Most of us are exposed to the oil and gas industry when we fill up our gas tanks or pay the home heating bill. However, there is more to “oil and gas.” It touches our lives in several ways including when we use electricity, plastics, fertilizers, pesticides or fire up the gas grill. It can also affect our retirement fund or investment portfolio.
The industry consists of three major sectors: upstream, midstream and downstream. Upstream companies find the oil and gas and bring it to the surface using drilling or other technologies. Midstream companies are responsible for processing, storing, marketing and safe transportation of oil and gas products. Downstream companies include refiners, petrochemical plants, distributors and retail outlets. Each sector has its own opportunities, unique terminology and tax issues.
Individuals can profit from the industry, too—they could inherit a family farm that has an oil well, lease the land to someone who wants to drill a well or grant a pipeline easement for a fee. People can invest in oil and gas by purchasing stock, buying interest in an oil and gas partnership or participating in the drilling of a well. All these approaches have complicated tax implications.
The well on the family farm is subject to ad valorem tax and severance tax. The owner(s) pay income tax on the profits from the well. They may also be subject to the Ohio Commercial Activity Tax (CAT), sales and use tax or other taxes. When calculating the income tax liability, it is imperative that the tax preparer understands the implication of percentage depletion, cost depletion, intangible drilling costs, potential tax credits available and related issues. Lack of knowledge can result in an overstatement of the current tax liability and create potential compliance issues.
The drilling of a new well incurs geological and geophysical costs as well as tangible and intangible costs. Geological and geophysical (G&G) costs include surveys of a topographical, geological and geophysical nature. Seismic testing is used to detect oil and gas and determine the best location for the well pad. Intangible costs include expenses incurred in drilling the well or expanding an existing well that has no salvage value. Tangible (equipment) costs are expenses incurred to operate the well that do have salvage value. If the drilling activity is not successful in finding commercially viable oil or gas, the expenses are called dry hole costs. When a successful well’s production declines to the point that it is no longer feasible to operate, plugging costs are incurred to close the well.
Each of these costs has specific tax treatments. The tax treatment of seismic costs or geological and geophysical costs has changed multiple times but is currently amortizable with certain restrictions. Intangible costs can be expensed or amortized. Tangible costs are generally depreciated. Dry hole and plugging costs are expensed. Knowing the appropriate treatment can result in considerable tax savings.
Leasing land to an oil and gas operator will create taxable income to the land owner in the form of rental payments and/or royalty payments. Terms of lease agreements vary significantly, but generally create ordinary income to the land owner. Royalty income is considered investment income. There may be expenses such as severance tax deducted from the royalty payment. A deduction for percentage depletion should also be considered.
The tax treatments of granting pipeline easements on the real estate can be complicated and can include payments related to loss of crop production. Tax issues involve basis calculation to determine whether a taxable gain has been realized, whether the easement is considered temporary or permanent and whether taxable gain is treated as ordinary or capital gain.
If a person decides to invest in the industry by purchasing an interest in a publicly traded limited partnership, or master limited partnership, several of the previously mentioned issues will appear on the K-1 the investor receives from the partnership. The partnership can be an oil and gas transporter, producer, well operator or combination of the activities. If it is an oil and gas producer, percentage depletion, cost depletion and intangible costs will be stated on the K-1.
Footnotes to the form 1065 K-1 will disclose quantities of oil and gas produced that is measured in Barrel of Oil Equivalent (BOE). This is used to determine if the calculated depletion exceeds the allowable amount. The footnotes may also include excess Intangible Drilling Costs related to Alternative Minimum Tax calculations or tax credits for marginal production or federal enhanced oil recovery credit. These issues add additional complexity to the tax concepts involved with passive activity rules and partnership basis issues.
It can be rewarding to feel that we filled up the gas tank of the car on the day of the week when gas prices were lower. It can also be financially rewarding for the people involved in producing or investing in the oil and gas industry if the terminology and tax treatments are understood.
