By Russell Putnam
Due Diligence Analyst, FactRight, LLC
There are many types of oil and gas investment programs and each involves different risks, potential returns and tax benefits. In this installment of Oil and Gas 101, we will focus on intangible drilling costs, or IDCs: What they are and how they can potentially benefit direct participation program investors. We will also touch on some tax treatments of IDCs within the federal tax code with the caveat that this article is for general information only and investors should consult with their tax professional about any tax matters related to their investments.
Direct participation programs, or DPPs, in the oil and gas sector include royalty programs, working interest income based programs and drilling programs. Royalty and income based programs can provide investors with income from producing wells and a depletion deduction, but do not provide drilling related tax benefits. However, drilling programs (i.e., drilling, completing and operating wells) can provide investors with potential for distributions and multiple tax benefits, the most significant being the intangible drilling cost deduction.
What are IDCs?
Intangible drilling costs, or IDCs, are expenses that are necessary and incident to drilling and preparing oil and gas wells for production, but have no salvageable value. IDCs include such expenses as labor, fuel, repairs, hauling, supplies, chemicals, surveys, and installation costs.
It’s also important to note what an IDC isn’t. IDCs do not include expenses for tangible equipment that has salvage value, which must be capitalized and depreciated, leasehold costs, or costs unrelated to drilling, such as storage, treatment or well operating costs.
The tax code provides that working interest owners in an oil and gas well in the United States can elect to recover IDCs in one of two ways. One is to capitalize the IDCs and recover them through depreciation over a 60 month period starting in the month they’re incurred. The other way is to elect to deduct 100% of the IDCs as a current business expense in the first year eligible costs are incurred, which the majority of taxpayers choose to do. Working interest owners are permitted to make their own elections. IDCs that are paid to an operator, without recourse, are deductible in the tax year they’re paid as long as the wells associated with those IDCs are spudded (i.e., drilling begins) in that year or within the first 90 days of the following year. Because IDCs must be prepaid before the end of the taxable year, the investment entity and investors will be unsecured creditors of the operator until the prepaid costs are deployed for drilling.
Passive activity loss limitations in the tax code and individual investor circumstances may alter the timing as to when a taxpayer can deduct their proportionate share of IDCs. The tax code generally prevents taxpayers from taking deductions from passive activity to offset active income, such as wages. However, a working interest in oil and gas wells is not considered passive activity if the taxpayer’s interest is owned directly or through an entity that doesn’t limit the taxpayer’s liability with respect to the drilling. One of the most common drilling program structures is a limited partnership where the general partners and limited partners take on very different levels of risk (and reward):
- General partner interests—expose investors to unlimited liability associated with drilling
- Limited partner interests—generally limit investor liability to the amount of their capital contribution
In the limited partnership structure, general partners are allowed to use their share of IDCs to offset active and passive income, while limited partners can only use their share of IDCs to offset passive income, but may carry forward unused amounts to offset passive income in the following year.
IDCs generally comprise approximately 60% to 80% of the drilling costs; however, the amount of the deduction will vary based on the program’s strategy and allocation of IDCs among working interest owners. For example, a partnership may maximize the IDCs that are allocated to investors by allocating offering costs, tangible equipment costs, and leasehold costs to a manager or sponsor’s working interest or by allocating borrowing proceeds to certain costs other than IDCs. Limited partnerships may also allocate IDCs differently between general and limited partners in order to maximize the write off for general partners, who can offset their active income as previously discussed. While drilling programs often provide IDC deductions greater than 70% of an investor’s investment, some programs that combine drilling and other oil and gas related activities may provide a lower, or nominal, IDC deduction.
Other Tax Considerations
The IDC deduction is a significant tax benefit; however, investors in drilling programs should be aware of other tax considerations associated with the deduction, including:
- Investors may have to recapture a portion of their previously deducted IDCs, as income, if the property associated with the IDCs is later sold.
- The IDC deduction cannot reduce the alternative minimum taxable income by more than 40% for many investors.
- Investors should consider that drilling programs that are structured to maximize tax benefits may not necessarily be structured to maximize economic returns.
- While tax-related benefits are important considerations for oil and gas investors, it’s important to identify the investment’s profit motive, because without one, the DPP could be deemed abusive and investors could be subject to tax and/or legal consequences.
- Investors considering a drilling program investment should consult their tax advisors regarding the tax consequences associated with investment and their individual circumstances.
Please see the FactRight password protected report center, which is available for FINRA-member broker dealers, for reports on oil and gas programs that FactRight has previously reviewed, which include discussion of the IDCs associated with those specific programs