oil wells

Oil and Gas as an Investment

Investments in oil and gas have potential for both income and tax benefits.

Some are risky in the "wildcat" style, while others pose much smaller risks for investors. Some have the potential for a rags-to-riches story, too, although a stable income and substantial tax advantages are more likely. Much depends on the type of investment.

Oil and Gas

Intangible Drilling Costs
One of the tax benefits of oil and gas investments is the ability to deduct intangible drilling costs, or IDCs. IDCs are expenses connected with drilling and preparing wells for production. Included are such items as wages, fuel, repairs, hauling charges and supplies. Initially, as much as three-fourths of an investment can go to pay for these intangibles, allowing a large deduction early into the investment.

Depletion Allowance
Depletion is similar to depreciation in that it is a deduction made to recover capital invested in the oil and gas as it is removed from the ground and sold--being depleted. Just as real estate is assumed to depreciate (drop in value) as it grows older, the oil and gas is assumed to be depleted and drop in value as it is used up.

One of two types of depletion allowance may be available to an investor. Cost depletion is always available, while percentage depletion is available only for certain types of products and certain producers and retailers. Where both types are available, the investor is required to compute the depletion allowance which would be provided by each, and must deduct whichever produces the greater amount.

Under the cost depletion method, the amount of the allowance is determined by a formula based on actual costs and units (such as barrels of oil). Cost of Units divided by Estimated Number of Units to be Recovered, times Units Sold in Period.

While cost depletion is based in part on the investor's actual costs, percentage depletion has no direct relationship to the individual investor's costs in the initial calculation. Instead, it is a percentage of the property's gross income less royalties and rents. The percentage is determined by law.

Percentage depletion is limited to amounts received for actual production. This excludes lease bonuses, advance royalties, or any amounts unrelated to actual production. The deduction, however, is limited to no more than 50% of the taxable income the individual investor receives from the investment.

Another limitation also applies to the percentage depletion. When determining whether to use cost or percentage depletion, the investor must determine whether using the percentage depletion allowance will result in a deduction that is more than 65% of total personal income for the year (not just income from the investment). If it does exceed 65%, but if the investor still must use percentage depletion (because it is greater than cost depletion), the excess over the 65% limit may be carried forward to any future years where it may be used as a deduction under the limitations specified.

Passive Loss Rule Exception
Similar to the rental real estate exception mentioned previously, investors with a working interest in oil and gas are not subject to the passive loss rule, whether or not they materially participate. In this case, a working interest refers to the investor's responsibility for the costs of both developing and running the activity. A limited partnership does not represent a working interest.
Other Features Of Oil And Gas Investments
We've looked primarily at features that are peculiar to oil and gas investment, such as IDCs and depletion allowance. There are other features this type of investment has in common with other investments, such as tax benefits available for tangible drilling costs--piping, tools, and machinery.

Capital gains offsets are available for oil and gas investments if the program sells oil reserves while they are still in the ground. Investors may also benefit from capital gains offsets for selling their interests.

Be Careful of Leveraged Transactions
In a leveraged oil and gas drilling partnership transaction, a promoter ("Promoter") forms a general partnership ("Partnership") to participate in the drilling of oil and gas wells located primarily in the United States and for the production and sale of hydrocarbons. Partnership acquires a non-operating working interest in a collection of wells from a Promoter entity. Partnership uses the accrual method of accounting. Investors ("Investor" in the singular, "Investors" in the plural) purchase units in Partnership for the right to share in any profits from Partnership's wells. As a result of Partnership's ownership of a non-operating working interest, the Investors are entitled to their proportionate share of IDC deductions. Promoter informs prospective investors that, for federal tax purposes, Partnership will be classified as a partnership.

Investment in Partnership
An Investor acquires an interest in Partnership with a combination of cash and debt. The face amount of an Investor's note (the "Investor Promissory Note," or "IPN") exceeds the amount of cash he contributes. The amount by which the IPN exceeds Investor's cash investment varies, but typically the debt-to-cash ratio is within a range of 2-to-1 to 4-to-1.

The IPN has a term ranging from 15 to 20 years and bears interest at or above a market rate (typically, 6% to 8%). Payment of the principal balance is due at the end of the term. Interest is typically payable annually or semi-annually out of Partnership's profits. If Partnership's profits are insufficient to cover Investor's interest obligation, in some cases the interest accrues unpaid until the end of the IPN's term, and in other cases either Investor must make interest payments out of pocket, or Partnership is required to obtain outside financing to offset Investor's interest obligations.

Investor's liability for the IPN is fully recourse, and is secured by Investor's interest in Partnership and Investor's rights to profits from Partnership. Payment of the IPN principal and interest is typically made first out of Investor's share of Partnership profits, but Partnership looks to Investor to pay any portion of the IPN not covered by Investor's share of profits. In some cases, if a successful well is drilled, the IPN can be converted for a fee to a nonrecourse obligation to the extent of Investor's allocable share of anticipated profits from the well.

Partnership's balance sheet generally shows the Investor Promissory Notes as the majority of its assets, and usually classifies the IPNs as "Accounts Receivable." In some cases, however, the IPNs are shown as assets in other areas of Schedule L. Partnership's balance sheet includes the face amount of the Investor Promissory Note in the total amount of capital contributed to the Partnership. In the year the IPN is contributed to capital, Partnership often presents the contribution on Schedule M-2 as a cash contribution.

Partnership's Operation
Partnership, through a Managing Partner, signs a prospect agreement ("Prospect Agreement") with an entity owned or controlled by Promoter (the "Promoter Exploration Company"). The Prospect Agreement assigns working interests in oil and gas leases held by the Promoter Exploration Company to Partnership. The Promoter Exploration Company is not the leasehold Operator of those properties, but rather holds non-operating working interests. Partnership typically does not allocate any amount paid for the leasehold assigned under the Prospect Agreement to reflect the acquisition of working interests. In addition, Partnership's balance sheet (Schedule L) typically does not reflect the acquisition of interests in oil and gas properties.

The Partnership enters into an agreement based on a document entitled "Turnkey Contract" with another entity owned or controlled by the Promoter (the "Promoter Turnkey Driller") to drill oil and gas wells on the leasehold for a fixed price. Partnership pays "management fees" and "overhead costs" to the Promoter Turnkey Driller under the Turnkey Contract. Partnership prepays the Promoter Turnkey Driller for a portion of its drilling services at the time the parties execute the Turnkey Contract. Partnership's prepayment consists of both cash (from the cash contributed by Investors) and a note (the "Driller Promissory Note," or DPN).

Similar to the Investor Promissory Notes, the terms of the DPN can vary from one Partnership to another, but in most cases the DPN issued by a particular Partnership has the same maturity date and interest rate as the IPNs contributed by that Partnership's Investors. The DPN is secured by Partnership's assets, including the unpaid balance of the IPNs. Further, Investors assume personal liability for their pro rata share of the DPN, to the extent of the unpaid balance of their IPN. In some cases, an Investor's personal liability is provided for in the terms of his IPN, and in other cases the Investor assumes personal liability by entering into a separate Assumption Agreement with the Promoter Turnkey Driller. The Promoter Turnkey Driller, which uses the cash method of accounting, includes the cash received from Partnership in income, but does not include any unpaid amount of the Driller Promissory Note.

In many cases, however, the Promoter Turnkey Driller is a shell entity with no employees or equipment of its own, and the Turnkey Contract is not a true turnkey contract. Any actual drilling is performed under agreements between unrelated drilling contractors and the leasehold Operator. Neither the Promoter Turnkey Driller, nor the Promoter, nor the Promoter Exploration Company, nor Partnership is a signatory to these agreements or in anyway is responsible for causing the wells to be drilled. Furthermore, the leasehold Operator of the wells is generally unaware of the transfer of working interest from Promoter Exploration Company to Partnership and, thus, will continue to look to Promoter Exploration Company for payment of its proportionate share of costs associated with the drilling and operation of the wells.
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