Intangible Drilling Costs: Tax Deduction Benefits That Save You Money

Upstream refers to all activity that takes place in the earliest stages of oil and gas production. This includes everything from exploration, production, drilling, and extraction up to transportation, which is classified as mid-stream. Most tax benefits associated with oil and gas operations occur in the upstream phase of natural resource production.

All oil and gas operators qualify for IDC, ICC, TDC, and TCC. The deductible percentages are determined by the type of well and how the expenses line out. Horizontal wells with significant completion costs usually result in the highest deductions.

While smaller than the huge oil conglomerates, the operators at Thoroughbred Ventures are globally known, publicly traded, and highly productive entities that qualify for these high-dollar deductions. At tax time, direct participation investors can deduct IDCs on the 1040 form for the year when the non-salvageable expenses are paid out

The Alternative Minimum Tax (AMT) is the safety net to ensure that taxpayers are responsible for only a base minimum income tax in spite of any allowed deductions. The most likely scenario for this arrangement is the 65% rule: If the deductions exceed 65% of the net income from oil and gas operations, your AMT could be negatively impacted.[3]

Under these circumstances, you may choose to defer the first year IDC tax deduction benefits and, instead, capitalize and amortize over time in favor of the Alternative Minimum Tax. In either case, you, as the direct participant, are safeguarded against overpaying taxes.

To comply with federal income tax regulations, the partnership or S corporation is responsible for reporting any depletion, production costs, and intangible drilling costs after being deducted against royalties from oil and gas operations. This reduces tax burdens and is reported separately to any working interest partners and stakeholders, but totals are not included in the net income reported to the IRS.

There are several different formulas for calculating the cost of drilling to determine your IDC oil and gas tax deductions, including: [4]

• Total cost of the well: The sum of all costs associated with drilling, extraction, development, completion, and facilities.
• Cost per 1,000 ft.: The cost to drill 1,000 ft multiplied by the feet projected or realized.
• Drilling Cost: Percentage of total well cost (e.g., 17% for rigs)
• Completion Cost: Percentage of total well cost (e.g., 19% for fluids)
• Facilities Cost: The total cost (fixed and variable) for any surface equipment, infrastructure, and structures.
• Lease Cost: The total cost per acre multiplied by the number of acres being leased.

In today’s market, the overall cost of drilling a well depends on where you are, what team is at the helm, and more. Recent data supports 1.1 to 1.4 million for cost per 1,000 lateral feet, whereas overall costs vary more widely, with averages at $5 million to over $15 million.[5]

Yes, tangible Drilling Costs are also 100% tax deductible. Tangible drilling costs include all investment dollars allocated to the equipment involved in drilling. This is also 100 percent deductible. Tangible Drilling Costs may be depreciated over a seven-year period. (Tax Code Section 263). Tangible drilling costs are the hard expenses that carry a salvage value if needed. Any equipment purchased for use in drilling and development projects is eligible for Tangible Drilling Cost tax deductions.

This includes equipment like:

• Pipes
• Steel
• Rigs and drilling equipment
• Drill bits
• Cementing equipment
• Casings
• Wellheads
• Storage tanks

Like intangible costs, these expenses are 100% deductible, though the structure is different and not fully available in year one. Rather, these are capitalized and amortized over a 7-year timeline. This still reduces your overall tax burden and creates opportunities for liquidity instead of increasing your tax burden.