WHY INVEST IN GAS?

Tax Advantages of Direct Domestic Oil and Gas Investments

The current Internal Revenue Code (the “Code”) makes a direct investment in domestic oil and gas drilling and production a potentially significant tax advantaged investment. Congress has approved these incentives to stimulate domestic oil and gas production. The thinking goes: If enough benefit is derived by the investing public, they will provide the capital required to bring on new production, which will in turn lessen our country’s dependence on foreign energy sources. The following is a brief overview of some of the more significant tax benefits. Note that purchasing stock in publicly traded energy companies does not generate similar tax benefits.

Direct Participation is an “Active” Business Activity. One of the key tax advantages is the exemption of oil and gas working interests from being classified as “Passive Activities.” Under the Code, losses from Passive Activities cannot be offset against income from “Active” businesses. However, the Code specifically states that ownership of a working interest in an oil and gas well is not a Passive Activity. As a result, deductions can be offset against active income from items such as salaries, business income, stock dividends and stock trades.

First Year Deduction for Intangible Drilling and Completion Costs (IDC’s). Approximately 65% to 80% of a direct domestic oil and gas investment may constitute IDCs and be deductible in the tax year of the investment, even if the well does not start drilling until 90 days after the year the contribution of capital was made.

Example: (IDC’s amounting to 80% of $100,000 investment and utilizing the full write off at 35% marginal tax rate)

The investor could also realize additional savings on state income taxes in many states, and self-employed investors could realize additional savings on self employment taxes. Costs falling into the IDC category such as drilling expenses, site preparation, rig costs and high pressure fracturing of rock formations make up most of the expenses of creating a typical well.

Depreciation. Additional expenses may generally be depreciated over a seven year period. Equipment such as pipe, well casings, tubing, storage tanks, pumping units and other items that remain with the well after its completion are considered depreciable.

Percentage Depletion Allowance. The Code provides a tax allowance to recognize that oil and gas wells deplete their resources over time. Because no one can say how long a well will produce, Congress decided that 15 to 25 percent of each dollar an investor receives from a direct oil and gas investment should not be federally taxed at all. The owner of an economic interest in an oil and gas property is generally entitled to claim the greater of “percentage depletion” or “cost depletion”. Percentage depletion is generally available only to the domestic oil and gas production of “independent producers”. To qualify as an independent producer, the taxpayer, either directly or through related parties, may not be involved in the refining of more than 50,000 barrels of oil (or equivalent of gas) on any day during the taxable year or in the retail marketing of oil and gas products exceeding $5 million per year in the aggregate. Although it could be higher, generally a percentage depletion allowance of 15% is used. Essentially, the depletion allowance could make 15% to 25% of the gross income from a direct investment in an oil and gas property tax free. One important limitation on the depletion allowance is that the deduction in any tax year may not exceed 65% of the tax payers’ taxable income from all sources. Any excess generally can be carried forward.

Important Considerations: The above examples are for general information only and are not intended as individual tax advice. Federal and State tax laws are complex. Consult your personal tax advisor concerning the applicability and effect of oil and gas investments on your personal tax situation and, more specifically, whether or not oil and gas investments would produce favorable tax advantages in your tax situation. This information was current as of the date this document was first written. However, tax laws change from time to time, and there can be no guarantee of the interpretation of the tax laws. The tax benefits of oil and gas investments are merely one factor to consider in evaluating a potential investment and do not eliminate the risks of such investments.