INVESTMENT - OIL AND GAS - TAX ADVANTAGED?

Regarding tax-advantaged investments for wealthy or sophisticated investors, one commodity stands alone: oil. With the U.S. government's backing, domestic energy production has created tax incentives for investors and small producers, and oil is no exception.

How Oil Tax Benefits Work

Several significant tax benefits are available for oil and gas investors found nowhere else in the tax code. The main tax benefits of investing in oil include:

Intangible Drilling Costs

Intangible drilling costs include everything but the actual drilling equipment. Labor, chemicals, mud, grease, and other miscellaneous items necessary for drilling are considered intangible. These expenses generally constitute 60-80% of the total cost of drilling a well and are 100% deductible in the year incurred.2 For example, if it costs $300,000 to drill a well and determined that 75% of that cost would be considered intangible, the investor would receive a current deduction of $225,000. Furthermore, whether the well produces or even strikes oil doesn't matter. The deductions will be allowed as long as it starts to operate by March 31 of the following year.

Tangible Drilling Costs

Tangible costs pertain to the actual direct cost of the drilling equipment. These expenses are also 100% deductible but must be depreciated over seven years. Therefore, in the example above, the remaining $75,000 could be written off according to a seven-year schedule.

Active vs. Passive Income

The tax code specifies that a working interest (as opposed to a royalty interest) in an oil and gas well is not considered a passive activity. This means that all net losses are active income incurred in conjunction with well-head production and can be offset against other forms of income, such as wages, interest and?capital gains.

Small Producer Tax Exemptions

This is the most enticing tax break for small producers and investors. This incentive, commonly known as the "depletion allowance," excludes 15% of all gross income from oil and gas wells from taxation. This special advantage is limited solely to small companies and investors. Any company that produces or refines more than 50,000 barrels of oil per day is ineligible. Entities that own more than 1,000 barrels of oil per day, or 6 million cubic feet of gas per day, are also excluded.

Lease Costs

These include purchasing lease and mineral rights, lease operating costs and all administrative, legal, and accounting expenses.?These expenses must be capitalized and deducted over the life of the lease via the depletion allowance.

Alternative Minimum Tax

All excess intangible drilling costs have been specifically exempted as a "preference item" on the alternative minimum tax (AMT) return. The AMT was established to ensure taxpayers paid a minimum or their "fair share" of taxes by recalculating the income tax owed and adding specific preferential tax deductions or items.

Oil Tax Breaks and Energy Infrastructure Development

The list of tax breaks effectively illustrates how serious the U.S. government is about developing the domestic energy infrastructure. Perhaps most telling is that there are no income or net worth limitations other than what is listed above (i.e., the small producer limit). Therefore, even the wealthiest investors could invest directly in oil and gas and receive all the above benefits if they limit their ownership to 1,000 barrels daily. This is the only investment category in America that can compete with the smorgasbord of tax breaks available to the oil and gas industry.

Investment Options in Oil and Gas

Several different avenues are available for oil and gas investors. These can be broken down into four major categories: mutual funds, partnerships, royalty, and working interests. Each has a different risk level and separate rules for taxation.

Mutual Funds

The mutual fund investment method contains the least risk for the investor since mutual funds invest in a basket of securities. However, the mutual fund investment does not provide any of the tax benefits listed above. Investors will pay tax on all dividends and capital gains, just as they would with other funds.

Partnerships

Several forms of partnerships can be used for oil and gas investments. Limited partnerships are the most common, as they limit the liability of the entire producing project to the amount of the partner's investment. These are sold as securities and must be registered with the Securities and Exchange Commission (SEC). The tax incentives listed above are available on a pass-through basis. The partner will receive a Form K-1 each year detailing their share of the revenue and expenses.

Royalties

Royalties are the compensation received by those who own the land where oil and gas wells are drilled. Royalty income comes "off the top" of the gross revenue generated from the wells. Landowners typically receive anywhere from 12% to 20% of the gross production–obviously, owning land that contains oil and gas reserves can be highly profitable.

Furthermore, landowners assume no liability relating to the leases or wells. However, landowners are also not eligible for any tax benefits enjoyed by those who own working or partnership interests. All royalty income is reportable on Schedule E of Form 1040.

Working Interests

Working interests are the riskiest and most involved way to participate in an oil and gas investment. Operational interests allow investors a percentage of ownership in drilling activities. Active interests are also called operating interests.

All income received in this form is reportable on Schedule C of the 1040. Although it is considered self-employment income and is subject to self-employment tax, most investors who participate in this capacity already have incomes that exceed the taxable wage base for Social Security.

Working interests are not considered securities and, therefore, require no license to sell. This type of arrangement is similar to a general partnership in that each participant has unlimited liability. Working interests can often be bought and sold by a gentleman's agreement.

Net Revenue Interest (NRI) and Oil Taxation

For any project, regardless of how the income is ultimately distributed to the investors, production is broken down into gross and net revenue. Gross revenue is simply the number of barrels of oil or cubic feet of gas per day produced, while net revenue subtracts both the royalties paid to the landowners and the severance tax on minerals that most states assess. The value of a royalty or working interest in a project is generally quantified as a multiple of the number of barrels of oil or cubic feet of gas produced daily.

For example, suppose a project produces 10 barrels of oil per day, and the going market rate is $35,000 per barrel. In that case, this number varies constantly due to several factors. The wholesale cost of the project will then be $350,000.

Now assume that the oil price is $60 a barrel, severance taxes are 7.5%, and the net revenue interest–the working interest percentage received after royalties have been paid–is 80%. The wells are pumping out 10 barrels of oil daily, equivalent to $600 per day of gross production. Multiply this by 30 days–the number usually used to compute monthly production–and the project is posting gross revenue of $18,000 per month. Then, to calculate net revenue, we subtract 20% of $18,000, which brings us to $14,400.

Then, the severance tax is paid, which will be 7.5% of $14,400 (Note: Landowners must also pay this tax on their royalty income). This brings the net revenue to about $13,320 monthly or about $159,840 annually. But all operating expenses plus additional drilling costs must also be paid out of this income. As a result, the project owner may only receive $125,000 in income from the project per year, assuming no new wells are drilled. Of course, if new wells are drilled, they will provide a substantial tax deduction plus additional production for the project.

FINAL COMMENTS:

From a tax perspective, oil and gas investments have never looked better. Of course, they are not suitable for everyone, as drilling for oil and gas can be risky. Therefore, the SEC requires that investors for many oil and gas partnerships be accredited, which means they meet specific income and net worth requirements. But for those who qualify, participation in an independent oil and gas project can provide strong returns on a tax-advantaged basis.

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