Congressional Incentives Encourage Domestic Petroleum Development

The Congress offers several tax benefits to investors and private financiers investing in oil and natural gas production. The tax incentives are aimed at promoting domestic production and reducing dependence on oil imports. The Congress has structured the tax incentives in such a way to present investments in oil and gas ventures attractive to investors and thus to increase participation in oil and gas projects. These tax incentives are not 'loopholes'. The Congress has included them in the tax code to increase funding of oil and gas exploration/production projects.

Intangible Drilling Cost Tax Deduction

The intangible expenditures account to about 70-80% of total cost of drilling a well. Intangible Drilling costs include labor, chemicals, mud, grease, etc. Intangible Drilling Cost (IDC) is 100% deductible in the first year. An investment of $100,000 would yield up to $75,000 in tax deductions in the first year. These deductions are available in the year the money was invested. The deductions are available even in case the well does not start drilling until March 31 of the next year of making the contribution of capital.
(**See Section 263 of the Tax Code)

Tangible Drilling Cost Tax Deduction

The total amount of the investment allocated to the equipment “Tangible Drilling Costs (TDC)” is 100% tax deductible. In the example above, the remaining tangible costs ($25,000) may be deducted as depreciation over a seven-year period.
(**See Section 263 of the Tax Code)

Active vs. Passive Income

The Tax Reform Act of 1986 introduced the concepts of "Passive" and "Active" income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifies that Working Interest from an oil and gas well is "Active" income, and deductions can be offset against income from active stock trades, business income, salaries, etc.
(**See Section 469(c)(3) of the Tax Code).

Lease Costs

Lease costs (purchase of leases, minerals, etc.), sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are also 100% tax deductible through cost depletion.

Alternative Minimum Tax

Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This Tax Act specifically exempted Intangible Drilling Cost as a Tax Preference Item. "Alternative Minimum Taxable Income" generally consists of adjusted gross income, minus allowable Alternative Minimum Tax itemized deduction, plus the sum of tax preference items and adjustments. "Tax preference items" are preferences existing in the Code to greatly reduce or eliminate regular income taxation. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon.