Major Tax Issues are Depreciation and Depletion

1
Major Tax Issues are Depreciation and Depletion

• Capitalized costs to deplete
• Lease bonus and legal costs
• GG
• Possibly IDC
• Delay rentals if not elected to expense (year by
  year, lease by lease)
• Costs to depreciate major areas
• Lease well equipment
• Tank batteries
• Transportation equipment

2
Allocation of GG Costs

• Allocate reconnaissance GG to areas of interest
  (equally)
• Within an area of interest, allocate detailed
  survey costs based on net acreage acquired by
  lease
• If acreage abandoned, write off, otherwise add to
  depletion base
• See Problem 10-1

3
Problem 10-1 Area 1

• Allocate reconnaissance GG to areas of interest
  (equally)
• 21,000 / 3 7,000
• 55,000 7,000 62,000
• Within an area of interest, allocate based on net
  acreage acquired by lease
• Lease A 1,000 X 100 1,000 20,667
• Lease B 3,000 X 50 1,500 31,000
• Lease C 2,000 X 25 500 10,333
• Total net acreage 3,000 62,000

4
Problem 10-1 Area 2

• Allocate reconnaissance GG to areas of interest
  (equally)
• 21,000 / 3 7,000
• 60,000 7,000 67,000
• 67,000 allocated to Lease D

5
Problem 10-1 Area 3

• Allocate reconnaissance GG to areas of interest
  (equally)
• 21,000 / 3 7,000
• 70,000 7,000 77,000
• The 77,000 allocated to Area 3 may be deducted
  since no leases were acquired

6
Intangible Drilling Costs

• We will not delve into the minutia of classifying
  costs as IDC
• Taxpayer may make an election to expense IDC for
  income tax purposes
• Election is to be made in a timely filed return
• Even without election, IDC is deductible if it
  results in a dry hole
• Integrated producers must capitalize 30 of IDC
  and amortize over 60 months
• Refinery runs exceed 50,000 bbls on any one day
  in the year
• Sells more than 5,000,000 in oil, gas, or other
  products through a retail outlet during year

7
IDC Deduction Problem 10-2

• Dry exploratory well 100,000 May 1
• Dry development well 200,000 May 1
• Successful expl well 250,000 May 1
• Water injection well 270,000 Aug 1
• Deepening a well (S) 80,000 Aug 1
• Workover, minor 50,000 Aug 1
• If independent, deduct all but 50,000 workover

8
IDC Deduction Problem 10-2 (Contd)

• If integrated producer
• Deduct dry hole expense 300,000
• Of the next three, deduct as IDC 70, or 420,000
• Successful exploratory well 250,000
• X 30 75,000 75,000 X 8/60 10,000
• Water injection well
• 270,000 X 30 81,000 81,000 X 5/60 6,750
• Deepening a well (S)
• 80,000 X 30 24,000 24,000 X 5/60
  2,000
• Total 738,750

9
Depreciation Under MACRS

• Lease well equipment is 7 year property and
  would be depreciated using DDB, HY, no salvage
  with switch to SL when greater (also office
  furniture)
• Transportation equipment is generally 5 year life
  with DDB, HY, no salvage
• Gas plant is real property with 39 year SL
  half-month, no salvage

10
Depreciation Under MACRS

• The taxpayer may elect to use SL method (HY no
  salvage) on additions in a particular class in a
  year
• The taxpayer may also elect to use
  units-of-production (though not commonly done)

11
Depreciation of Lease Well Equipment

• Well 1 was equipped at a cost of 50,000 0n
  March 1, 2005
• 2005 Depreciation
• 50,000 X 2/7 14,286
• 2006 Depreciation
• (50,000 - 14,286) X 2/7 10,204

12
Depletion

• Allowable depletion is greater of (1) cost
  depletion or (2) percentage depletion

13
Computing Depletion

• Compute cost depletion by property
• Current production/reserves at BOY X Undepleted
  costs
• Compute percentage depletion by property
• Lesser of (1) 15 of sales or (2) net income from
  property (before depletion)
• Overall depletion is limited to 65 of
  taxable income of the entity

14
65 Limitation - Problem 17

• Gross sales (2,300 x 365) 839,500
• (1)15 of sales (15 x 839,500) 125,925
• (2)Net income from property limit 325,000
• Lesser of (1) or (2) 125,925
• 65 limit
• 800,000 x 65 520,000
• Allowed depletion is 125,925

15
Recapturable IDC Depletion

• Omit this topic on 379-382
• Omit HW problem 3 and 10

16
Enhanced Oil Recovery Credit

• Omit this topic on p. 382

17
Lessors Transactions

• Capitalize acquisition costs
• May have purchased royalty
• Allocate to surface and minerals if purchased in
  fee
• Income transactions
• Delay rentals received
• Lease bonus
• Royalties may take depletion