One of the least understood tax strategies is an investment in an oil or gas drilling partnership. If done properly, the investor can have a large deduction in the year of the investment and the opportunity to receive tax advantaged investment income for as long as the investment is profitable.
The investment has to be made by December 31st for the investor to receive the tax benefit in the year of investment. The investor should consult their tax advisor to determine their tax liability for the current year and the characterization of the income that caused the liability: passive or non-passive income.
At this point, the investor should consider their risk tolerance for such a tax-advantaged and illiquid investment. In certain programs, the investor can deduct up to 100% of their investment in the current year, and begin receiving tax advantaged income early in the next year.
The question is: How does this happen? The answer is: The tax advantages are due to our long term quest for energy independence. Over the years, certain energy related items have been added to the Internal Revenue Code to make drilling for oil and gas a very favorable taxable event. I will discuss how the following four items makes such an investment very tax-favored – intangible drilling costs, functional allocation exception to the passive loss rules, alternative minimum tax, and the depletion allowance. I will try and make this “tax gibberish” as non-tax as possible. Suffice to say, this investment creates great tax benefits.
Intangible Drilling Costs
When wells are drilled, the costs associated with the drilling are divided into two types: tangible and intangible. Tangible costs are defined as a salvageable part of the drilling costs and are depreciated over seven years. Intangible costs are the remainder of the costs incurred to drill and complete a well. Such costs include, but are not limited to, labor, chemicals, grease, fuel, supplies, and other necessary costs for drilling a well, and preparing it for production. Based upon the drilling program, the intangible drilling cost may range from 70-85% of the total cost to drill and complete a well.
The amount of tangible and intangible drilling costs allocated to investors is based upon each drilling program. In some programs the investor may receive 100% of the intangible drilling costs and no tangible costs. In other programs the investor may receive 80-90% of the IDC’s and an allocation of the tangible drilling costs. The drilling programs do this based upon partnership accounting that allows a disproportionate allocation of revenue and expenses between partners. The Internal Revenue Code requires the allocation to withstand an economic viability test that requires value be traded for equal value.
Deductibility of Intangible Drilling Costs
When the investor decides which drilling program to invest in, he receives an allocation of IDC’s – for example 80, 90, or 100%. At this point the investor has options as to when to deduct the IDC’s. An investor may deduct 100% of the allocated IDC’s in the year of investment. Or, the investor may choose to amortize the deduction over 60 months, or may elect to deduct part of the IDC’s in the year of investment and capitalize and deduct the remaining IDC’s over a 60 month period. As you can see, there is great flexibility for the investor. The drilling partner’s obligation is to start, or spud, all the wells within 90 days following the end of the year of investment. This makes the IDC’s deductible in the year of investment. At this stage we have touched on intangible drilling costs, functional allocation, and timing of the deduction.
A quick example may help: cost to drill and complete a well, $1,000,000. Amount of cost that are intangible: 85%. Total intangible drilling cost: $850,000. IDC’s allocated to investors: 100%. Total IDC’s allocated to investors: $850,000.
Exception to passive loss rules
An investment in a drilling partnership would typically be in the form of a limited partnership. This would be considered passive activity in that the investor does not materially participate in the operations in a substantial manner. Accordingly, this investment would only be deductible against passive income. However, there is a major exception to the passive loss rules. By holding an oil and gas working interest in an entity that does not limit liability (general partner) during the drilling and completion phases, the investor may take the IDC deduction against non-passive income (earned or portfolio income). This exception to the passive law rules opens up huge opportunities to reduce non-passive taxable income. In most programs investors who elect to be a general partner are converted to a limited partner when all the wells have been completed, as determined by being placed into production. However, if the investor has passive income they can elect limited partner status and receive the benefit of the IDC deduction against their passive income. Hence, you can have your cake and eat it, too!
Alternative Minimum Tax (AMT)
One of the major questions I receive is how AMT figures into the IDC deduction. By regulation, IDC deductions are not tax-preference items. However, if an investor reduces Alternative Minimum Taxable Income (AMTI) by more than 40%, AMT will be triggered. If the investor elects to amortize their IDC deduction over 5 years, none of this will be considered excess IDC’s. When an investment is made in a drilling partnership the investor must monitor his AMTI.
When the wells the investor owns begin profitably producing, the investor will receive income from the wells. This income will be partially sheltered with a depletion allowance. The current depletion percentage is 15%. Accordingly, for each $1,000 an investor receives, $150 would be tax-free.
As you can see, an investment in an oil and gas drilling partnership is a very tax-advantaged investment. The investors’ suitability to invest in an illiquid commodity whose price fluctuates with the market is the real question. The investor must do due diligence on the drilling partnership to investigate management’s experience, prior track record, and the reasonableness of future assumptions.
Think about the current dialogue concerning the price of oil. The investor must be able to stomach this press. Also, the investor should do additional due diligence on the drilling partnership. The investor should ask management of the drilling partnership to provide them with a sensitivity analysis based upon the projected prices of the commodity (oil or natural gas). This analysis should show how the drilling partnership will fare based upon price changes of the commodity, and the management team’s risk management experience (i.e., hedging).
Handled properly this is a great tax advantaged investment. For full disclosure, I own several of these drilling partnerships and am very pleased with their performance.