DEPLETION

1
DEPLETION

• PATRICK HENNESSEE

2
CONCEPT OF DEPLETION

• PHYSICAL DEPLETION
• ECONOMIC DEPLETION
• ACCOUNTING DEPLETION
• TAX DEPLETION

3
TAX DEPLETION

• ECONOMIC INTEREST
• ACQUIRED BY INVESTMENT
• ANY INTEREST IN MINERALS IN PLACE
• SECURES LEGAL RELATIONSHIP
• INCOME FROM THE EXTRACTION OF MINERALS
• RETURN OF CAPITAL

4
STATUTORY AUTHORIZATION

• SEC. 611 - BASIC AUTHORIZATION
• SEC. 612 - BASIS FOR COST DEPLETION
• SEC. 613 - BASIC AUTHORIZATION FOR
  PERCENTAGE DEPLETION
• SEC. 613A - LIMITS ON PERCENTAGE DEPLETION

5
DEPLETION FOR OIL GAS
PERCENTAGE DEPLETION

NET INCOME
COST
15 X G. I.
LIMIT
DEPLETION
LESSER OF
GREATER OF
DEPLETION BEFORE THE LIMITS
OF SECTION 613A
6
BASIS DEPLETION

B A A I S
YR1 YR2 YR3 YR4 YR5
DEPLETION
7
COST DEPLETION
UNITS SOLD THIS YEAR
BASIS OF PROPERTY AT END OF YEAR
X
UNITS SOLD THIS YEAR
ESTIMATED UNITS AT END OF YEAR

8
COST FORMULA IN TERMS OF DOLLARS(Use with
sub-lease bonus)

9
OIL GAS RESERVES

• ESTIMATED UNITS EXPECTED TO BE PRODUCED
  PROFITABLY
• INCLUDES
• DEVELOPED PROBABLE RESERVES
• IRM
• IF COST DEPLETION APPROACHES OR EQUALS 50 OF
  THE NET TAXABLE INCOME FROM THE PROPERTY OR THE
  COST PER BBL. APPEARS EXCESSIVE...

10
Decline Curve
Production
Time
11
PERCENTAGE DEPLETIONSECTION 613

• GROSS INCOME FROM THE PROPERTY
• REG. 1.613-3(a)
• PRODUCTION TAXES
• TRANSPORTATION COSTS
• DECREASE GROSS INCOME
• (IF CHARGED BY PURCHASER)

12
BONUS EXHAUSTION RULE

• WORKING INTEREST OWNER
• GROSS INCOME
• REDUCE BY PRORATA PORTION OF ANY BONUS PAID
• THEORY PREVENT DOUBLE DIPPING ON DEPLETION
  DEDUCTION
• NO LONGER LOGICAL

13
100 NET INCOME LIMIT

• GROSS INCOME LESS ALL ALLOWABLE DEDUCTIONS
• OPERATING EXPENSES
• LABOR, REPAIRS, SUPPLIES, WORKOVER COSTS, ETC..
• LOSSES
• DEPRECIATION
• OVERHEAD
• IDC
• TAXES

14
1997 Taxpayer Relief Act

• Marginal Properties
• 100 Limit Temporarily Suspended
• For Tax Years
• After December 31, 1997 and
• Before January 1, 2000

15
ATTRIBUTION OF DEDUCTIONS TO PROPERTIES

• ALLOCATE ITEMS THAT ARE DIRECTLY RELATED TO
  EACH PROPERTY TO THAT PROPERTY
• LOE, PRODUCTION TAXES, DEPRECIATION, ETC.
• EXCLUDE ITEMS THAT NEED NOT BE USED CHARITABLE
  CONTRIBUTIONS, OTHER NON BUSINESS ITEMS
• SEGREGATE ITEMS RELATED TO OIL AND GAS
  PRODUCTION BUT NOT DIRECTLY RELATED TO SPECIFIC
  PROPERTIES (INDIRECT COST)
• ALLOCATE BETWEEN PRODUCTION AND NON-PRODUCTION
  ACTIVITIES
• ALLOCATE THOSE ITEMS RELATED TO OIL AND GAS
  PRODUCTION TO INDIVIDUAL PROPERTIES

16
Allocation of costs for the taxable income limit
Non Business Exp.
Indirect business expenses
Indirect Production /Dev. Exp
Non Production/Dev. Exp
Property B
Property C
Expenses Directly Attributable to Specific
Properties
17
DEPLETION ON LEASE BONUS

• NO PERCENTAGE DEPLETION ON LEASE BONUS
• COST DEPLETION ON LEASE BONUS
• COMPUTE COST DEPLETION ON
• LEASE EXPIRES WITHOUT PRODUCTION
• PAYEE MUST RESTORE COST DEPLETION TO BASIS
• AND REPORT IT AS TAXABLE INCOME

18
DEPLETION - PROBLEM 1 Sean Patrick, an oil
operator acquired a lease from Kyle O'Tracy in
19X7. Sean paid Kyle 500 per acre for a 640
acre lease or 320,000 total. Sean also spent
2000 for title work regarding the lease. Prior
to acquiring the lease, Sean spent 10,000 for a
geological survey in this same area. No other
leases were acquired in the area. In June of
19X7, Sean spent 900,000 in drilling and
200,000 in equipping a well on this lease. The
geologist working on the project estimates Sean's
share of the recoverable reserves to be 300,000
barrels at the time the well was completed. In
19X7, 30,000 barrels of oil are produced. Of
this 30,000 barrels, 3,000 barrels were produced
in December of 19X7. Sean did not receive the
payment for the December runs until January 21 of
19X8. The December oil check (received in
January) was for 3000 barrels at 30 per barrel.
Sean is on a calendar year basis. (a) Compute
cost deletion for Sean assuming he is a cash
basis taxpayer. (b) Compute cost
depletion for Sean assuming he is an accrual
basis taxpayer.
19
DEPLETION - PROBLEM 2 In 19X7, Sean Patrick's
share of production from an oil property was
30,000 barrels of oil, which sold for 30 per
barrel (900,000). Expenses attributable to this
property were Lease operating expenses
40,000 Depreciation 44,000 Overhead
26,000 Severance Taxes (7)
63,000 Other direct expenses 27,000
Total 200,000 Sean paid a
bonus of 250,000 for this property last year and
the well was drilled in December of 19X6. There
was no production 19X6. Sean's share of the
recoverable reserves was estimated to be 270,000
at the end of 19X7. Compute Sean's depletion
deduction assuming the 65 of taxable income
limit does not apply. Using the above facts
compute Sean's depletion deduction if he had
drilled a dry hole into the existing formation on
this same property this year. This dry hole cost
was 500,000.
20

DEPLETION - PROBLEM 3 Elizabeth Finley, an
oil operator acquired an oil lease from Kyle
O'Tracy for which she paid Kyle a lease bonus of
24,000. The recoverable reserves under the lease
were estimated to be 100,800 barrels. During
19X7, 10,080 barrels attributable to Elizabeth
were produced and sold for 30 per barrel. The
Sunshine Refinery purchases the oil from
Elizabeth and deducts transportation charges of
.20 per barrel, severance taxes of 5.00 per
barrel. Thus, in 19X7, Sunshine paid Elizabeth a
net amount of 249,984. Depreciation on the
equipment on this property was 7,200 for 19X7.
IDC was 100,000 and operating and overhead cost
was 20,000. Sunshine paid Kyle's royalty
directly to him. Compute Elizabeth's depletion
on this property.
21
DEPLETION FOR MARGINAL PRODUCTION

• INCREASED BY 1 POINT FOR EACH THAT THE
  AVERAGE PRICE OF CRUDE IS LESS THAN 20
• (FOR PRECEDING CALENDAR YEAR)
• FOR INDEPENDENT PRODUCERS ROYALTY OWNERS
• DEPLETION NOT TO EXCEED 25

22
APPLICABLE PERCENTAGE FOR MARGINAL PRODUCTION

• CALENDAR APPLICABLE
• YEAR PERCENTAGE
• 1991 15 PERCENT
• 1992 18 PERCENT
• 1993 19 PERCENT
• 1994 20 PERCENT
• 1995 21 PERCENT
• 1996 20 PERCENT
• 1997 16 PERCENT
• 1998 17 PERCENT

23
MARGINAL PRODUCTION

• CRUDE NATURAL GAS
• FROM DOMESTIC WELLS
• FROM STRIPPER WELL PROPERTY
• FROM HEAVY OIL PROPERTY
• 20 DEGREES API OR LESS

24
STRIPPER WELL PROPERTY
TOTAL AVERAGE DAILY PRODUCTION NUMBER OF WELLS
ON THE PROPERTY

• MUST BE 15 BBLS. /DAY OR LESS
• MUST QUALIFY EACH YEAR

25
EXAMPLE OF STRIPPER WELL CALCULATION
TOTAL PRODUCTION 15,000 BBLS

5,000 BBLS
1,000 BBLS
9.000 BBLS
15,000 BBLS / 365 DAYS 41.09 BBLS / DAY
41.09 BBLS PER DAY / 3 WELLS 13.7 BBLS

PER DAY
PER WELL
26
PARTNERSHIPS S CORPORATIONS

• DEPLETION IS COMPUTED SEPARATELY BY
• 1. EACH PARTNER AND
• 2. EACH SHAREHOLDER

27
SEC. 613A LIMITS

• CANT BE A RETAILER
• CANT BE A REFINER
• CANT GET DEPLETION ON MORE THAN 1,000 BBLS PER
  DAY
• DEPLETION CANT EXCEED 65 OF TAXPAYERS
  ADJUSTED TAXABLE INCOME
• CANT BE FOREIGN PRODUCTION

28
FIXED CONTRACT GAS

• DOMESTIC NATURAL GAS
• SOLD UNDER A FIXED PRICE CONTRACT AS OF FEB. 1,
  1975
• DEPLETION RATE 22
• NO LIMITS FROM SEC. 613A

29
THE VALUE OF PERCENTAGE DEPLETION

• DEPLETION TAX FREE CASH FLOW
• THE TAX FREE CASH FLOW
• 20 PER BBL X 15 X 1,000 BBLS X 365 DAYS
• 1,095,000

30
REFINER

• TOTAL REFINERY RUNS
• 50,000 BBLS ON ANY DAY
• RELATED TO REFINER
• OWN 5 OR MORE OF A REFINER OR
• REFINER OWNS 5 OR MORE OF THE TAXPAYER
• PARTNERS ARE NOT RELATED

31
RETAILER

• SELLS (DIRECTLY OR THRU RELATED PERSON) MORE THAN
  5,000,000 ANNUALLY OF PRODUCT,
• THRU ANY RETAIL OUTLET OPERATED BY TAXPAYER OR
  RELATED PERSON
• RETAIL OUTLET PRODUCT SALES gt 5 OF GROSS
  RECEIPTS
• OR TO PERSONS
• OBLIGATED TO USE TRADE NAME OR TRADE MARK, OR
• TO ONE GIVEN AUTHORITY TO OCCUPY TAXPAYERS RETAIL
  OUTLET
• DONT INCLUDE BULK SALES TO INDUSTRIAL USERS

32
RELATED TO RETAILER?

PRODUCER
RETAILER
5
5
ok
RETAILER
PRODUCER
NEITHER MAY TAKE DEPL.
PRODUCER MAY TAKE DEPL. UNLESS RETAILER
BUYS PRODUCERS PRODUCT
33
TRANSFER OF PROVEN PROPERTY

• BETWEEN 12/31/74 10/12/90
• TRANSFEREE NOT ALLOWED DEPLETION
• AFTER OCT. 12, 1990
• THIS RULE WAS REPEALED
• ON PROPERTIES THAT DEPLETION WAS DISALLOWED
  BECAUSE OF A TRANSFER BEFORE OCT. 12, 1990
• A QUALIFIED TRANSFER IS REQUIRED TO REGAIN
  PERCENTAGE DEPLETION

34
THE 1,000 BBL. LIMIT(THE DEPLETABLE QUANTITY)

• AVERAGE DAILY PRODUCTION
• TOTAL PRODUCTION
• 365 DAYS
• ALLOCATED TO EACH PROPERTY
• 1,000 (DQ) DEPL.
• X ON EACH
• AVE. DAILY PRODUCTION PROPERTY

35
Example
Tentative
BBLs of
Property /BBB x Production x Depl.
Rate Depletion A 20 x
300,000 x 15
900,000 B 20 x 200,000
x 15 600,000 C
20 x 500,000 x 15
1,500,000 Total
1,000,000
3,000,000
1,000,000 bbls 365 days
Ave. Daily Production ( 2,739.726 bbls per day)
1,000 2,739.726
Adjustment Factor
36.5
36
Example Continued
1st Tent. 2nd Tent.
Property Depletion x Adj. Factor
Depletion A 900,000 x .365
328,500 B 600,000
x .365 219,000 C
1,500,000 x .365
547,500 Total 3,000,000
1,095,000
At this point you would go back and check to see
if cost depletion would be used on each property.
37
RELATED PARTIES

• ALLOCATE THE DEPLETABLE QUANTITY (1,000 bbls per
  day) BETWEEN RELATED PARTIES (BASED ON RELATIVE
  PRODUCTION)
• COMPONENT MEMBERS OF CONTROLLED GROUPS
• BUSINESSES UNDER COMMON CONTROL
• FAMILY MEMBERS

38
CONTROLLED GROUP

• PARENT SUBS - gt 50 CONTROL
• MUST SHARE ONE DEPLETABLE QUANTITY

P
CORPORATIONS P, A, B ARE RELATED AND
MUST SHARE A DEPLETABLE QUANTITY
40
70
55
A
B
C
39
BUSINESS UNDER COMMON CONTROL

• 50 OR MORE OF INTEREST IN 2 OR MORE CORPS.,
  TRUSTS, OR ESTATES OWNED BY SAME OR RELATED
  PERSONS
• TAKE INTO ACCOUNT ONLY PERSONS WHO OWN AT LEAST
  5

40
BUSINESS UNDER COMMON CONTROL
5 or more owners

60
55
A
B
THE DEPLETABLE QUANTITY OF 1,000 BBLS. PER DAY IS
ALLOCATED TO A AND B - IN PROPORTION TO THEIR
TOTAL PRODUCTION
41
FAMILY MEMBERS

• INCLUDES TAXPAYER, SPOUSE AND
• MINOR CHILDREN

42
65 LIMIT

• DEPLETION MAY NOT EXCEED 65 OF ADJUSTED
  TAXABLE INCOME
• ADJUSTED TAXABLE INCOME
• TAXABLE INCOME ADJUSTED FOR
• PERCENTAGE DEPLETION
• NOL AND CAPITAL LOSS CARRYBACK
• DISTRIBUTIONS OF TRUSTS

43
STEPS IN COMPUTING DEPLETION

• COMPUTE DEPLETION AS IF 65 LIMIT DID NOT APPLY
• COST DEPLETION
• 15 OF GROSS INCOME
• 100 OF NET INCOME LIMITATION
• IF 1,000 BBL. LIMIT APPLIES
• ALLOCATE THE 1,000 BBLS PER DAY AMONG EACH
  PROPERTY

44
COMPUTE ADJUSTED TAXABLE INCOME

• TAXABLE INCOME PLUS
• ALL DEPLETION ON THE RETURN UP TO THIS POINT
• NOL CAPITAL LOSS CARRYBACKS
• TRUST DISTRIBUTIONS TO BENEFICIARIES
• COST DEPLETION (IF USED DUE TO THE 1000 BBL LIMIT

45
COMPUTE 65 LIMIT

• 65 X ADJUSTED TAXABLE INCOME
• ALLOCATE TO EACH PROPERTY BASED ON RELATIVE
  DEPLETION
• ANY DEPLETION NOT USED
• IS CARRIED OVER AND USED WHEN THE 65 LIMIT DOES
  NOT APPLY

46
65 Limit Computation
Step 1 - Compute depletion before applying Sec.
613A Cost 15 of 100 of 1st Prop.
Depl. Gross I. Net Inc. Tentative 1
1,000 6,000 4,000 4,000 2 0
7,000 9,000 7,000 3 1,000
5,000 4,000 4,000 4
5,000 5,500 9,000
5,500
TOTAL 20,500 Prior to
applying the 65 limit, the depletion deduction
is 20,500

47
Step 2 - Compute the 65 Limit

• Taxable Income
  (4,731)
• Add depletion from step 1 20,500
• Adjusted Taxable Income 15,769
• 
  X 65
• 65 Limit
  10,250

First Adjustment Factor
10,250 20,500
50
48
Apply the 1st Adjustment Factor

• 50
• Cost 1st Adj.
  Cost 2nd
• Prop. Depl. Tentative Factor
  Shift Tentative
• 1 1,000 4,000 2,000 No
  2,000
• 2 0 7,000
  3,500 No 3,500
• 3 1,000 4,000 2,000
  No 2,000
• 4 5,000 5,500
  2,750 Yes 5,000c
• Percentage
  Depletion 7,500

Remember we are allowed to deduct 10,250
of percentage depletion this year. After this
computation we have only 7,500 due to the cost
shift on Prop. 4
49


50 Cost 1st Adj.
Cost 2nd Prop. Depl. Tentative
Factor Shift Tentative 1
1,000 4,000 2,000 No
2,000 2 0 7,000
3,500 No 3,500 3 1,000 4,000
2,000 No 2,000 4
5,000 5,500 2,750 Yes
5,000c Dep. 15,000
7,500

50
2nd Adjustment Factor
Reallocate the 10,250 of allowable
depletion between properties 1, 2, and 3.

2nd Adjustment Factor 10,250 / 15,000 68.3

68.3 Cost 1st Adj.
Allow Depl. Prop. Depl. Tentative
Factor Depl. C/O 1
1,000 4,000 2,733 2,733
1,267 2 0 7,000
4,784 4,784 2,216 3 1,000 4,000
2,733 2,733 1,267 4
5,000 5,500 5,000c
5,000c 500
20,500 15,250 5,250