Are Intangible Drilling Costs Deductible?
Are Intangible Drilling Costs Deductible?
The right kind of oil investment starts earning you money before the ground is even broken. As the driving force of domestic U.S. energy production, acquisition of working interest of oil and gas wells provide income tax burden mitigation opportunities.
During the initial year of acquiring working interest in oil and gas wells, a timing difference usually occurs as the acquisition funds used to purchase the oil and gas working interest are deployed. As a normal cash basis taxpayer, the cost of the proposed wells to be drilled represents a prepayment of the cost of the future new wells to be drilled. As this investment capital is deployed for drilling the new proposed wells, two primary deductions are generated.
The first is intangible drilling costs commonly referred to as IDCs which relate to any intangible costs incurred during the drilling, testing, completing, or stimulating the proposed oil well. The second primary deduction was modified by the enactment of the Tax Cuts and Jobs Act if 2017 (“TCJA”) This deduction is commonly referred to as bonus depreciation (Section 168 ( k )) which relates to the current year expense (deduction) of tangible costs (tangible personal property) attributable to the drilling, testing, completing, stimulating, or equipping an oil and gas well.
Why Are Intangible Drilling Costs Deductible?
Intangible drilling costs refer to all the materials, labor, and stimulation costs attributable to the various stages as referenced above for drilling a new well or re-entering an existing well to exploit a different payzone (geological formation). Section 263 ( c ) of the Internal Revenue Code and regulations issued by the Internal Revenue Service which apply to this Code Section describe in significant detail the type of costs which may be deducted as intangible drilling costs.
Based on certain contractual arrangements and a contractual obligation to prepay drilling costs, a cash basis taxpayer (the majority of individual taxpayers) may prepay and claim in the year of prepayment, a deduction for intangible drilling costs providing the well is spudded (drilling commences) within ninety days of December 31 of the previous year.
How to Benefit from Intangible Drilling Tax Deductions
Using income tax mitigation strategies such as diversifying your investment portfolio with a direct ownership of acquiring working interest in oil and gas wells may provide the accredited investor a prudent method for wealth accumulation. Congress has enacted legislation to promote domestic oil and gas production with the objective of the United States becoming a net petroleum exporter.
Current deductions for intangible drilling costs (IDCs) promote domestic U.S. production. Intangible Drilling Cost deductions generally apply to only domestic production. The income tax benefit of claiming these deductions reduce the net amount of the invested capital by the associated reduction in income tax cost (liability) of the individual or entity providing the invested capital.
For example, assuming the invested capital equals $100,000 and the applicable combined federal and state income tax rate of the individual investing the capital equals 45 percent, the actual net amount of the investment capital reduced by the income tax impact would equal $64,000. In this example, the current year combined intangible drilling costs, bonus depreciation, and other allowable deductions is assumed to equal 80 percent of the invested capital or $80,000. These deductions of $80,000 multiplied by the 45 percent assumed income tax rate yields a tax savings of $36,000.
The benefit of IDCs reduces the amount of invested capital required to drill new wells. These income tax benefits serve to promote domestic production and have enhanced the ability of U.S. domestic producers to achieve the status of being a net production exporter.
The legal structure and business model of the investing entity may impact the desired economic results of direct ownership of oil and gas wells. Applicable income deductions are allocated to the individuals or entities providing the investment capital. The most common legal form of the investing entity is usually a limited partnership.
The recommended business model is an Oil Fund which owns all of the components of the oilfield being developed. The objectives of the Oil Fund are as follows:
Consistent Monthly Revenue Distributions – After an Oil Fund receives the subscribed capital as presented in the offering memorandum and implements the plan of oilfield development deploying this capital, usually consistent monthly distributions of net production income from the oil and gas sold in the prior month are distributed to the Oil Fund subscriber—not for a single well but an entire field of opportunities.
Scalability – Owners receive their respective ownership percentage of all the active resources being developed in comparison to owning only wellbores which is normal business model of a drilling fund.
Increased Divestiture Options – The development of divestiture strategies are monitored and evaluated as the oilfield is being developed.
Multiple on Invested Capital Returns – By the Oil Fund owning all components of the oilfield being developed, the members of the investing entity accrete the increased value in the oilfield as the invested capital is deployed. Ideally, with this accretion in the value of the oilfield, upon the complete divestiture of the oilfield, a multiple of invested capital may be returned to the members of the investing entity. This this possible multiple return on invested capital, the members may achieve their desired accumulation of wealth.
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Investments in oil and natural gas partnerships are speculative and involve a high degree of risk. Oil and natural gas wells are naturally depleting assets. Cash flows and returns may vary and are not guaranteed. Past performance is no indication of future performance. Nothing herein shall be construed as tax or accounting advice. Investors may lose money. Some of the risks other than those described herein associated with investment in Larimer County Energy Fund are described in the Risk Factors section of the Confidential Private Placement Memorandum concerning the Larimer County Energy Fund accompanying, preceding, or following this Executive Summary. Prospective investors are urged to read and consider carefully the risks described in that section. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the investment opportunity described in this Executive Summary. Neither the Securities and Exchange Commission nor any state securities commission has determined the accuracy or completeness of the information contained within this Executive Summary or in the Confidential Private Placement Memorandum concerning the offering of limited partnership interests. The offering of limited partnership interests is made only by the Confidential Private Placement Memorandum, which must accompany, precede, or follow this Executive Summary, and an investment decision can only be made by the execution of definitive investment documents. Investors in Larimer County Energy Fund are required to be “Accredited Investors,” as defined in Rule 501(a) of Regulation D under the Securities Act of 1933.