Would you be excited as an investor if you had the chance to invest a sum of money late in the tax year and yet deduct almost your entire investment as a business expense in the year you invested? Not only that, but the deduction would offset your other self-employed income for self-employment (SE) tax purposes. Better still, the deduction/loss would not be limited as a passive loss. Finally, when the business investment begins to payoff, the resulting income is subject only to regular income tax and is not considered self-employment income. This “have your cake and eat it too” result can be accomplished with the right type of investment and proper planning. Such an opportunity exists in the oil and gas industry.
The appeal to an operator planning to drill for oil or gas is that he can offer potential investors significant tax benefits along with the opportunity to share in the actual results of the exploration and production activity. This could be the deciding factor when the potential investors are deciding where to put their money.
The Internal Revenue Code (IRC) provides several incentives to the oil and gas industry to encourage investment in and development of oil and gas exploration activities. One of the more significant incentives is the ability for investors to deduct the portion of the costs incurred in the drilling operation that are deemed intangible drilling costs (IDC). There are, however, certain requirements that must be met for the taxpayer to be able to claim the IDC deduction.
Requirements to Claim IDC Deductions
First, since IDCs are paid for by working interest owners, it goes without saying that the investor must have a working interest in the property. Sole proprietors, participants in joint ventures, partners in partnerships and shareholders in subchapter S corporations are deemed to own their respective shares of whatever assets are owned by the entity. Therefore, working interests held by one of these entities would be considered to be owned in part by the investors. This is in contrast to shareholders in regular C corporations who are not considered to own a share of the entity’s assets. As a result of being considered the owner of a working interest you are deemed to be engaging in a trade or business. This means those losses/deductions can offset other SE income currently.
Second, the taxpayer must be considered an active participant in the venture to be able to avoid running afoul of the passive activity rules of IRC Section 467. Those rules generally restrict a taxpayer’s ability to deduct losses from activities that he is not actively participating in. Active participation usually requires a taxpayer to spend a significant amount of time in the activity and/or take part in significant operating decisions. This is normally a major problem for most investors since they lack the time and/or talent required to be classified as active participants. Luckily, IRC Section 469(c)(3)(A) states that when a taxpayer holds a working interest either directly or indirectly through an entity that doesn’t limit his liabilities with respect to that interest, the activity will not be considered passive and the related losses/deductions will not be limited by these rules. It is important to note that the requirement that the taxpayer’s liability not be limited eliminates the use of subchapter S corporations, limited partnerships and limited liability companies. For the most part, this means you would want to structure it as either a joint venture (electing to be taxed as a partnership) or a general partnership.
Expenses, Timing and Taxes
So to this point, you have carefully chosen to conduct this operation as either a joint venture or general partnership. The general rule for income tax reporting purposes is that expenses are deducted only when economic performance has occurred. This usually means that you may only deduct the costs for events that have already happened in the tax year. This would seem to be a problem when the investors put up money late in the tax year. How can you drill all the wells you raised money for in only a month or two before the end of the current year? The answer hinges on another unique aspect of the oil and gas industry.
IRC Section 461(i)(2)(A) provides a solution to this timing problem. It states that amounts paid for IDC during the tax year are treated as deductible in the current year as long as actual drilling begins within the first 90 days of the following year. This means that when you pay a third party for drilling a well in year one and the actual drilling is begun by the ninetieth day of year two, that amount of drilling costs will be deductible in year one.
Having established that the taxpayer can make an investment late in the year, get a current year deduction which offsets both regular tax and self-employment tax and those losses will not be limited by the passive activity rules, it only remains to be seen how future net income can be earned and not be subject to SE tax.
If the operation continues to operate as a joint venture or general partnership, the income earned will be taxed as ordinary income and will be subject to the SE tax as well. The final step necessary to achieve all the tax benefits mentioned involves taking advantage of the fact that the owners in a joint venture can choose to form a limited partnership at any time to conduct future business. Similarly, general partners can choose at any time to convert from a general partnership to a limited partnership (“LP”) with no adverse tax consequences. Once it is determined that there will be no further significant expenditures for IDC, the formation or conversion of an LP can take place. Earnings of the investor after the conversion to an LP will be excluded from future SE tax calculations under IRC Code 1402(a)(13).
There are numerous issues to consider before adopting this type of structure that are not addressed here. This article is intended merely to demonstrate that proper planning can make major differences in outcomes when it comes to income taxation of oil and gas operations.