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Complex Rules For Energy Investors

two oil well rigs in a North Dakota landscape
photo by Tim Evanson

Whether in a game or an investment venture, overly complicated rules can scare off potential players. But understanding the rules and choosing to play are the only ways to reap the full rewards of either.

The tax rules governing investment in oil, natural gas and other energy interests are far from simple. That doesn’t mean you should let them keep you away from these opportunities, however.

The International Energy Agency said last year that the United States is poised to surpass Russia and Saudi Arabia as the world’s top producer of oil by 2015, and we have already passed Russia as the leading producer of natural gas. The widespread application of hydraulic fracturing and other advanced recovery technologies has permitted the hydrocarbon boom. Across the country, from the northern Plains to the deserts of the Southwest to Appalachia, thousands of ordinary citizens now derive income - in some cases, a lot of income - from the energy industry.

This turn of events is beneficial, but it is also complicated. How complicated the situation is for a given individual will vary.

In many instances, an agent for a large energy company will approach a landowner and ask to lease the rights to extract minerals from the property. These leases often carry an upfront payment, plus a stream of royalties depending on how much oil or gas is produced and the price at which it is then sold. While this price will fluctuate along with well-known benchmarks, such as the spot prices for West Texas Intermediate (oil) or Henry Hub (gas), it will not necessarily match the benchmark prices. In fact, it usually varies, often by quite a bit, because of differences in the quality of the minerals being produced, the accessibility of pipelines or other mechanisms to get it to market, and the supply situation in the particular part of the country where extraction takes place. The landowner’s royalty may also increase after the party doing the drilling has recovered its costs, since it is the driller who takes most of the economic risk. A landowner needs to understand the lease’s provisions before signing. Those provisions may differ from one energy company to another.

Some individuals have a chance to invest directly in the oil or gas wells instead of simply leasing the mineral rights. These direct investments are called “working interests.” In these cases, the investor directly owns a share - sometimes as small as 1 percent or less - of a hole in the ground. (Hopefully the hole contains something valuable.) The investor has to shoulder his or her share of the upfront costs to acquire the mineral rights and drill the hole. In return, the investor gets to share some of the hoped-for profits.

A working interest has another benefit: The investor can take advantage of favorable tax treatment for energy drilling. Oil and gas industry lobbyists worked hard to secure these tax breaks, and small investors get to take advantage of them just like Exxon and BP. But in order to capture this advantage, the investor, or the investor’s accountant, has to know how these very complicated tax rules work.

As a tax preparer with over 12 years of experience, I’ve seen my fair share of clients whose previous accountants did not fully take advantage of the tax benefits available to them from their oil and gas investment activity. Taxpayers with working interests in energy investments typically incur expenses for well drilling, known as “intangible drilling costs” or IDCs, which are deductible for regular tax purposes but not for the federal Alternative Minimum Tax (AMT). However, there is an exception to this. An AMT preference item for “independent producers,” for which many individual taxpayers qualify, allows them to get full benefit of their IDC deductions. This rule is often mishandled or overlooked by accountants who are not familiar with the intricacies of oil and gas taxation.

Though the rule is an obscure one by most tax preparers’ standards, the difference is noticeable when it is properly applied. I have seen cases for taxpayers with substantial oil and gas investments where this mistake cost over $50,000 in taxes in a single year.

Another complicated area is the income tax deduction for “depletion,” which is the exhaustion of the mineral reserves as they are tapped by the well. The principle is similar to depreciation, except rather than depreciating a hard asset, such as business equipment, you record depletion for the oil or gas itself. Depletion can be calculated based on either the cost of acquiring the reserves or on the value at which they are sold at the wellhead. The calculations are quite complex and subject to multiple limitations. In some cases, depletion can result in deductions that actually exceed your original cost of the well.

Again, I’ve seen cases in which taxpayers simply neglected to claim these tax benefits, which can be substantial. While their complexity means tackling the rules properly requires effort, it is worthwhile to take the trouble when it can mean high levels of tax savings in the end.

America’s energy boom is good for the national economy and for individual producers. But whether you are drilling, investing or just leasing your family’s long-held mineral rights, you need to know what you are doing to get the maximum benefit from your investment. If this is all new to you, as it is to thousands of American families, you would be well advised to find someone knowledgeable to guide you through the process. Don’t let complex rules keep you on the sidelines.

Vice President David Walters, who is based in our Oregon office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning,” and Chapter 6, “Transfer Taxes.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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