Mosburg _6_28_99

THE WHYS AND HOWS OF OIL AND GAS INVESTMENT IN THE NEW MILLENIUM

Chapter One: The "Basics" of Oil & Gas Investment (Continued)

By Lewis G. Mosburg, Jr.
Copyright 1986, 1999 by Lewis G. Mosburg, Jr. All Rights Reserved.

Part Two: The Benefits of Oil & Gas Investment: The Tax Advantages of Oil and Gas

The first feature of oil and gas investment to gain the attention of most investors is its admitted tax advantages.¹

From a tax standpoint, an "ideal" investment would generate the following tax results:²

Expenditures should be currently deductible for income tax purposes. (This will cut both the after-tax cost of your investment, and also its risk.)³

Revenues should be sheltered from taxation. (This permits you to keep more of those dollars after-tax.)

Oil and gas investment ranks high in meeting both these ideals:

All costs associated in participating in non-productive wells ("dry holes") will be currently deductible as Abandonment Losses. While we don't like drilling dry holes,⁴ at least Uncle Sam picks up about half of the loss as a result of the deductions generated by those "Abandonment Loss Costs."⁵
Most importantly, those costs involved in the drill and testing of even productive wells will also be currently deductible as "Intangible Drilling and Development Costs." These "Intangibles" or "IDCs" customarily amount to approximately 60% to 70% of the costs associated with productive drilling ventures.
As you receive revenues from these producing wells, over 15% of your production dollars can be received tax free as a result of the Percentage Depletion Allowance.⁶

There are some tax-oriented investments that offer tax advantages which oil and gas investment does not, or offers to a lesser degree. In those other investment areas, opportunities for sheltering all revenues (or a substantially greater portion of those revenues) from taxation may be available. Long term capital gains conversion or tax-free exchanges also may be more readily available in other investment areas.⁷ However, in addition to its most high-profile tax advantages – deductibility of Intangibles and income sheltering through Percentage Depletion – oil and gas drilling offers these extra tax benefits:

The high initial deductibility reduces your "Adjusted Gross Income" ("AGI"), thus permitting you to take advantage of tax benefits that are "phased out" for "high-bracket" investors.⁸ These phased-out opportunities include such benefits as IRA deductions, Roth IRA contributions, Child Tax Credit, Itemized Deductions, Personal Exemption Deductions, Education Tax Credits, and Education IRA contributions.
Self-employment taxes and estimate payments for future taxes can be reduced through the high initial deductibility of oil and gas investment.⁹
In other tax-shelter areas, high deductibility and income sheltering is often secured through the use of leverage, "gray area" (questionable) deductions, or deductions gained at the expense of the economics of the project. However, oil and gas is the only "tax sheltered" investment whose tax benefits can be realized without reliance on leverage or questionable deductions, and without interfering with the legitimate economics of the venture!

This is not to say that certain oil and gas ventures don't rely upon tax positions which the IRS might challenge: we'll explore this further in Chapter Two. And leverage, intelligently utilized, could be to your advantage in your investment strategy – if the project is successful!¹⁰ But in oil and gas, using leverage, or taking a slightly more aggressive tax position, is up to you, not a must in order to realize significant tax benefits. And while some tax-structuring techniques can hurt the economics of your venture, the tax approaches we'll be talking about should make your oil and gas investment more profitable, rather than less profitable, on both a pre-tax and after-tax basis!

All tax-sheltered investment areas have been adversely affected by so-called "tax reform." However, oil and gas investment survived Washington's attacks to a far greater degree than any of the other traditional "tax shelter" areas. Most importantly, oil and gas is the only investment area which permits you legitimately to avoid the "passive activity" loss restrictions which Congress enacted to "kill off" investment in tax shelters.¹¹
The returns from an oil and gas investment can be reinvested in conventional securities, thus converting "drilling dollars" to a stock investment. If the oil and gas venture has been profitable, you have increased the after-tax dollars available to you to make your stock and bond investments.

There are other techniques you can utilize to increase the tax benefits of oil and gas investment.¹² Invariably, however, there is a price to be paid for utilizing these techniques. The "price tag" may be worth it. But blindly to jump at the higher deductions, without understanding the cost, can prove disastrous.¹³

Remember, also, as pointed out in Part One of Chapter One of this series [contained in the "Archives" of this Newsletter], that this "ideal" investment will still not be good for you unless the project also possesses economic merit: see the next article in this series. Likewise, despite the project's economic merit, oil and gas activities always involve some degree of risk – frequently, substantial risk. While the tax consequences of oil and gas drilling reduce this risk, they do not eliminate it: there is always risk involved in oil and gas investment, irrespective of the tax advantages!

Coming Next: "The Economic Potential of Oil and Gas"

¹In this article, we're only overviewing – and often oversimplifying – the tax consequences of oil and gas investment. We'll get into a lot more detail in Chapter Two.

²Remember, however, that this "ideal" investment, taxwise, doesn't exist in the real world: even the best "tax shelters" offer only a portion of these benefits, with each investment area having its own plusses and minuses.

³The portion of you investment which is protected against risk by the tax consequences is referred to as your "soft dollars." That part that remains at risk – your after-tax cost – is referred to as your "hard dollars."

⁴Don't let anyone tell you that, as a result of the deductions, you are "made whole" or even are "making money" on non-productive wells. Your promoter may be making money on those same wells as a result of charges for supplies or services, sometimes reasonable and sometimes excessive, for those wells. (This is particularly true if the well is being drilled on a fixed-cost or "turnkey" basis.) However, you have stilled lost your after-tax ("hard dollar") investment!

⁵Why do we talk about a fifty percent tax savings when the top federal rate is much lower? Because the combined federal/state/local rate, including the federal self-employment tax, normally amounts to about fifty percent. However, you'll have to consult your own tax adviser to determine whether or not state and local tax deductions are also available to you; whether the alternative minimum tax or other aspects of your personal tax and economic situation would affect the amount of tax benefit you would receive; etc.

⁶Since Percentage Depletion is calculated against your gross income from the property, your tax-free income as a percentage of your otherwise taxable income will be higher than 15%. And this percentage will increase even more in periods of lower oil prices.

⁷Tax-free exchanges are key to the economics of many activities undertaken within the oil and gas industry by the professional oil man and these industry opportunities can also be reflected on your own tax return. However, specialized investor use of tax-free exchanges is more difficult in oil and gas investments, which frequently must be structured as "partnerships" for tax purposes to provide necessary limitations against liability.

⁸And for "not-so-high-tax-bracket" investors as well: for instance, the IRA phase-out begins once a married couple's AGI exceeds $50,000!

⁹Be sure to check with your tax advisor before reducing estimate payments, however: this could create pitfalls, both taxwise and economically.

¹⁰Leverage can be used in connection with oil and gas investment and may make economic sense, particularly in connection with acquisitions of producing properties. However, leverage significantly increases the risks of the project and creates risks of its own, as investors learned to their sorrow in the late 70s and early 80s. And "non-recourse" leverage – at one time a popular tax structuring technique – now is a sign of both tax problems and questionable economics.

The use of leverage in connection with oil and gas investment will be discussed later in this series.

¹¹The use of the petroleum "working interest exception" to the passive activity loss restrictions will be discussed in the chapter on taxation.

¹²Examples are "Functional Allocation" and the creation of "Excess Write-Offs" – deductions in excess of your initial cash investment.

¹³Again, more in later articles.

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