04 Jan Tax Aspects
INFORMATIONAL ONLY – PLEASE CONTACT YOUR ACCOUNTING PROFESSIONAL FOR YOUR CONSIDERATION
GENERAL CONSIDERATIONS
CONGRESS AND OTHER GOVERNMENT ENTITIES HAVE CREATED MANY TAX INCENTIVES TO MAKE PARTICIPATION IN OIL AND GAS VENTURES ONE OF BEST TAX ADVANTAGED INVESTMENTS AVAIABLE. THESE INCENTIVES WERE IMPLEMENTED TO STIMULATE THE ECONOMY AND MAKE THE UNITED STATES MORE ENERGY INDEPENDENT AND LESS RELIANT ON IMPORTS. THESE MANY INCENTIVES CAN BE APPLIED TO THE DOMESTIC NATURAL AND GAS PRODUCTION FINANCED BY PRIVATE SOURCES. DRILLING PROJECTS OFFER MANY TAX ADVANTAGES THESE BENEFITS CAN GREATLY ENHANCE SOME OF THE ECONOMICS.
Participation in the project is intended to appeal primarily from an economic standpoint, albeit with risk. Favorable federal income tax treatment presently available with respect to oil and/ or gas drilling, testing, Completion and production has a direct material effect on the desirability of participating in an oil and gas drilling, testing and completion program for certain tax payers. Any deductions for federal income tax purposes available to the investor resulting from his or her participation in the project and the year in which such deductions are taken may have a material effect upon the economic result afforded to him or her. The benefit to a particular investor of various deductions will depend on the nature and extent of other income, deductions and credits of that investor. for this reason, each prospective investor is urged to consult his or her personal tax advisor. All federal income matters discussed herein are subject to and be without notice by legislation, administrative action, and judicial decision. such changes could deprive the project and its investors of certain tax benefits they might otherwise receive and may or may not be retroactive with respect to specific transactions occurring prior to the effective date thereof.
TAX CODE BENEFITS FOR OIL AND GAS INVESTORS
This section is inserted as general tax code information related to oil and gas wells Investment, Each individual investor will have their own set of financial interests and is encouraged to consult with and rely on their financial professional to best optimize their investments. The following information is for your convenience and should not be construed as tax advice. The U.S. tax code may be accessed at http://www.fourumilab.ch/ustax/ utsx.thml for the most current oil and gas information. Congressional incentives encourage domestic petroleum development.
DEPLETION ALLOWANCE
A benefit implemented to help support smaller oil companies and direct investors, the 1990 Tax Act allows certain entities to exempt 15 percent of their gross income from federal taxes. This exemption applies only to companies that produce no more than 50,000 barrels per day of oil or other entities that produce no more than 1,000 barrels of oil per day or 6 million cubic feet per day of gas. Percentage depletion allowable by reason of the “independent producer exemption” will be available to Investors who qualify as independent producers ( other than those who owned a pre October 12, 1990 interest in a proven property acquired by the project) since each investor must individually determine his or her eligibility for the “independent producer exemption”, there can be no assurance that the percentage depletion will be available to any particular Investor.
SMALL PRODUCERS TAX EXEMPTION
The 1990 Tax Act offers some special advantages for small companies and individuals. This Tax incentive, known as the “Percentage Depletion Allowance”, is specifically intended to encourage participation in oil and gas drilling. This tax benefit is not available to large oil companies, retail petroleum marketers, or refiners that process more than 50,000 barrels per day. It is also not available for entities owning more than 1,000 barrels of oil or 6,000,000 (cubic feet of gas average) daily production. The “Small producers Exemption” allows 15% of the gross income (not net income) from an oil and gas producing property to be tax free.
INTANGIBLE DRILLING COST TAX DEDUCTION
The intangible expenditures of drilling (labor, chemicals, mud, etc.) are usually about (65-80%) of the cost of a well. These expenditures are considered “intangible drilling costs (IDC)s”, which is 100% deductible during the first year. For example, a $100,000 investment would yield up to $75,000 in tax deductions during the first year of the venture. These deductions are available in the year the money was invested, even if the well does not start drilling until march 31st of the year following the contribution of capital. (see Section 263 of the Tax code.)
TANGIBLE DRILLING COST DEDUCTION
The total amount of the investment allocated to the equipment “tangible Drilling Cost’s (TDC)” is 100% tax deductible. In the example above, the remaining tangible costs ($25,000) may be deducted as depreciation over a seven year period. (see Section 263 of the Tax Code) PASSIVE ACTIVITY LIMITATIONS It is expected that the project will initially incur tax losses from initial operations (possibly from deductions of Intangible costs). The availability of tax losses generated to the Working Interest Holder to offset his income from other sources depend on (i) the classification of the projects property as “Working Interest” as defined by the passive loss limitations added by the Tax Reform Act of 1986, and (ii) the determination that the project does not have an effect on the Holders liability.
PASSIVE VS ACTIVE INCOME
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” income. The act prohibits the offsetting of losses from passive activities against income from Active businesses. The Tax Code specifically states that a working interest in an oil and gas well Is NOT a ‘PASSIVE’ activity and therefore, DEDUCTIONS CAN BE OFFSET against income from active stock trades , business income, salaries etc. (see section 469(c)(3) of the tax code).
ACTIVE INCOME
Income from investing in oil wells is treated as active, which can allow for any losses associated with the investment to directly offset income from other active income sources such as stock trading or regular income. LEASE COSTS Lease costs such as; purchase of leases, minerals, sales expenses, legal expenses, administrative accounting and Lease Operating Costs (LOCs) can also be 100% tax deductible.
STATE AND LOCAL TAXES
Certain states and localities in which investors may reside or where the project conducts business may levy income taxes for which such investors may be liable in respect to their share of the project income and it may be necessary for such investors to file income tax returns with such states or localities to report such income. The Tax summary of the Memorandum is limited to federal income tax and does not address issues of state and local law. Therefore, each potential investor is urged to consult his or her tax advisor regarding the impact of state and local law on participation in the project.
ALTERNATIVE MINIMUM TAX Prior to the 1992 Tax Act, Working Interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This tax act specifically exempted Intangible Drilling cost as a Tax Preference Item. “Alternative Minimum Taxable Income” generally consists of adjusted gross income, minus allowable Alternative Minimum tax itemized deduction, plus the sum of tax preference items and adjustments. “Tax preference items” are preferences existing in the Code to greatly reduce or eliminate regular income taxation. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon.
INCENTIVE TO MARGINAL WELLS
The U.S. Senate and House of Representatives have passed a tax incentive bill to help small oil and gas producers. This bill provides a tax credit of up to $9 per well per day for marginal wells. A typical marginal well produces 15 barrels of oil or 90,000 cubic feet of gas per day. If the average crude price for a year is less than $18 a barrel or $2 per thousand cubic feet of gas, the maximum tax credit is $3 for the first three barrels of crude produced, if prices plunge below $15 a barrel and .50 cents per thousand cubic feet and if gas prices average less than $1.67 per thousand cubic feet.