The President continues to believe that a good way to grow our economy and spur job growth will be to cause businesses to send more money to the federal government than to spend it in the free enterprise system.  The tax increases for the oil and gas industry are the same as the ones I wrote about last March and include:

• Repeal of percentage depletion,
• Eliminate expensing of intangible drilling costs,
• Extend the amortization period for geoligical and geophysical costs,
• Repeal the domestic manufacturer’s deduction (only for oil and gas companies),
• Remove the exception to passive loss limitations for working interest owners in producing properties, and
• Repeal the enhanced oil recovery credit and the credit for production from marginal wells.

It seems to me these proposals will have the opposite of the President’s stated desired impact. These types of policies will most likely result in fewer jobs, reduced government revenue, a shift away from domestic production to foreign production, and more reliance of foreign sources of energy.

It appears this administration is attempting to increase the cost of production to the point that alternative energy sources become economic options. Unlike many in Washington, I expect the market to react with changes in behavior if these proposals are enacted. The results could force producers to move overseas or even force them out of business, as well as significantly increasing prices for consumers. Of course, this may be just what the President is hoping for.

Here are some of the more significant provisions for oil and gas producers and their impact.

Losing the tax deduction for IDC is a big deal since this generally represents the vast majority of the drilling costs for a well. By requiring these costs to be capitalized and spreading the deduction over a number of years through the cost depletion deduction, the result will be higher taxes and reduced net present value of cash flow on the properties.

The loss of percentage depletion is another direct tax increase. While this affects all interest holders, it will significantly impact royalty holders. Most royalty owners are only able to take percentage depletion because they have very little cost basis against which to compute cost depletion.

Another change to the depletion deduction is the explicit requirement to have a reserve report to support the cost depletion calculation. Since not all companies pay for a reserve report to be completed each year, this will require an additional cost in addition to the increased taxes due to the loss of percentage depletion.

The specific exclusion of oil and gas companies from the manufacturing deduction is simply done to raise money and will have the ancillary effect of slower economic growth.

Repealing the passive activity exception for working interests will mean that many holders of working interests will be required to treat the income and losses as passive. The net effect will be a deferral of the net deductions in many cases.

The repeal of the Marginal Well Tax Credit will remove the ability for many wells to be economically productive. Collectively, these wells represent about 20% of the nation’s oil and 12% of its gas. Many of these wells may end up abandoned.

Increasing the recovery period for geological and geophysical costs from 24 months to 7 years will increase the net present cost of exploration activity.

If you’ve got questions on any of the proposed changes or how they could impact your business, please contact us.

A tax partnership is a tool used in certain drilling arrangements to ensure that the working interest owner who bears the cost of drilling a well also gets the tax benefits related to those costs.

Consider the following example.  A working interest owner who doesn’t have the cash to drill and develop his property strikes a deal with a third party operator to fund all of the drilling costs in exchange for a working interest in the property.  Even though the operator will incur all of the costs to drill that well, he can only deduct IDC in proportion to his ultimate working interest percentage.  The remaining IDC is treated as additional leasehold cost and is depleted (deducted) over time.  As a result, tax deductions for IDC paid in one year are not realized for tax purposes until later years. 

Here’s where a tax partnership  can be a huge benefit to the operator.  By establishing a tax partnership and contributing all of the property and the costs of drilling and development to that partnership, all of the costs incurred (and resulting tax benefits) can be allocated to the operator regardless of the ultimate working interest percentages.

Using a tax partnership is not without its hassles.  The biggest headache is the administrative burden of accounting for the activity of the partnership and the requirement to file a federal partnership tax return each year.  Therefore, you should carefully consider the tax implications before deciding to use a tax partnership.

If you have questions about whether you might benefit from using a tax partnership, we can help.