what you are missing in deductions or income deferral techniques. With tax rates as high as they are today you need every possible deduction. We know them.