Oil and Gas Accounting: Tax Depletion
What is oil and gas tax depletion?
Depletion is “the process of associating the capital costs of finding and producing minerals with the production of the minerals.”
Uh huh….so what does that mean? Oil & Gas Accounting rules say that you must capitalize all of the costs incurred to acquire, explore, and develop oil and gas producing properties. Those costs are generally referred to as capitalized leasehold costs.
The way you are able to take the tax deduction for all of those costs is known as depletion. Depletion is calculated and maintained on a property by property basis and is only deductible by persons who hold an economic interest. There are 2 types of depletion: cost depletion and percentage depletion.
You can deduct the higher of percentage or cost depletion on a property by property basis. One property can benefit from percentage depletion while another property benefits from cost depletion. [Note: This is actually also true at the well level (one property may include multiple wells), but can get very complicated very quickly. Talk with a tax professional to determine your best course of action.] Capitalized leasehold costs are deducted by calculating percentage or cost depletion once an oil or gas well begins production.
What is Percentage Depletion?
Percentage depletion is one of the best tax benefits available to oil and gas investors. It is a deduction without having an actual expense to back it up. Imagine being able to reduce your current income by 15% just because the IRS said you could. That is exactly what this is. Like most things related to oil and gas accounting, calculating percentage depletion can be challenging.
How to calculate percentage depletion
Percentage depletion is calculated based on a percentage of gross income from the property. Percentage depletion can only be taken by a property that has net income. If a property has a net loss, percentage depletion cannot be deducted in the current year. It is VERY important to pay attention to the definition of net income in this scenario.
Net income is calculated by subtracting the following from Oil and Gas Gross Revenue on a property by property basis:
Lease Operating Expenses, Production Taxes, Intangible Drilling Costs, Dry Hole Costs, Depreciation from Tangible Drilling Cost, Other Expenses, and Overhead Expenses
It is important to allocate depreciation expense to the correct property as it is used to calculate net income for that property.Once net income is calculated, multiply gross income by 15% for those properties that did not have a loss.
- The allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income.
- If net income is less than 15% of gross income, the deduction is limited to 100% of net income (before the deduction for depletion).
There are two other limitations to the percentage depletion deduction:
- A taxpayer’s total percentage depletion deduction for the year from all oil and gas properties cannot exceed 65% of taxable income, computed without deducting percentage depletion, the domestic production activities deduction, NOL carrybacks, and capital loss carrybacks (if a corporation).
- If the average daily production exceeds 1,000 barrels, then the quantity limitation rate must be calculated.
Unlike cost depletion, percentage depletion is not limited to the depletable base of the property and can be deducted as long as the property generates income. Percentage depletion is not allowed for foreign oil and gas producers, domestic retailers, and domestic refiners.
What is Cost Depletion?
Of the two depletion calculations, cost depletion is the easier to calculate. It is calculated based on the adjusted depletable base of the property as follows:
CD = [CP ÷ (CP + ER)] X DTB
CD = Cost Depletion
CP = Current units sold
ER = Ending reserves
DTB = Depletable Tax Basis remaining as of the end of the current tax year before current tax depletion is applied.