In 2014, The oil and gas industry posted new record-shattering numbers which included $15.7 billion in state, local, and royalties. The highest amount of dollars ever recorded in state history. It is also the highest taxes paid by state in any industry.
So how come the nation’s largest producer have a continued rise in paying corporate taxes while having a decline in oil and gas taxes contributed? It’s because the oil and gas industry has a domino effect where it stimulates the economy for job growth and has catapulted the growth of supporting industries at the same time. This is why the government gives the oil and gas industry such great tax breaks. It’s because this industry stimulates the economy in so many different areas that it increases the overall money the government keeps in their pocket. Pretty clever America.
When oil well investing is involved, there are healthy tax-advantaged drops for smart investors. 1 investment category continues to be an outlier for outperforming all other commodities in the long-term. Can you guess? (Duh, pretty obvious, I know) It’s oil! With the U.S. government’s support, North American oil and gas production has kick started a bundle of tax incentives for investors and well producers.
Some major tax breaks are offered for oil and gas investors can’t be found any where else in the IRS tax codes.Now, imagine this complete guide sparks the fire inside you to get even more simple insights to investing that will boost your portfolio by at lease 2x once you understand how to use the right oil and gas financial strategies.
(Company man supervising tool going into the well.)
Strike Oil The main perks of prepared investments in oil include:
Intangible drilling costs: These can be anything besides the actual drilling tools. Manpower, drilling fluids, mud, greasers and other materials are also going to be intangible drilling costs. These costs are roughly 65-80% of the complete price of drilling the well and 100% deductible within the same year. For instance, if it costs $400,000 to drill the well, and it was forecasted that 75% of that price is considered intangible, the financier(s) of the well would receive a current deduction of $300,000 ($400,000 * 0.75). Also, it DOES NOT MATTER whether or not the well even produces or hits oil. As long as it starts to work by March 31st of the year after, then the tax breaks will be permitted.
Tangible drilling costs: Tangible prices are the direct expense of the drilling tools. These costs are 100% deductible. However, they should have depreciated in value after 7 years. Let’s say we use the example above of $75,000 and if you apply direct expense to the $75,000 this remaining cost can be written off in 7 years.
Small producer tax exemptions: This is usually the best tax advantage option for smaller producers and investors. This feature, that is called “depletion deduction,” removes 15% of all gross earnings from the wells. This exclusive benefit is only available to alone to small producers and investors. A business that produces or processes over 50,000 barrels of oil per day is not eligible. Companies that own over 1,000 barrels of oil per day, or 6,000,000 cubic feet of gas per day are removed from eligibility as well.
Active income vs. Passive income: This tax rule explains that a working interest (instead of a royalty interest) in a well isn’t a passive interest. This implies that every net loss is active income, which is dependent on well production. Unfortunately, this can throw off other sorts of earnings like wages, interest, and financial gains.
Lease costs: These represent the acquired lease and mineral rights, lease operational expenses, administrative costs, legal counsel, and accounting expenses. These expenses are 100% written off within the same year they’re sustained.
Alternative minimum tax: All the rest of the intangible drilling prices are excused as a “preference item” on the alternative minimum tax return.
Developing energy infrastructure: This list of deductibles points out the magnitude of importance the U.S. government is emphasizing on the expansion of the North American oil and gas industry. This statement by the government is urging potential investors by giving opportunities to to these wealthy individuals without tough requirements on net worth before proceeding forward investing. Which means that the richest investors can invest in oil and gas market and have all of the advantages mentioned above. However, the investors must limit their production of oil to 1,000 barrels per day. There is no other industry out there for investing that can compete with the massive amount of benefits that are at an investor’s grasp in the oil and gas market.
Opportunities in oil and gas: There are many different options that are available for oil and gas investors. They are in 4 major funnels: mutual funds, partnerships, royalty interests, and business interests. every one of these funnels represent a risk percentage and different rules for taxes.
Working Interests: This is the riskiest and most collaborated approach with others out of all oil and gas investing. Every earning received of working interests is reported to Schedule C of the 1040. It’s self-employed earnings and is processed as self-employed tax, which is then subject to self-employment tax, most investors who engage in working interests already have earnings well above the taxed wage base for Social Security. Working interests aren’t securities so there is no need for a license if wanting to sell. This venture is a general partnership, so each investor in this partnership has infinite liability. A Gentlemen’s Agreement contract is usually how these partnerships are bought and sold.
Royalties: This is the money received by landowners where oil and gas wells are drilling. These earnings are “off the top” of the gross revenue obtained from the wells. Landowners receive a 12-20% cut of the total production of the well (owning land that contains oil or gas underneath will make you rich overnight.) Landowners also do not have any liability with what happens with the oil or gas well. However, these owners are ruled out from the tax breaks enjoyed by those that own working or partnership interests. All royalty earnings are reportable on Schedule E of kind 1040.
Partnerships: Many different partnerships can be utilized for oil and gas investing. Limited Partnerships are formed the most, as they restrict the risk of the entire project to the amount of money invested by the partner. These investments are sold on the market as securities and should be authorized by the Securities and Exchange Commission (SEC). The tax benefits mentioned above are available on a pass-through basis. The partner(s) will be issued a K-1 form every year with the share included in the revenue and expenses.
Mutual funds: This financial gain option has the least amount of risk for the partner investing, but it does not give the investor any of the tax breaks mentioned above. Investors pay taxes on all dividends and financial gains just like other funds.
Net revenue interest (NRI): Every project that is being worked on regardless of the amount earned and shares sorted by investor, is separated into 2 categories: Gross revenue & Net revenue. Gross revenue is the amount of barrels or cubic feet produced per day. Net revenue subtracts the royalties paid to the landowners and the severance tax on minerals that’s recorded by the state. The worth of a royalty or worker’s interest during a project is measured by the various amount of barrels of oil or cubic feet of gas produced daily. For instance, if a project is generating 20 barrels of oil per day and the market is $10,000 per barrel (there are so many different variables that play into the price per barrel of oil, just watch The News and hear about how there’s a new war about to start because of it), then the total cost of the project is going to be $200,000.
Now let’s say the price per barrel of oil is $90 (Oh yeah, big checks!), severance taxes at 8% and net revenue interest (worker’s interest proportion issued when royalties are compensated) is at 75%. The wells are generating 20 barrels of oil per day, that involves $1,800 per day of gross production. Now, multiply your number by 30 days to get your monthly production and BOOM! The number in this case will be $54,000. Finally, to calculate the net revenue, subtract 25% from $54,000, which give us $40,500 before severance tax paid.
Now let’s take the severance tax of 8% and take the net revenue of $40,500 to calculate our net revenue of ($40,500 * 0.08) $37,260 per month or $447,120 per year. However, all operational expenses and added drilling expenses has to be paid out of these total earnings calculated. Additionally, the well owner could solely receive $130,000 earnings from the project each year if there are no new wells drilled. Also, if new wells happen to be drilled, they will have a massive tax break and potentially more well production for their existing well projects.
The Bottom Line From a tax perspective, oil and gas investments are built for setting you up for financial freedom. We know they’re risky, because finding a well that produces consistently in the long-term is hard to come by and everybody would be doing it, right? That’s why the SEC requires investors for oil and gas partnerships of any kind to be accredited to meet certain earnings and net worth prerequisites. And what about those qualified people who are approved to move forward with investing in a well? They know exactly which cards to play to give them their desired ROI due to the knowledge of tax regulations and government incentives that they have learned to leverage their edge in the oil and gas industry.
(Workers loading a tool down an oil well.)
Tax Benefits for Joint Venture Interests
Unique tax benefits in the oil and gas industry you may not know.
100% deduction of beginning capital within the year of investment (IDCs) 100% deduction of all money invested within 7 years, gain or loss (TDCs) Limited tax incurred from returns, a small amount of oil and gas returns are tax free (Depletion Allowance)
There are plenty of tax incentives that are at the finger tips of approved investors that are involved in JV’s. For instance, this law states drilling costs and production earnings presently provide tax breaks with most partners potentially deducting 100% against their own earnings.
Just check with a tax professional that can get you the detailed tax info you need before you begin investing.
Key tax edges below this law include:
Intangible drilling costs (IDC) – IDCs are 100% written off within the year the costs are incurred. Another option is that every partner can vote to amortize. Oil and gas companies can expense 65%-80% and 30% of these expenses must be amortized over a 60 month period.
Intangible completion costs (ICC) – ICC are fully written off once the partnership incurs the cost.
Lease and well equipment costs (L&W) – Equipment costs are 100% depreciated over 5-7 years depending on the type.
Business expenses – These are legal charges incurred to arrange a start-up operation venture.
Prospect expenses – These expenses can be depreciated and amortized over 2 years.
Syndication expenses – Syndication expenses should be financed and is deducted as a financial loss upon discontinuation of a venture.
Lease operation costs – Lease operation costs begin once a well is generating oil or gas. Costs are subtracted from revenue and are fully written off.
Depletion deduction – There’s a write off for access of qualifying statutory depletion. Basically 15% of the gross earnings from the well is reimbursed.
Net revenue from producing well – Net revenue from a well that’s in production is considered operational earnings. It’s not categorized as passive activity. It is established as self-employment income (schedule C). The current self employment tax: 15.3%
Alright! Now you should have an easier grasp of what it’s like investing in oil wells with some terminology to use at some meetings to have an intense debate with some C-level E&P executives. I wrote this article because I want to simplify the advantages of starting an oil and gas venture. This is just the beginning to get your mind to shift gears about how reasonably accessible it is to invest in such a bankrolling and roaring industry. The goal of this simple oil and gas tax guide will give you the upper hand to position yourself to hopefully further your education to working with a few well projects in the future, developing lasting relationships with oil and gas leaders that view you as a well expert, and the starting stages to spark interest to further your career. Professionals will value your insights.