Oil Gas And Energy

<div class="Section1">In the case of &ldquo;natural gas from geopressured brine&rdquo; (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7874">7874</a>), the applicable percentage rate is 10 percent.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 613A(b)(2).<br /> <br /> </div></div><br />

<div class="Section1">Yes, in two ways. First, a limited partner&rsquo;s tax basis in the partnership interest is <em>increased</em> by the excess of the deductions for depletion over the basis of the property subject to depletion. (This can occur only when percentage depletion is taken.)<a href="#_ftn1" name="_ftnref1">¹</a> However, Treasury Regulation Section1.705-1(a)(2) provides that the previous rule does not apply in the case of oil and gas property the basis of which is allocated to and computed separately by the partners of the partnership owning such property under IRC Section613A(c)(7)(D) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7872">7872</a>). Second, the limited partner&rsquo;s tax basis in the partnership interest is <em>reduced</em> (but not below zero) by the amount of allowable depletion deductions for each tax year.<a href="#_ftn2" name="_ftnref2">²</a> The basis was not reduced due to depletion deductions calculated at the electing large partnership level (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a>).<a href="#_ftn3" name="_ftnref3">³</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 705(a)(1)(C); Treas. Reg. &sect; 1.705-1(a)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 705(a)(3); Treas. Reg. &sect; 1.613A-3(e)(6)(ii).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 776(a)(3), prior to repeal.<br /> <br /> </div></div><br />

<div class="Section1">No.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 721(a); Treas. Reg. &sect; 1.721-1.<br /> <br /> </div></div><br />

<div class="Section1">It is not completely clear whether the &ldquo;at risk&rdquo; rules will ever operate to disallow the percentage depletion deduction. Some authorities suggest that percentage depletion is deductible regardless of an individual&rsquo;s amount at risk. These authorities point out that the conference committee report and effective date provisions of the Tax Reform Act of 1976 specifically mentioned depreciation and amortization, but omitted any reference to depletion. Furthermore, Proposed Treasury Regulation Section1.465-1 provides that a taxpayer&rsquo;s amount at risk in an oil and gas limited partnership is to be increased by the excess of the deductions for depletion over the basis of the property subject to depletion. As this appears to allow percentage depletion even if the taxpayer has no other amount at risk, the authorities question whether a deduction for percentage depletion should also be allowed in early years when percentage depletion does not exceed the basis of the property and the taxpayer has no other amount at risk in the partnership.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. See, e.g., Haft, <em>1984 Tax Sheltered Investment Handbook</em> (Clark Boardman Company, Ltd.), at5-6.<br /> <br /> </div></div><br />

<div class="Section1">The depletion allowance is a formula for computing and excluding (i.e., by way of income tax deductions) from the proceeds of mineral operations the portion of the proceeds which represents a tax-free return of an investor&rsquo;s capital.<a href="#_ftn1" name="_ftnref1">¹</a> In other words, the depletion allowance is an income tax deduction that compensates the owner of wasting mineral assets (e.g., oil or gas) &ldquo;for the part exhausted in production, so that when the minerals are gone, the owner&rsquo;s capital and his capital assets remain unimpaired.&rdquo;<a href="#_ftn2" name="_ftnref2">²</a> Depletion is similar in concept to depreciation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="716">716</a>).<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. See <em>Jefferson Lake Sulphur Co. v. Lambert</em>, 133 F. Supp.197 (E.D. La. 1955), <em>aff&rsquo;d</em>, 236 F.2d 542 (5th Cir. 1956).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. <em>Paragon Jewel Coal Co., Inc. v. Comm.</em>, 380 U.S. 624 (1965).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Percentage depletion is generally available to individuals (including limited partners) who qualify as &ldquo;independent producers or royalty owners&rdquo; (i.e., certain &ldquo;small producers&rdquo;) and to individuals who own a depletable interest in (1) certain domestic regulated natural gas, (2) domestic natural gas sold under certain fixed contracts, and (3) certain domestic natural gas produced from geopressured brine.<a href="#_ftn1" name="_ftnref1">¹</a> (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7872">7872</a> regarding calculation of depletion in the case of an electing large partnership.) The IRC formerly prohibited certain transferees of an interest in a &ldquo;proven&rdquo; oil or gas property from using the small producer&rsquo;s percentage depletion method; however, for transfers occurring after October11, 1990, this limitation generally does not apply.<a href="#_ftn2" name="_ftnref2">²</a> (See Treasury Regulation Section1.613A-3(i)(2) regarding &ldquo;transfers&rdquo; and &ldquo;transferees&rdquo; in the context of &ldquo;proven&rdquo; properties and, also, for examples illustrating the effects of the old and new rules on the transfer of such properties.)<br /> <br /> Percentage depletion is available under IRC Section613(b) with respect to certain minerals (other than oil and gas) recovered from an oil or gas well, without regard to the restrictions on oil and gas contained in IRC Sections 613(b)(7) and 613A.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect;&sect; 613A(b), 613A(c); Treas. Reg. &sect; 1.613A-3.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 613A(c)(9), prior to amendment by OBRA &rsquo;90.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. <em>Louisiana Land and Exploration Co. v. Comm.</em>, 90 TC 630 (1988), <em>nonacq. at</em><strong>1995</strong> C.B. 1 (IRS 1995).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> No. Percentage depletion is not available with respect to advance royalties or lease bonuses.<a href="#_ftn1" name="_ftnref1">¹</a> Prior to TRA &rsquo;86, gross income received in the form of advance royalties or lease bonuses was eligible for percentage depletion by a &ldquo;small producer&rdquo; (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7878">7878</a>) even though no oil or natural gas had as yet been extracted from the ground (the &ldquo;<em>Engle</em> rule&rdquo;).<a href="#_ftn2" name="_ftnref2">²</a> According to the Service, however, this depletion deduction had to be taken in the year in which the lease bonus or advanced royalty payment was includable in the gross income of the taxpayer.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If the economic interest in the property expires, terminates, or is abandoned before income has been derived from production (in the case of a lease bonus), or before the royalty has been recouped from production (in the case of an advanced royalty), the taxpayer is required to adjust the capital account by restoring any excess depletion deduction taken under the <em>Engle</em> rule and to include the excess in income in the year the expiration, termination, or abandonment occurs.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 613A(d)(5).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. <em>Comm. v. Engle</em>, 84-1 USTC &para; 9134 (U.S. 1984).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. &sect; 1.613A-3(j)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. &sect;&sect; 1.612-3(a)(2), 1.612-3(b)(2).<br /> <br /> </div></div><br />

<div class="Section1">The applicable percentage in the case of a depletable property that qualifies as &ldquo;regulated natural gas&rdquo; or &ldquo;domestic gas sold under fixed contract&rdquo; (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7874">7874</a>) is 22 percent.<a href="#_ftn1" name="_ftnref1">¹</a> Thus, 22 percent of the &ldquo;gross income&rdquo; received from the property is the amount allowable as percentage depletion.<a href="#_ftn2" name="_ftnref2">²</a> Remember, however, that the amount which must be deducted as the depletion allowance on a specific property is the <em>greater of</em> the percentage depletion or cost depletion (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7873">7873</a>).<a href="#_ftn3" name="_ftnref3">³</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 613A(b)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 613(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 613(a).<br /> <br /> </div></div><br />

<div class="Section1">Gain from the disposition of an interest in an oil or natural gas property is treated as ordinary income (&ldquo;recaptured&rdquo;) to the extent that depletion deductions reduced the adjusted basis of the oil and natural gas property.<a href="#_ftn1" name="_ftnref1">¹</a> Taxation of the recaptured amount may be deferred through use of an installment sale. However, income (other than interest) from an installment sale of an oil or natural gas property is treated as recaptured IRC Section1254 gain until all such gain is reported, and any remaining income is then treated as other than IRC Section1254 gain.<a href="#_ftn2" name="_ftnref2">²</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 1254.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. &sect; 1.1254-1(d).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The two deductions that are particular to oil and gas programs (and certain other extractive industries) and which provide the major incentives for investing in an oil or gas limited partnership are (1) the deductions for intangible drilling and development costs (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7866">7866</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7869">7869</a>), and (2) depletion (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7870">7870</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7884">7884</a>). Of course, subject to certain limitations (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7862">7862</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7865">7865</a>), deductions for interest, taxes, depreciation, and operating expenses <em>may</em> be passed through and deducted by the limited partner. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the new interest deduction rules imposed by the 2017 tax reform legislation.<br /> <br /> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a> regarding electing large partnerships.<br /> <br /> </div><br />