A Closer Look: Tax Treatment of Depletion Expenses

In simplest terms, depletion is a cost-recovery approach for oil and gas extraction operations, which allows a business to gradually expense the physical removal of those natural resource assets over a number of years. Deductions for depletion are only available to taxpayers who hold an economic interest in an oil and gas entity, and depletion calculations must be made on a property-to-property basis – not on a company’s aggregate holdings.

There are two methods for computing depletion, and the IRS generally requires business owners to use the one that provides the larger deduction. Here’s a closer look at each option:

Cost method. To establish a depletion basis for each property, take each parcel’s adjusted basis (original cost, plus any additions or improvements), and subtract any depreciation deductions, deferred expenses or other deductions. Then, subtract the residual value of land and improvements at the end of extraction operations and cost or value of land acquired for purposes beyond oil and gas production. When dividing the depletion basis by the property’s total recoverable (or ending) reserves, the result is a depletion rate per unit. The cost depletion deduction is then calculated by multiplying that depletion rate per unit by total oil or gas units sold for the fiscal year.

A key tax issue in the cost method is developing defensible estimates of total recoverable reserves. The IRS does offer an elective safe harbor approach for that calculation, which is 105 percent of each property’s proven reserves (both developed and undeveloped). If this election is chosen, it is effective for the current tax year and all subsequent filing years unless revoked by the taxpayer. If revoked, the option cannot be re-elected for five years.

Percentage method. The percentage depletion method is limited to independent oil and gas producers or royalty owners, and it is currently calculated as the lesser of 15 percent of gross or net income from each property. If a property has a current year net loss, percentage depletion cannot be used for that parcel. In addition, a taxpayer’s total percentage depletion deduction from all oil and gas properties cannot exceed 65 percent of taxable income and, if average daily production exceeds 1,000 barrels, a quantity limitation rate must be calculated.

 

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August 4, 2017