By: Catalyst Wealth Management
January 15, 2022
A relevant business comparison for an oil and gas operator who drills a well is a real estate developer who constructs an office building. They both might finance their operations project-by-project.
For tax purposes, ‘capital’ costs and ‘expense’ costs are distinguishable generally by the useful life expectancy of the result. For example, costs for operating an office building and costs for operating an oil well are “expensed”, that is, deductible currently in the tax year incurred.
Construction costs for constructing an office building and costs of drilling and equipping an oil well are ‘capital’ costs. They both produce a capital asset that has a useful life of more than one tax year. For tax purposes, capital costs are normally recovered (i.e. deducted) over that useful life.
Investor Tax Benefits
Here is where an oil operator (and their investors) enjoy tax benefits not available to any other business. Often, they will finance an oil and gas project by offering equity interests in an entity that allows the tax benefits to flow through to the investors.
Intangible drilling costs
An oil operator’s project involves geological and seismic studies, acquisition of leases from landowners, engaging a drilling contractor who employs workers, drilling rigs, and equipment to drill and complete wells.
Such expenditures in any other business would ordinarily be considered capital costs. But as much as 80% of the costs of drilling an oil and gas well, while being capital in nature, are all deductible in the year incurred. Generally, eligible intangible drilling costs are the costs of drilling that have no salvage value. In most other industries similar costs would be capitalized for tax purposes.
That’s not all. The future production from an oil and gas well is eligible for depletion allowances. For small producers, percentage depletion is a deduction of 15% of gross income from a well for the life of the well. That’s true even though a big share of the capital costs were deducted in the first year of the well.
An investor enjoys those tax benefits typically by investing in a limited partnership. The limited partnership pays the costs of drilling and completing the wells and shares the proceeds from the production of completed wells.
The investor acquires a limited partner interest. As such he is not liable for the debts and obligations of the partnership. His losses are limited to the amount of his investment contribution. However, he is prohibited from participating in the management or operations of the partnership.
Typically, the oil and gas operator or sponsor serves as the general partner who manages the partnership’s business and is generally liable for the partnership debts and obligations.
Dry Hole Deduction
What if the well is plugged as a dry-hole, not capable of producing commercially? The entire costs of the well are deductible like an expense (ordinary loss) regardless of whether they are capital or expense items.
Limitations on Tax Advantages
Tax advantages to an investor are not without limit. The good news is that, subject to limitations, intangible drilling costs are not treated as a preference for alternative minimum tax purposes.
On the other hand, a limited partner’s losses may be subject to a limitation on losses from passive activities. Those passive losses are deductible only to the extent of a taxpayer’s passive income. A limited partner’s interest, as opposed to a working interest, is considered passive.