DEVELOPMENT OF OIL AND GAS PROPERTIES

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DEVELOPMENT OF OIL AND GAS PROPERTIES

• PATRICK HENNESSEE

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THE NATURE OF IDC

• EXPENDITURES
• WITHOUT A SALVAGE VALUE
• FOR DRILLING
• PREPARATION FOR PRODUCTION

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IDC DEFINED REG. SEC. 1.612-4

• EXPENDITURES MADE BY AN OPERATOR FOR WAGES,
  FUEL, REPAIRS, HAULING, SUPPLIES, ETC., THAT ARE
  (1) INCIDENT TO AND NECESSARY FOR THE DRILLING OF
  WELLS AND THE PREPARATION FOR PRODUCTION OF OIL
  OR GAS AND (2) DO NOT HAVE A SALVAGE VALUE.

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DRILLING TO TOTAL DEPTH
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CEMENTING CASING

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Fracking Perforating the formation
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• COMPLETING THE
• WELL

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Drill Stem
Drilling Mud
Drill Bit
Bit Cuttings
DRILLING
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How Wells Are Completed

• Evaluate Formation
• Isolate the Formation
• Stimulate Well
• Install Production Equipment

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WELL LOGGING
Self Potential
Resistivity
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Drill Stem
Packer
Formation Tester
DRILL STEM TEST
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Cement
Drilling Mud
Casing
CEMENTING
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Oil Flows
Hydraulic Pressure Fractures Rock
Sand lodges in fractures
HYDRAULIC FRACTURING
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WORKOVER COSTS

• REMEDIAL OPERATION TO INCREASE PRODUCTION IN A
  PRODUCING WELL
• GENERALLY
• COSTS FOR IMPROVING, MAINTAINING, OR SUSTAINING
  PRODUCTION FROM CURRENTLY PRODUCTIVE RESERVOIRS
  OPERATING EXPENSE
• COSTS TO OBTAIN PRODUCTION FROM NEW RESERVOIR
  IDC

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OFFSHORE DRILLING
OFFSHORE MOBILE RIGS

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OFFSHORE MOBILE RIGS

• ISSUE GG VS. IDC
• IF WELL COULD ACTUALLY PRODUCE OIL IF DESIRED
• TREAT AS IDC
• STANDARD OIL CO., 68 TC 325
• SUN COMPANY, 74 TC 1481

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OFFSHORE DRILLING PLATFORMS

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OFFSHORE DRILLING PLATFORMS

• IDC
• COSTS OF DESIGNING AND CONSTRUCTING THE PLATFORM
• TRANSPORTING THE PLATFORM TO THE SEA
• NO DEDUCTION FOR ACTUAL MATERIALS USED IN
  CONSTRUCTION

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Problem 1

• Classify the expenditures in problem 1 as
• Leasehold costs (capital expenditures)
• Intangible Drilling Costs (IDC)
• Lease and well equipment (Eq.)
• Lease operating costs (LOE)

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____ 1. Research of lease location by engineer,
geologist, etc. ____ 2. Administrative costs in
connection with drilling contracts. ____ 3.
Surface casing. ____ 4. Cost of switcher,
pumper, and gauger to operate the wells. ____ 5.
Cost of minor repair of pumps, tanks,
etc. ____ 6. Equalization payments of a
unitization when paid in connection with
equipment. ____ 7. Survey and seismic costs to
locate a well site on leased
property. ____ 8. Costs of drilling. ____ 9.
Grading, digging mud pits, and other dirt work to
prepare drill site. ____ 10. Geological and
geophysical expenditure leading to the
acquisition or retention of an oil and gas
property. ____ 11. Expenses in connection with
leasing the property from the
landowner. ____ 12. Cost of constructing roads or
canals to drill site. ____ 13. Surface damage
payments to landowner around the drill
site. ____ 14. Crop damage payments to landowner
due to transporting the drilling rig to
and from the drill site. ____ 15. Cost of well
casing.
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____ 16. Grading existing roads in order to
transport oil to the refinery. ____ 17.
Treat-o-lite and other materials and supplies
consumed in operating the
lease. ____ 18. Salt water disposal equipment and
well. ____ 19. Costs of setting the rig on drill
site. ____ 20. Transportation costs of moving
rig. ____ 21. Technical services of geologist,
engineer, and others engaged in drilling
the well. ____ 22. Legal costs of securing lease
and clearing title. ____ 23. Legal fees incurred
to obtain access to the property and to
obtain easements, etc. ____ 24. Drilling mud,
fluids, and other supplies consumed in drilling
the well. ____ 25. Transportation of
drill pipe and casing. ____ 26. Cementing of the
casing (but not the casing itself). ____ 27. Rent
of special equipment and tanks to be used in
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____ 28. Transportation of tubing to supply yard
but not from supply yard to
well. ____ 29. Cost of production
tubing. ____ 30. Pulling sucker rods, pump, and
cleaning the well. ____ 31. Utilities to run
pump. ____ 32. Severance taxes on oil
produced. ____ 33. Cost of well head and
"Christmas Tree." ____ 34. Perforating the well
casing. ____ 35. Logging costs. ____ 36. Costs of
removing rig from location. ____ 37. Dirt work in
cleaning up the drill site. ____ 38. Lease bonus
paid to landowner. ____ 39. Purchase price of an
existing lease. ____ 40. Costs of pumps and
motors including transportation. ____ 41. Cost of
tanks, flow lines, treaters, separators, etc.,
including transportation. ____ 42.
Depreciation on equipment used on the
lease. ____ 43. Rental on lease
equipment. ____ 44. Dirt work for tanks and
production equipment.
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____ 45. Cost of acidizing, fracturing the
formation, and other completion cost. ____
46. Seismic work to determine the size of the
reservoir or reserves. ____
47. Legal fees incurred in drafting contracts,
division orders, etc. ____ 48. Travel incurred
in acquiring lease. ____ 49. Swabbing costs to
complete the well. ____ 50. Wells drilled for
pressurizing the producing zones such as
water flooding. ____ 51. Laying pipelines,
including dirt work and easements. ____ 52.
Salaries for painting and cleaning on the
lease. ____ 53. Installation costs of tanks and
production equipment. ____ 54. Construction
costs of trucks turnaround pad and overflow
pits at new tank battery. ____ 55. Bottom-hole
contribution. ____ 56. Costs of plugging the
well if dry. ____ 57. Costs of drill stem
tests. ____ 58. Open hole testing. ____ 59.
Rental payments to mineral owner when not based
on production. ____ 60. Remaining basis in
equipment which is transferred to another
person under any type of reversionary agreement.
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THE ELECTION

• DEDUCT IN 1ST YEAR IDC IS INCURRED
• NO FORMAL STATEMENT REQUIRED
• BUT MAKE ONE

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STATEMENT

• TAXPAYER HEREBY ELECTS TO EXPENSE ALL
  INTANGIBLE DRILLING AND DEVELOPMENT COST OF OIL
  AND GAS WELLS UNDER THE AUTHORITY OF SEC. 263(c)
  AND REG. SEC. 1.612-4(a).

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PARTNERSHIP

• PARTNERSHIP MAKES THE ELECTION
• NOT THE INDIVIDUAL PARTNERS
• TO BE SAFE
• ATTACH A STATEMENT TO THE 1065

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SECOND ELECTION

• USED ONLY WHEN TAXPAYER ELECTED TO CAPITALIZE
  IDCs
• ELECTION TO EXPENSE DRY HOLES
• STATEMENT ON THE RETURN
• FIRST YEAR TAXPAYER DRILLS A DRY HOLE

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IDC - PROBLEM 2 Kyle O'Tracy invested 10,000
in an oil and gas venture on December 18, 19X6.
7,000 of this represented IDC, 2,500 was for
equipment and 500 was for leasehold cost. The
well was completed on December 28, 19X6 as a
producer. This was the first time Kyle had
invested in an oil and gas well. Kyle started to
file his tax return for 19X6 (at 800 p.m., April
15, 19X7) when his good friend Mable called and
invited him to a party that started at 900 p.m.
Kyle, being more of a party animal than Spuds
Mckinsey quickly completed Form 4868, Application
for Automatic Extension of Time to File U.S.
Individual Income Tax Return and dropped it in
the mail on his way to the party. What is Kyle'
status regarding his IDC election when he finally
files his return on August 15, 19X7?
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IDC - PROBLEM 3 Sean Patrick, an individual (who
has never been involved in the oil and gas
business before) acquired an oil and gas lease
from his brother on March 20, 19X6. Sean decided
to develop the property late in 19X6 and a well
was spudded in on December 18, 19X6. By the end
of the year Sean, a cash basis taxpayer, had
spent 28,000 in drilling cost. The well was
completed by mid January of 19X7. Sean spent a
total of 178,000 in drilling and completion cost
and 42,000 in equipping the well. Because Sean
had very little taxable income in 19X6, he
decided to expense the entire well in 19X7.
Therefore, on his 19X6 return, Sean had reported
nothing regarding his oil and gas
activities. What do you think Sean's status
regarding the IDC election is at this point?
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SECTION 59(e) ELECTION

• ONLY IF TAXPAYER HAS ELECTED TO EXPENSE IDC
• THIS ELECTION IS USED TO CAPITALIZE ANY AMOUNT OF
  IDC
• AND AMORTIZE OVER 5 YEARS
• AMOUNT CAPITALIZED IS NOT TAX PREFERENCE IDC
• PARTNER MAKES ELECTION

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INTEGRATED OIL COMPANIES

• MUST CAPITALIZE 30 OF THEIR DOMESTIC IDC
• AMORTIZE THIS OVER 60 MONTHS
• BEGINNING WITH THE MONTH THAT COSTS ARE INCURRED
  OR PAID

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Electing Large Partnerships

• 1997 Act - Simplification
• Electing Large Partnerships -- 100
• Depletion
• AMT
• Section 29 Credit
• IDC
• Generally same as before - partnership level
• Disqualified Person - retailer, refiner
• Permitted to make their own 59(e) election

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FOREIGN IDCs

• CAPITALIZE ALL PRODUCTIVE IDC
• AMORTIZE OVER 10 YEARS
• OR
• RECOVER ADD TO COST BASIS AND USE COST DEPLETION
  TO

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WHEN TO DEDUCT IDC

• GENERAL RULES
• ACCRUAL BASIS
• DEDUCT IN YEAR INCURRED
• CASH BASIS
• DEDUCT IN YEAR PAID IF COST HAVE BEEN INCURRED

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PREPAID IDC

• IMPORTANT FACTORS
• NOT A MERE DEPOSIT
• NOT RESULT IN A MATERIAL DISTORTION OF INCOME
• BONAFIDE BUSINESS PURPOSE
• MUST BE REASONABLE AMOUNT
• LEGALLY REQUIRED TO MAKE THE PREPAYMENT
• HELPFUL TO HAVE A DATE WHEN DRILLING IS TO BEGIN
• HELPFUL IF ALL WORKING INTEREST OWNERS
  PARTICIPATE IN THE PREPAYMENT
• HELPFUL IF CONTRACT IDENTIFIES THE WELLS TO BE
  DRILLED

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PREPAID IDC TO A TAX SHELTER MAY BE DEDUCTED
WHEN

• CASH IS PAID IT IS NOT RAISED BY LOANS SECURED
  BY THE TAX SHELTERS ASSETS OR LOANS ARRANGED BY
  PERSONS INVOLVED WITH THE TAX SHELTER
• AND
• IF THE WELL IS SPUDDED DURING THE FIRST 90 DAYS
  OF THE FOLLOWING YEAR.

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TAX SHELTER DEFINED

• AN ENTERPRISE (other than a C Corp.) REQUIRED TO
  BE REGISTERED WITH STATE OR FEDERAL AGENCIES
• A PARTNERSHIP THAT 35 OF ITS LOSSES ARE
  ALLOCABLE TO LIMITED INTEREST OR
• AN ENTITY OR PLAN WHO'S PRINCIPAL PURPOSE IS
  AVOIDANCE OR EVASION OF TAXES

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IDC - PROBLEM 4 Elizabeth paid 40,000 for a
limited partnership interest in a drilling
program set up by Big Oke Oil Company which also
became general partner. In December 19X7,
Elizabeth's 40,000 investment was used to make
four different types of prepayments 1. Prepayme
nts were made to independent third parties under
footage and daywork drilling contracts. The
amounts paid were based on estimates of how much
it would cost to drill the well on a cost per
foot or per day basis. The partnership had the
right to cancel the contract at any time. If it
did so, it would be entitled to a refund of the
repayment reduced by whatever amount the
contractor had by then earned under the contract
for services actually performed.
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IDC - PROBLEM 4 -- continued
2. Prepayments were made to independent third
parties under turnkey drilling contracts. These
contracts were for a flat fee and were not
refundable. If, however, a well was canceled,
the prepaid amount was to be applied to the
drilling of a different well.
3. Prepayments were made to independent third
parties on well servicing contracts. The amount
of the prepayment was based on an estimate of the
service to be provided under the contract. The
contracts could be canceled at any time, in which
case the prepayment was refundable except to the
extent earned by the contractor at that time.
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4. Prepayments were made to Big Oke under a
contract requiring Big Oke to supervise the
drilling of the wells provided for in the
turnkey, footage and daywork contracts. The
prepayment was based on an estimate of the work
to be done by Big Oke. These prepayments were
not refundable. Work on most of the wells
called for under the turnkey, footage, and
daywork contracts was not commenced until the
following year. The IRS will concede that all
prepayments involved will qualify as IDC. Can
Elizabeth (who is on the cash basis as is the
partnership) can claim the entire amount of her
40,000 investment as a deduction on her 19X7
return?
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IDC - PROBLEM 5 On December 18, 19X6, Kyle
O'Tracy, cash basis, calendar year taxpayer, paid
150,000 to Big Oke Partnership (also cash basis,
calendar year entity) for a 20 limited
partnership interest. Kyle's 150,000 was raised
as follows .....50,000 was his own
money. .....50,000 from a loan arranged by Big
Oke's general partner. .....50,000 for a
loan from Penny Square Bank (an unrelated
third party. The well was spudded in on March
1, 19X7. Big Oke paid the 150,000 to the
drilling contractor on a turnkey contract with a
valid business purpose by the end of 19X6. Can
Kyle deduct any or all of the 150,000 payment in
19X7?
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WHO CAN DEDUCT IDC?

• ONLY WORKING INTEREST OWNERS
• DURING THE COMPLETE PAYOUT PERIOD
• MUST PAY FOR THE IDC
• AND ONLY FOR THE COST ATTRIBUTABLE TO THEIR
  FRACTIONAL SHARE