As the phrase implies, intangible drilling costs (IDC) include the expenses of designing, fabricating, preparing or drilling a well site prior to actual oil and gas production. Since IDCs can account for up to 80 percent of all pre-production expenses, it’s wise for investors and producers to know the key tax rules on deducting or depreciating these substantial expenses.
The IRS allows independent operators or working interest owners to deduct IDCs with no salvage value (such as wages, fuel, repairs, hauling, supplies and other costs directly related to site preparation and well drilling) as a current business expense. Similarly, when special drilling rigs are needed to improve or restore production from an existing well (“workover costs”), those costs are also considered deductible as an ordinary business expense. An IDC election must be taken in the first year an operator incurs such expenses and, once the decision is made, it is binding on all future tax years. Typically, the deduction is recorded as “Other Expenses” on Schedule C of Form 1040.
While proper IDC classification is very important, since tangible drilling costs must be capitalized and depreciated over a seven-year period, be aware that there are notable restrictions on what entities and costs can be taken as a current business expense. These include:
Integrated producers. The IRS forbids integrated oil and gas producers (those not filing as S Corps or single-entity LLCs) from taking all IDC expenses as a current year deduction. Instead, integrated producers may immediately deduct 70 percent of IDCs, but must capitalize the remaining 30 percent of those expenses over a five-year time period.
Certain contractor expenses. While all IDC expenses are deductible, care must be taken to ensure that those bills are properly classified. For example, if a claimed IDC links to an expense for depreciable property, or to production costs that link to a taxpayer’s depletable income, those contractor expenses must be capitalized.
Non-operator expenses. If a taxpayer is not a current operator or working interest owner in an oil and gas business, but chooses to invest in the development of a well site, that taxpayer cannot claim IDC as an immediate business expense. Instead, IRS rules require that investor to depreciate any labor, supply or other preparation costs over a period or five to 10 years.
Non-U.S. IDC expenses. If IDCs were incurred for an oil or gas well located outside of the United States, those costs cannot be taken as a current business expense. But the IRS does allow operators or working interest owners to include those costs as part of the well’s adjusted basis, which can be beneficial in depletion or depreciation calculations.
For more information, watch our webinar “Oil and Gas Taxation 101” on demand.
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August 11, 2017