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Drill deep for tax breaks in oil and gas funds

by on
in Small Business Tax Deduction Strategies

Who says there are no great “tax shelters” left for investors?

Strategy: If you can bear the risk, you can invest in oil and gas drilling funds. Investors can qualify for a special up-front tax break: the deduction for intangible drilling costs. A dollar invested now might provide a deduction of 50 cents, 70 cents or even 90 cents this year.

In drilling funds, investors pool their money, which is used by a driller to hunt for oil, natural gas or both.

As with other types of partnerships, public drilling funds are composed of many investors who may contribute tens of millions of dollars to drill in several places. In private drilling funds, a few wealthy investors make larger commitments, but the total amount raised winds up being smaller.

In either case, you may benefit from two prime tax shelters:

  1. In the first year or two, from a deduction for intangible drilling costs (IDC)
  2. Over the life of the venture, from an allowance for “percentage” depletion.

Net result: Thanks to intangible drilling-cost deductions, an investor may receive a large up-front deduction to shelter other income. And ongoing revenues from selling the oil and gas will be partially sheltered from tax by the percentage depletion deduction. (A special provision in the tax code allows oil and gas intangible drilling costs to be deducted up front without regard to the dreaded “passive loss” rules as long as the drilling entity is not a limited partnership.) Investors can usually expect first-year write-offs of anywhere from 50% to 90% of the investment. In some cases, payments for the investment are made over several years.

Example: Strike It Rich Fund (SIRF) raises $10 million. After all costs, $8.5 million is spent on drilling the first year. Of that $8.5 million, $8 million is deductible, thanks to the IDC write-off. Normally, it takes awhile for oil and gas to be “lifted” and sold. Thus, SIRF may have no income in its first year. With $8 million in tax deductions and zero in income, it reports an $8 million loss for the year.

That loss is passed through to the investors who put up the $10 million. Thus, each investor can report a loss of 80% of the contribution. A $10,000 investor would get an $8,000 tax loss. However, to get the initial write-off, individuals can’t invest as limited partners. Many drilling funds are structured so investors are general partners, or investors may enter into a joint venture.

Caution: There are risks attached to the deal. Theoretically, investors are exposed to all the obligations of the drilling fund. If some kind of drilling disaster occurs, you could be liable for damage awards.

Typically, the sponsor will try to reduce those risks. A multimillion-dollar insurance policy will be in place; someone else will put his assets on the line before those of the investors. Probably, there will be a plan for investors to convert to limited partners after the drilling is done and tax deductions are no longer needed.

What if you don’t want to assume the extra liability? They might invest as a limited partner. In that case, you’re participating in a passive activity and can’t deduct the losses immediately unless you have passive income from other sources. Instead, the losses will be carried forward to offset income from the drilling fund. Thanks to the loss carry-forward, any drilling fund income (assuming there is some) may be sheltered for several years.

If the drilling is successful, revenues will start to flow to investors. That’s where percentage depletion comes in. If oil and gas is discovered and produced, you can deduct 15% of the gross revenues. That’s what’s meant by percentage depletion. An investor might shelter 20% to 25% of drilling fund net revenues with the depletion write-off.

Tip: Percentage depletion continues as long as income is being received. Because percentage depletion deductions aren’t limited to amount invested, you can potentially shelter more than you invested.

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