The profit incentive behind developing oil and gas wells is an alluring prospect for investors, but the prohibitively high costs of drilling for oil and gas can act as a deterrent for those looking to enter the industry. The reality is that oil and gas exploration is inseparable from the high costs of drilling; however, a savvy investor can take advantage of these unavoidable costs and leverage them for favorable tax deductions. Keep reading for a short primer on Intangible Drilling Costs (“IDC’s”) and how you can leverage them to turn some of your most significant expenses into tax deductions.
What are Intangible Drilling Costs?
IDCs are costs incurred in the drilling of a well, from non-salvageable costs that do not produce long-term physical (or tangible) assets. Put simply, IDCs are costs incurred for intangible expenses related to the well, such as wages, permitting costs, fuel, supplies, excavation, building necessary infrastructure, transporting and installing equipment, and other related expenses. IDCs typically account for 60-80% of a well’s total drilling costs and are fully tax-deductible; therefore, leveraging these costs properly is essential to maximizing the value of your investments.
The Tax Deductions for Intangible Drilling Costs
IDC tax deductions were first introduced in 1913 to offset the high costs of entering the oil and gas industry. IDC tax deductions are only available for United States domestic and offshore exploratory or developmental wells with active operations. The amount deductible from taxes through IDCs depends on the timeline of incurred costs and filing for IDC deductions, as well as the size of the entity seeking the deduction. For starters, IDC tax deductions are available and can be claimed in the tax year in which the costs were paid or incurred, even if drilling starts as late as March 31st of the following year. Additionally, the wells drilled or prepared do not need to produce oil or gas to be eligible for IDC tax deductions, so long as all other conditions are met. Secondly, the amount of IDCs deductible from your taxes can depend on the entity claiming such IDC deductions. Smaller independent producers can deduct 100% of their IDCs in the year they are incurred, whereas larger entities, such as major oil corporations, are subject to stricter requirements and are often limited to deducting 70% of their IDCs in the first year, with the remaining 30% amortized over the next five years. Furthermore, the entity type can affect how IDCs are deducted. For entities taxed as partnerships, IDCs are deductible at the partnership level and can be listed on the individual tax returns of the partners, but this isn’t the case for corporations, which are subject to stricter and more complex requirements.
Conclusion
IDCs are an essential tool for maximizing the value of any oil and gas asset, regardless of the size of the drilling project or entity incurring the drilling costs. With 60-80% of drilling costs being IDCs, proper bookkeeping and a thorough understanding of what costs are tax-deductible are skills that will separate average investors and developers from professionals who can capture the full value of their investments, expenditures, and oil and gas assets. For more information on IDCs and to understand how these costs can help your bottom line, reach out to the team at RR&A.
Saayem is a Junior Associate at R. Reese & Associates and part of the Commercial Contracts, Land and Title, and Transactions Teams. To learn more about Saayem, visit his attorney page.
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