51. Oil and Gas Drilling Programs

An oil or gas tax shelter may be structured in a variety of forms that permit the passthrough of tax benefits directly to the individual investors. Although some truly complex, multithread entities have evolved, the usual structure is the limited partnership.

The first step in an oil and gas venture is the preliminary exploration that identifies potential oil or gas locations. Once potential sites are located, more intensive surveys must be made. In order to conduct these surveys, the oil operator may either pay the landowner a nominal amount for exploration rights, or, as is frequently the case, acquire an oil and gas lease before making the survey. The lease gives the operator the right to make the necessary surveys as well as to develop any deposits that are actually located.

The interest acquired by the lessee in the oil and gas is called the working interest, and it gives him or her the right to locate a well site, perform the drilling operations, and to remove any oil and gas found. The owner of the working interest bears the burden of all costs of the
operation. The lessor, in addition to a specific bonus payment per acre and specific delay rental per acre until production, usually receives a royalty interest that entitles him or her to a fraction of all oil and gas produced or its cash value. Of course, the owner of oil and gas property may undertake development himself or herself.

The tax shelter of oil and gas drilling programs is primarily a conversion shelter in that most, if not all, of the original investment cost can be written off as intangible costs are incurred, usually in the year the investment is made. These deductions offset an equal amount of ordinary income, as a deferral. When a well is brought in, the participation interest can be sold at favorable capital gain rates, or, if the interest is held by the investor, the income from the well will usually be sheltered in part by percentage depletion under IRC 613A

Tax Advantages in Oil and Gas Operations - The tax advantages that make oil and gas ventures attractive for both operators and investors include the following.

Costs That Are Deducted as Incurred: Among the expenditures that may be deducted as incurred are:

(1) Intangible drilling costs;

(2) Lease rentals; and

(3) Cost of general exploration not related to an area of interest.

Costs That Are Capitalized but Deducted When Property Is Abandoned:

Lease acquisition costs and exploration costs, including such items as geological and geophysical studies, on nonproductive properties.

Costs That Are Capitalized and Deducted Through Depreciation: These are generally the costs of the physical equipment actually used to drill an oil or gas well, raise the oil or gas to the surface, and deliver it to the purchases.

Costs That Are Capitalized and Deducted Through Cost Depletion:

Exploration costs and lease acquisition costs on productive properties (not available if percentage depletion produces large deductions).

Depletion: The owner of an economic interest in an oil or gas property can deduct each year the greater of cost depletion or percentage depletion.

Disadvantages of Oil and Gas Programs - Despite the extremely high returns that are possible, oil and gas drilling funds have some substantial disadvantages. Among them are the following.

(1) Economic Risk Is Very High: The odds are that any given investment will produce no return. Thus, no one should get involved who cannot easily afford to lose his or her entire stake (even with a 100% tax write off).

(2) An Oversight Could Jettison the Tax Breaks: Any number of simple errors on the part of the fund could be enough to kill the write-offs the drilling fund investor expects. Such oversights could include flaws that would affect either the fund's limited-partnership status (thus preventing the flow-through of deductions) or the validity of the intangible expense contracts (that would affect the deductions themselves).

(3) Statutory Changes Might Imperil the Tax Breaks: Just as percentage depletion was restricted, so a Congress bent on eliminating loopholes might go after other tax features upon which investors rely.

(4) Liquidity Is Poor: Generally, a limited partner's interest in a drilling fund that has not yet produced profitably is a very illiquid investment.

(5) Evaluating a Prospective Drilling Fund Is Difficult: Even when the layperson has the results of a general partner's earlier drilling fund ventures, the analysis is no easy task.

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