Tax aspects of Oil and Gas drilling partnerships.

1. Tax Aspects of Oil and Gas
Drilling Partnerships

2. Objectives for Investors
1. Cash distributions for the life of the Investment
2. Accelerated write-off in the first year
3. Ability to exclude investment income from taxable income

3. Tax Considerations Overview
1. Intangible Drilling Costs (“IDC”)
 IRC Sections 263 (c), 59 (e)
2. Major exception from “passive activity loss
rules” by Investor General Partnership (“GP”)
 IRC Section 469 (c)(3)
3. Functional Allocation
4. Alternative Minimum Tax
5. Depletion Allowance
 IRC Sections 611, 613, 613 (c) (6)

4. 1. Intangible Drilling Costs
 Intangible Drilling Costs (IDCs):
 Non-salvageable Value
 About 75% of the cost to drill and complete a well
 Tangible Drilling Costs:
 Salvageable Value
 About 25% of the cost to drill and complete a well

5. 1. Intangible Drilling Costs (cont.)
 Utilization
 Investors may deduct 100% of the IDCs in the year of
investment. IRC Section 263 (c)
 Investors may amortize the deduction over a 60 month period.
IRC Section 59 (e)

6. 1. Intangible Drilling Costs (cont.)
 Utilization (cont.)
 An investor may also elect to deduct in the year of investment
any part of their IDCs and capitalize and deduct the remaining
IDCs ratable over a 60-month period.

7. 1. Intangible Drilling Costs (cont.)
 In Service Rule:
 All wells must be spudded within 90 days following the end of the
year of investment in order to be eligible to be fully deductible in
the 1st year of investment. IRC Section 461 (i)

8. 1. Intangible Drilling Costs (cont.)
 Example:
 If you invest during 2010 and a portion of the Program wells are
not spudded prior to 12/31/2010 but those wells are spudded
before 3/30/2011, rule is satisfied and you may deduct the IDCs
on your 2010 tax return

9. 2. Passive Activity
 The Rule
 An investment in a limited partnership is generally considered a
passive activity for the Investor (because of failure to materially
participate in operations on a regular continuous, and substantial
manner) which is only deductible against other passive income.
IRC Section 469

10. 2. Passive Activity (cont.)
 The Exception:
 By holding an oil and gas working interest through an entity
which does not limit liability (electing to be a general partner
during the drilling and completion phases) and Investor may take
advantage of an exception to the passive loss rules that allows
the IDC deductions to be taken against active income.
IRC Section 469 (c)(3)(a)

11. 2. Passive Activity (cont.)
 Passive activity loss rules generally do not apply to
corporations.
 The rules do apply, however, to:
 A personally owned service corporation, unless the employee-owners
own 10% or less of the stock
 A closely held C corporation (five or fewer owners). These can
use passive losses to offset taxable income determined without
regard to passive income, loss, or portfolio income
 Shareholders of S corporations

12. 2. Passive Activity (cont.)
 General Partner vs. Limited Partner
 Investor General Partners (“GPs”)
may deduct allocated IDCs from their investment against any
type of income.
 Investor Limited Partners (“LPs”)
may deduct allocated IDCs from the investment against
passive income only.

13. 2. Passive Activity (cont.)
 General Partner Considerations
 The Investor GP must have unlimited liability in order to qualify
for the passive loss rules exception under IRC Section 469 (c)(3)
(a).
 Investment in the Partnership must not be through an entity
which limits liability, such as a limited liability company or S
corporation.

14. 3. Functional Allocation
 Partnership accounting feature that allows
disproportionate allocation of revenue and expenses
between partners.
 The Code requires, however, that the allocation
withstand and “economic viability” test that requires
value be traded for equal value.
 IRC Section 704 (b)

15. 3. Functional Allocation (cont.)
 Program Sponsors often allocate up to 100% of
Intangible Drilling Costs deduction to Investors and
receive the Tangible Drilling Cost deduction and a
reversionary interest in return.
 This can result in the Investor receiving a first year
write-off of as much as 100%.

16. 4. Alternative Minimum Tax
 IDC deductions are NOT tax preference items (for
independent producers). Energy Policy Act of 1992
 However; an Investor that reduces Alternate Minimum
Taxable Income by more than 40% WILL trigger AMT.

17. 4. Alternative Minimum Tax (cont.)
 If you elect to amortize all of your IDCs over 5 years,
none of the deduction would be considered excess IDCs.
 Post-investment look back allows for tax planning to
avoid over investment.

18. 5. Depletion Allowance
 Shelters a portion of the revenue stream from an oil and
gas investment from income tax.
 Partnerships can utilize Percentage Depletion allowance
or cost depletion allowance. Generally, Percentage
Depletion is the higher of the two for the average
Partnership Investor.

19. 5. Depletion Allowance (cont.)
 Percentage Depletion, depending on the market price of
oil and gas, can fluctuate between 15% and 25%.
Currently, the percentage depletion allowance is 15% of
gross revenue derived from the investment regardless of
remaining basis. IRC Section 613
 The AMT preference on percentage depletion was
repealed in the Energy Policy Act of 1992

20. Conclusion
 Between 75% and 100% of IDC deduction is available to
be written off in year of investment.
 Alternatively, part of all of IDCs may be amortized over
60 months.
 Generally, not a preference item.

21. Conclusion (cont.)
 IDC deduction may be taken against any income by
Investors electing General Partner status.
 IDC deduction lowers adjusted gross income and
alternative minimum taxable income, and may reduce W-
4 withholding and quarterly estimated payments.
 Depletion Allowance excludes 15% of gross income from
the Investment from taxation.