Oil and Gas Drilling Advantages in U.S. Tax Code

Fundamentals Banner
In many ways, the U.S. tax code is used by Congress to encourage (or discourage) certain types of activity. Oil and natural gas drilling activities conducted within the United States help make our country less dependent on oil from foreign, even unstable, nations. Congress therefore provides incentives with the aim of stimulating private development of domestic oil and natural gas resources. These financial incentives should not be confused with “tax loopholes” frequently discussed in today’s media; they were deliberately made by Congress to boost domestic production. Oil and natural gas ventures are widely regarded as the best investment options available from a tax perspective.

There are several different ways in which the tax code favors oil drilling. One of these is the Intangible Drilling Cost Tax Deduction. Certain inputs, including labor, chemicals, grease, and mud, which combine to account for 65 to 80% of the total cost of any drilling project, fall under the Intangible Drilling Cost label, or IDC, and Section 263 of the Tax Code deals with this. IDC is 100% deductible during the first year of a drilling operation. Because IDC is such a large cost component in oil well drilling, this particular Deduction has enormous tax advantages in the year the money is spent, regardless of when the well comes online. Section 461 (i) (2) further explains this time element.

The portion of investment which is allocated to equipment is classified as Tangible Drilling Cost, or TDC. TDC is also 100% tax deductible over the Depreciation Lifecycle, currently 7 years, of the TDC expenditure. See Section 263 to learn more about TDC.

It is because of the Tax Reform Act of 1986 that we have today’s concepts of “Passive” versus “Active” income. Among other things, this piece of legislation made it illegal to offset losses from so-called “passive” against income from “active” businesses. Here again the oil and gas drilling activity was favored by allowing a Working Interest in an oil and gas well to be considered “Active.” This allows deductions (mentioned earlier) to offset income from active stock trades, regular business income, even salary. Section 469(c)(3) of the Tax Code explains this further.

Most of the public believes the oil and gas industry is solely run by a dozen or so multi-national corporations. While these well-known companies (called “Majors” within the industry) are a significant force, the US Tax Code has in place certain elements which benefit Small businesses that participate in oil and gas production.  In 1990, the Tax Act was passed which created the “Percentage Depletion Allowance.” Granted only to entities that own less than 1,000 barrels of oil (or 6 million cubic feet of natural gas) of average daily production,  the “Small Producers Exemption” allows 15% of an oil and gas producing property’s Gross Income to be completely tax-free. This is a significant encouragement to small businesses to participate in oil and gas production.

Even such peripheral expenses as sales, administrative, legal, Acquisition of Lease and Lease Operating Costs (LOC) are completely tax deductible through cost depletion.

The next game-changer in the Tax Code came in 1992. Prior to this year, the Alternative Minimum Tax (AMT) only impacted working interest participants in oil and gas wells to the extent that their regular tax was exceeded by their AMT amount. The 1992 Tax Act then made Intangible Drilling Cost (IDC) exempted as a “Tax Preference Item.” These are explicit preferences in the Tax Code aimed at reducing or eliminating excessive income taxation. Along with the IDC exemption, deductions for depletion (based on the quantity of Drilling Acreage the wells have) are also included as “Tax Preference Items”.

Continuing this trend of benefitting small drilling operations, the bill provides a tax credit of up to $9 per day for what the Tax Code considers “marginal” wells. Also known as “stripper” wells, these wells normally produce 15 barrels of crude or 90 thousand CF of natural gas per day. It is estimated that this type of oil well is responsible for wholly one quarter of America’s domestic oil supply.

More than 13,000 oil wells were plugged with cement in 2002, forever closing off their supply to the country. These Tax changes are aimed at reducing the financial need to plug these wells, ultimately boosting American oil and natural gas production. The Tax Code applies differently based on the market price of crude oil on the New York Mercantile Exchange: Below $15 per barrel carries a different tax credit than above.

This information is presented as educational material only. It is intended for an individual that is considered as a sophisticated investor. It should be remembered that oil well projects are considered high-risk investments, and are intended only for Accredited Investors with high risk tolerance. One should consult with a financial advisor.