January 2012

High Income, High Taxes - Invest in Oil and Gas Partnerships

Author: Robert Star | Photographer: Photography by Anne

Many individuals are looking for ways to reduce their tax liabilities and generate income from their investments. Sounds easy enough, but how can you accomplish both goals with one investment? One of the only strategies available to make an investment and receive substantial tax benefits is investing in oil and gas exploration and production partnerships, not to be confused with Master Limited Partnerships (MLPs), which are publicly traded securities. These are private partnerships through which you actually own a part of the assets and the oil and gas produced.

We have all heard the stories of the schemes where an individual invested in a drilling program, and the company had a couple of wells drilled and there was nothing there, sometimes referred to as a “dry well.” This was very popular in the 1980s, and many people got burned by these schemes. However, with the recent developments in drilling technology and geological studies, the modern day programs have drastically reduced the potential for a dry well by identifying the oil or gas in the ground before drilling begins.

So how do you benefit from investing in oil and gas? Let’s first discuss the tax benefits. The investment will be utilized to fund drilling costs associated with the operations. These costs are called Intangible Drilling Costs (IDCs) and may include the costs associated with clearing the ground and surveying the work as well as wages, fuel, repairs, and any other expense that may be included in the drilling of a well. Because these costs or expenses are “sunk” and have no salvage value, they can be deducted in the year the investment in made.

An investor needs to understand the investment is going into the ground; therefore it is sunk, or spent. The investor will not get their principal returned, but the money invested may be deductible up to 100%. Investors can elect to expense and deduct the IDC in the year of the investment or elect to capitalize and amortize it over 60 months. So why would you invest in something where you lose all of your invested capital? Let me explain the immediate tax benefit:

Hypothetical IDC Tax Savings*
No Oil & Gas Investment
Gross Income $300,000
IDC Deduction $0
Taxable Income $300,000
State Tax at 7% $21,000
Federal Tax at 35% $105,000

Total Tax $126,000

$50,000 invested in Oil & Gas
Gross Income $300,000
IDC Deduction ($50,000)
Taxable Income $250,000
State Tax at 7% $17,500
Federal Tax at 35% $87,500

Total Tax $105,000
Tax Savings $21,000

*This is a hypothetical tax savings example, based on the assumption the taxpayer lives in a state with state income tax and without consideration of other deductions, exemptions or calculations of the Alternative Minimum Tax (AMT). These results are strictly hypothetical and are in no way a guarantee of an investor’s tax liability, and individual results will vary.

So the immediate benefit is the tax benefit. In the above example you have a 42% immediate benefit from your investment. Now the company you invested with will start the process of drilling and bringing the oil and gas to market. The additional returns on the investment will depend on the geographic area of the program and the quality and volume of oil and gas brought to market.

For example, the gas found in the Appalachian Basin may result in a higher premium than many other regions of the country. This geographic area has a rich organic rock proven to produce high-energy content of natural gas. The wells drilled in this area may produce gas that may yield premiums between 14% and 24% over normal pipeline quality gas. So, not all oil and gas is created equal.

In order to protect against price fluctuations, from the time of the investment to the time the oil and gas comes to market, most of the programs use hedging strategies to protect prices from market volatility. This will protect the value of the gas and ultimately the amount of revenue the investor may receive.

An additional benefit is the stream of income generated after the wells have been drilled. These wells can produce oil and gas for over 20 years. Soon after the end of the year in which the investment was made, the oil and gas will start to go to market, and investors should expect monthly distributions from the revenue generated. These distributions can range and depend on how many wells were drilled in that time frame. Typically, after all the wells come online, an investor can expect anywhere from 5-18% annually. In our example that would be 5-18% of $50,000 annually.

Another tax benefit provided is the annual depletion allowance. The investor receives a percentage of depletion, calculated using 15% of the gross production income for the life of the wells. Therefore, this tax benefit allows 15% of the gross annual income of the partnership to be tax-free. The depletion deduction is not limited by the amount of the investment and may be used over the life of the wells to partially shelter income from the partnership.

There are two classes of investors in these partnerships. Investors can elect to be a general partner or a limited partner. In order to take the initial upfront deduction, the investor must elect to be a general partner. Being a general partner does come with some risk, as all the liability from the drilling will go to the general partners. These programs have insurance to cover any incidents and utilize sub-contractors that have their own insurance. Upon completion of all the wells, the general partners will automatically be converted to limited partners, thus limiting the liability. If concerned about the liability, an investor can elect to be a limited partner.

If you invest as a limited partner, your liability is limited to your capital contribution to the partnership. The use of the IDC deduction from the program will be a passive loss that cannot offset active income. The investor may not have enough net passive income from other investments in the year of the investment to offset all of the passive deduction from IDC. In that case, your unused passive loss from IDC may be carried forward indefinitely to offset your passive income in subsequent taxable years.

The tax advice in this article is not intended to be used and cannot be used by any taxpayer for purpose of avoiding taxes. Taxpayers should seek advice based on their particular circumstances from an independent financial or tax advisor.

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