Tax Advantages of Oil and Gas Drilling

Transcription

1 Tax Advantages of Oil and Gas Drilling 130 Maple Drive North, 2nd Floor Hendersonville, TN Toll Free: Office: Fax:

2 Tax Advantages of Oil and Gas Drilling From Houston Chronicle, October 12, 2004 Congressional Incentives Encourage Domestic Petroleum Development Oil and Natural gas from domestic reserves helps to make our country more energy self-sufficient by reducing our dependence on foreign imports. In light of this, Congress has provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. Drilling projects offer many tax advantages and these benefits greatly enhance the economics. These incentives are not "Loop Holes" -- they were placed in the Tax Code by Congress to make participation in oil and gas ventures one of the best tax advantaged investments. Intangible Drilling Cost Tax Deduction (See Section 263 of the Tax Code) The intangible expenditures of drilling (labor, chemicals, mud, grease, etc.) are usually about (65 to 80%) of the cost of a well. These expenditures are considered "Intangible Drilling Cost (IDC)", 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 31 of the year following the contribution of capital (See Section 461 (i) (2) of the Tax Code). Tangible Drilling Cost Tax Deduction The total amount of the investment allocated to the equipment Tangible Drilling Costs (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.) Active vs. Passive Income The Tax Reform Act of 1986 introdu ced 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, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. (See Section 469(c)(3) of the Tax Code). Small Producers Tax Exemption The 1990 Tax Act provided some special tax 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. Lease Costs Lease costs (purchase of leases, minerals, etc.), sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are also 100% tax deductible through cost depletion.

3 Tax Advantages of Oil and Gas Drilling (continued) Alternative Minimum Tax Prior to the 1992 Tax Act, working in terest 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. Tax Bill Gives Incentive to Marginal Wells The US Senate and House of Representative 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 pumps 15 barrels of crude or 90 thousand cubic feet of gas per day. There are 650,000 marginal or stripper oil and gas wells in the USA. Marginal wells provide as much as 25 percent of the nations crude supply (on par with Saudi Arabia) and about 10 percent of gas stocks. In 2002 alone, oil and gas wells were permanently plugged with cement (13,600 oil wells and 3,900 gas wells). This tax bill will act as a safety net to save many of these wells, thereby reducing our reliance on the Middle East. The tax credit phases-in 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 a barrel for the first three barrels of crude produced if prices plunge below 15 a barrel and 50 cents per thousand cubic feet if gas prices average less than 1.67 per thousand cubic feet. Crude oil is now above 54 a barrel on the New York Mercantile Exchange and gas futu res are near 7 per thousand cubic feet. From Houston Chronicle, October 12, 2004 THIS REPORT IS FOR EDUCATIONAL PURPOSES ONLY AND IS BEING PROVIDED TO ACCREDITED INVESTORS AT THEIR REQUEST.

4 Sec 469 c.3 Passive activity losses and credits limited (c)(3) Working interests in oil and gas property Tax Codes Applicable to Gas and Oil (A) In general The term ''passive activity'' shall not include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such interest. (B) Income in subsequent years If any taxpayer has any loss for any taxable year from a working interest in any oil or gas property which is treated as a loss which is not from a passive activity, then any net income from such property (or any property the basis of which is determined in whole or in part by reference to the basis of such property) for any succeeding taxable year shall be treated as income of the taxpayer which is not from a passive activity. Sec Capital expenditures (a) General rule No deduction shall be allowed for - (1) Any amount paid out for new buildings or for permanent improvements or betterment made to increase the value of any property or estate. This paragraph shall not apply to - (A) expenditures for the development of mines or deposits deductible under section 616, (B) research and experimental expenditures deductible under section 174, (C) soil and water conservation expenditures deductible under section 175, (D) expenditures by farmers for fertilizer, etc., deductible under section 180, (E) expenditures for removal of architectural and transportation barriers to the handicapped and elderly which the taxpayer elects to deduct under section 190, (F) expenditures for tertiary injectants with respect to which a deduction is allowed under section 193; (FOOTNOTE 1) or (FOOTNOTE 1) So in original. The semicolon probably should be a comma. (G) expenditures for which a deduction is allowed under section 179. (2)Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. ((b) Repealed. Pub. L , title XI, Sec (a)(16), Nov. 5, 1990, 104 Stat ) (c) Intangible drilling and development costs in the case of oil and gas wells and geothermal wells Notwithstanding subsection (a), and except as provided in subsection (i), regulations shall be prescribed by the Secretary under this subtitle corresponding to the regulations which granted the option to deduct as expenses intangible drilling and development costs in the case of oil and gas wells and which were recognized and approved by the Congress in House Concurrent Resolution 50, Seventy-ninth Congress. Such regulations shall also grant the option to deduct as expenses intangible drilling and development costs in the case of wells drilled for any geothermal deposit (as defined in section 613(e)(2)) to the same extent and in the same manner as such expenses are deductible in the case of oil and gas wells. This subsection shall not apply with respect to any costs to which any deduction is allowed under section 59(e) or 291.

5 (d) Expenditures in connection with certain railroad rolling stock In the case of expenditures in connection with the rehabilitation of a unit of railroad rolling stock (except a locomotive) used by a domestic common carrier by railroad which would, but for this subsection, be properly chargeable to capital account, such expenditures, if during any 12-month period they do not exceed an amount equal to 20 percent of the basis of such unit in the hands of the taxpayer, shall, at the election of the taxpayer, be treated (notwithstanding subsection (a)) as deductible repairs under section 162 or 212. An election under this subsection shall be made for any taxable year at such time and in such manner as the Secretary prescribes by regulations. An election may not be made under this subsection for any taxable year to which an election under subsection (e) applies to railroad rolling stock (other than locomotives). ((e) Repealed. Pub. L , title II, Sec. 201(c), Aug. 13, 1981, 95 Stat. 219) (f) Railroad ties In the case of a domestic common carrier by rail (including a railroad switching or terminal company) which uses the retirement-replacement method of accounting for depreciation of its railroad track, expenditures for acquiring and installing replacement ties of any material (and fastenings related to such ties) shall be accorded the same tax accounting treatment as expenditures for replacement ties of wood (and fastenings related to such ties). (g) Certain interest and carrying costs in the case of straddles (1) General rule No deduction shall be allowed for interest and carrying charges properly allocable to personal property which is part of a straddle (as defined in section 1092(c)). Any amount not allowed as a deduction by reason of the preceding sentence shall be chargeable to the capital account with respect to the personal property to which such amount relates. (2) Interest and carrying charges defined For purposes of paragraph (1), the term ''interest and carrying charges'' means the excess of - (A) the sum of (B) the sum of - i) interest on indebtedness incurred or continued to purchase or carry the personal property, and (ii) all other amounts (including charges to insure, store, or transport the personal property) paid or incurred to carry the personal property, over (i) the amount of interest (including original issue discount) includible in gross income for the taxable year with respect to the property described in subparagraph (A), (ii) any amount treated as ordinary income under section 1271(a)(3)(A), 1278, or 1281(a) with respect to such property for the taxable year, (iii) the excess of any dividends includible in gross income with respect to such property for the taxable year over the amount of any deduction allowable with respect to such dividends under section 243, 244, or 245, and (iv) any amount which is a payment with respect to a security loan (within the meaning of section 512(a)(5)) includible in gross income with respect to such property for the taxable year. For purposes of subparagraph (A), the term ''interest'' includes any amount paid or incurred in connection with personal property used in a short sale. (3) Exception for hedging transactions This subsection shall not apply in the case of any hedging transaction (as defined in section 1256(e)).

6 (4) Application with other provisions (A) Subsection (c) In the case of any short sale, this subsection shall be applied after subsection (h). (B) Section 1277 or 1282 In the case of any obligation to which section 1277 or 1282 applies, this subsection shall be applied after section 1277 or (h) Payments in lieu of dividends in connection with short sales (1) In general If - (A) a taxpayer makes any payment with respect to any stock used by such taxpayer in a short sale and such payment is in lieu of a dividend payment on such stock, and (B) the closing of such short sale occurs on or before the 45th day after the date of such short sale, then no deduction shall be allowed for such payment. The basis of the stock used to close the short sale shall be increased by the amount not allowed as a deduction by reason of the preceding sentence. (2) Longer period in case of extraordinary dividends If the payment described in paragraph (1)(A) is in respect of an extraordinary dividend, paragraph (1)(B) shall be applied by substituting ''the day 1 year after the date of such short sale'' for ''the 45th day after the date of such short sale''. (3) Extraordinary dividend For purposes of this subsection, the term ''extraordinary dividend'' has the meaning given to such term by section 1059(c); except that such section shall be applied by treating the amount realized by the taxpayer in the short sale as his adjusted basis in the stock. (4) Special rule where risk of loss diminished The running of any period of time applicable under paragraph (1)(B) (as modified by paragraph (2)) shall be suspended during any period in which (A) the taxpayer holds, has an option to buy, or is under a contractual obligation to buy, substantially identical stock or securities, or (B) under regulations prescribed by the Secretary, a taxpayer has diminished his risk of loss by holding 1 or more other positions with respect to substantially similar or related property. (5) Deduction allowable to extent of ordinary income from amounts paid by lending broker for use of collateral (A) In general Paragraph (1) shall apply only to the extent that the payments or distributions with respect to any short sale exceed the amount which - (i) is treated as ordinary income by the taxpayer, and (ii) is received by the taxpayer as compensation for the use of any collateral with respect to any stock used in such short sale.

7 (B) Exception not to apply to extraordinary dividends Subparagraph (A) shall not apply if one or more payments or distributions is in respect of an extraordinary dividend. (6) Application of this subsection with subsection (g) In the case of any short sale, this subsection shall be applied before subsection (g). (i) Special rules for intangible drilling and development costs incurred outside the United States In the case of intangible drilling and development costs paid or incurred with respect to an oil, gas, or geothermal well located outside the United States - (1) subsection (c) shall not apply, and (2) such costs shall - (A) at the election of the taxpayer, be included in adjusted basis for purposes of computing the amount of any deduction allowable under section 611 (determined without regard to section 613), or (B) if subparagraph (A) does not apply, be allowed as a deduction ratably over the 10-taxable year period beginning with the taxable year in which such costs were paid or incurred. This subsection shall not apply to costs paid or incurred with respect to a nonproductive well. Sec General rule for taxable year of deduction TITLE 26, Subtitle A, CHAPTER 1, Subchapter E, PART II, Subpart C, Sec STATUTE (a) General rule The amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income. >>>>>>>>>> (i) Special rules for tax shelters >>>>>>>>>>>>> (2) Special rule for spudding of oil or gas wells (A) In general In the case of a tax shelter, economic performance with respect to amounts paid during the taxable year for drilling an oil or gas well shall be treated as having occurred within a taxable year if drilling of the well commences before the close of the 90th day after the close of the taxable year. This information is solely for petroleum industry professionals, financial professionals, and accredited investors capable of funding high risk - high return ventures. Participants should consult with their own tax advisors.

8 AMT AND INTANGIBLE DRILLING COST Please See Page 6 (sec. Line 25) of IRS Form 6251 Following This Page Intangible Drilling Costs: Line 25 IRS form 6251.This line relates to the difference in timing of the deductions for intangible drilling costs. You can make an election under IRC 59(e) to write off intangible drilling costs over 60 months for regular tax purposes, and eliminate an entry on this line. (*If you elect to take your IDC deduction over 5 years / 60 months they do not count as a tax preference item! Which means you can take the deduction from AMT Income.) Independent oil and gas producers and royalty owners do not have to compute preference items for excess percentage depletion deductions. Excess intangible drilling costs (IDC) are generally not treated as a preference item unless they exceed 40% of AMT income; see the instructions to Form 6251; Line 25 page 6 (*As long as your IDC deduction does not exceed 40% of your AMT Income you can use these deductions! If you are not in AMT you only add back IDC deductions that are in excess of 40% of your estimated AMT Income.) Example: An investor has 300,000 in AMT or AGI In come he can use up to 120,000 in IDC deductions without having to add back IDCs as tax preference items. Or if the investor chose to write off the IDCs over 60 months (5 years) they could have up to 600,000 dollars in IDCs in one year without having to count the IDCs as a tax preference item in calculating AMT. *NOTE: Hornet Corporation is not a Tax Advisor, CPA, or Tax Attorney and is not certified to give any tax advice. The information in this report is for educational purposes only. Individuals should consult their own tax professional for advice. Hornet Corporation offers no professional tax advice.

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10 OVERVIEW OF OIL AND GAS DRILLING VENTURE INCOME TAX ADVANTAGES The basic tax considerations involved in oil and gas drilling program are as follows: Producing Well -70%-90% of our investment constitutes what are know as Intangible Drilling Costs (IDC s), and are written off your ordinary income or gains in the first year. Fifteen to thirty percent (10%-30%) of the amount of your investment constitutes Tangible Drilling Costs (well equipment). This portion of your investment is depreciated over a seven year period using the Accelerated Cost Recovery System (ACRS), or some use the section 179 tax credit and takes the deduction the 1 st year. Depletion Allowance Currently the allowance is 15%. Fifteen cents of every income dollar is not taxable, and therefore produces tax sheltered income. The deduction in any tax year may not exceed 65% of the taxpayers taxable income from all other sources. Dry Hole 100% of all dollars invested are written off as a loss against your ordinary income in the first year. * The above examples are provided for general information only. This information is not intended to be individual tax advice and individual should consult his or her personal tax advisor concerning the applicability and effect on each personal tax situation. The Laws change from time to time and there can be no guarantee of the future interpretation of the tax laws. CURRENT TAX RATES Marginal Income Federal Income Tax Rates Medicare Taxes State Taxes Where Total Tax Rate Applicable 311,950 ^ 174,700^ 114,650^ 56,800^ 35.0%+ 33.0%+ 28.0%+ 25.0%+ 2.9%+ 2.9%+ 2.9%+ 2.9%+ 0-12% 0-12% 0-12% 0-12% 37.9% to 49.9% 35.9% to 47.9% 30.9% to 42.9% 27.9% to 39.9% The above tax rate went into effect on January 1, The above chart is based on the taxpayer filing jointly with his/her spouse. In addition, self employed individuals may pay an additional 1.45% of income for Medicare taxes. The above chart is not to be used for general information only and should not be considered as individual tax advice. Consult your personal tax advisor. WHY INVEST IN OIL AND GAS In 1994 for the first time ever, over 50% of the oil consumed by the United States was imported form foreign countries and imports are expected to reach 75% by the year Recent history tells us this situation can seriously threaten our national security and domestic economy. Because oil and gas is considered such a vital resource to our country, Congress has allowed excellent tax benefits o those who invest in domestic production. In addition, because of skyrocketing demand and an unstable world, some economic forecasters are prediction the price per barrel of oil to excedd60 within the next year, an increase of about 400% over three years ago. The combination of tax benefits and high prices set the stage for a great opportunity for gain in the oil and gas industry. GENERALIZED TAX ADVANTAGES OF OIL & GA S DRILLING VENTURES Source: Research Institute of America Tax Guide The following general discussion is provided for background information only. Potential investors should consult with their own tax advisor. With the passage of the Tax Reform Act of 1986, oil and gas ventures are now one of the most tax advantaged investments. The Act specifically exempts oil and gas Working Interests from being classified as Passive Income. (See Section 469(C) (3) of the Tax Code.) Intangible Drilling and Development Costs: 1. What are intangible drilling and development costs (IDC S)? They are the cost of labor, fuel, repair, hauling, supplies, etc., incident to and necessary for the drilling and preparation of wells for the production of oil and gas, including work done by contractor under any form of contract, including turnkey contract. IDC does not include the pipe and equipment that becomes part of the well. The (IDC) Generally runs between 70% to 80% for oil wells, and 80% to 90% for gas wells, of the total investment. As investment in a gas well of 40,000 could result in a tax write-off of 34,000 (40,000.x 85% IDC). For and individual in the 36% tax bracket this could be a savings of 12,240. Far additional tax savings see the generalized tangible drilling cost discussion the following paragraph. Tangible Drilling Cost (Well Equipment): Tangible drilling costs (well equipment) attributable to th e venture is computed and reported as depreciation as an expense on the tax. In the preceding paragraph the difference between the total investment and the IDC (i.e.: 40,000 less 34,000) would be the amount subject to depreciation 6,000. For simplicity, assume a straight-line depreciation for five years, deduction of 1,200 per year. Again assuming a 36% investor tax bracket, this would equate to 432. Coupled with the IDC tax reduction of 12,672 in the year in which the investment was made. Additionally, the remaining 4,800 to be depreciated (over the next five years) would also result in a 1,728 tax savings. Operating Cost and Production Costs: These costs, including but not limited to, pumping costs, well maintenance costs, mineral severance taxes, transportation costs., insurance, tax preparation, bank fees, filing fees and all other costs associated with the production of income form an oil/gas well are 100%deductible in the year in which the cost occurred. This is not an offer to sell a security, nor is it the solicitation of an offer to buy a security. An offer may only be made by a prospectus, and this is not a prospectus. This example is for illustrative purposes only.

11 Example of How Tax Advantages Can Affect Your 1 st Year Return in a Properly Structured Oil and Gas Investment Sample 1 st Year Returns from an Oil and Gas Drilling Project 100, 000 Initial Investment BOE Oil 24, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Calculating Your Estimated Tax Rate: WORKSHEET -1a FIRST YEAR RETURN (EXAMPLE) INCLUDING TAX ADVANTAGES Your Federal Tax Rate + Your Stat e Tax Rate + Medicare Tax Rate 2.9 = (Your Est. Total Tax Rate) A) Estimated 1 st Year Production Revenu e (See projected Return Table) 1. Investment Amount X.75 X. ( Your Est. Tax Rate) = (B) B) Estimated 1 st Year Tax Savings 2. Est. 1 st Year Revenue X.15 = (Tax Free Revenue) X (Est. Tax Rate) = (C) B) Additional 1 st Year Tax Savings C) A) + B) +C) = Actual First Year Estimated Return This is not an offer to sell a security, nor is it the solicitation of an offer to buy a security. An offer may only be made by a prospectus, and this is not a prospectus. This example is for illustrative purposes only.