9.14 Intangible Drilling Costs

Intangible drilling and development costs (IDCs) refer to drilling and development costs of items with no salvage value, including wages, fuel, repairs, hauling, and supplies incident to and necessary for the preparation and drilling of wells for the production of oil or gas, and geothermal wells. For wells you are developing in the United States, you can elect to deduct the costs currently as business expenses or treat them as capital expenses subject to depreciation or depletion.

Electing current business deduction.

The election to deduct IDCs as a current business expense must be made on your income tax return for the first tax year in which you pay or incur the costs. As a sole proprietor, you deduct the IDCs as “other expenses” on Schedule C (Form 1040).

Prepayments. Tax-shelter investors may deduct prepayments of drilling expenses only if the well is “spudded” within 90 days after the close of the taxable year in which the prepayment is made. The prepayment must also have a business purpose, not be a deposit, and not materially distort income. The investor’s deduction is limited to his or her cash investment in the tax shelter. For purposes of this limitation, an investor’s cash investment includes loans that are not secured by his or her shelter interest or the shelter’s assets and loans that are not arranged by the organizer or promoter. If the above tests are not met, a deduction may be claimed only as actual drilling services are provided.

Caution

Drilling Expense Prepayments

Prepayments of drilling expenses are deductible by tax-shelter investors only if the well is “spudded” within 90 days after the close of the taxable year in which the prepayment was made, and the deduction is limited to the original amount of the investment.

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Amortizing intangible drilling costs.

If you do not elect to deduct IDCs as current business expenses, you may amortize them on Form 4562 (Depreciation and Amortization) over a 60-month period, beginning with the month they were paid or incurred.

Recapture of intangible drilling costs for oil, gas, geothermal, or mineral property.

Upon the disposition of oil, gas, geothermal, or other mineral property placed in service after 1986, ordinary income treatment applies to previously claimed deductions for intangible drilling and development costs for oil, gas, and geothermal wells, and to mineral development and exploration costs. Depletion deductions (9.15) are also generally subject to this ordinary income treatment upon disposition of the property.

AMT and intangible drilling costs.

If you are an independent producer or royalty owner and elect to deduct IDCs as a current business expense on Schedule C, you may qualify for an exception to the AMT preference rules for IDCs, but the exception is limited. If your IDC preference (figured under the regular AMT rules) exceeds 40% of your alternative minimum taxable income, figured without regard to the AMT net operating loss deduction, the excess over 40% must be included as a preference item; see the instructions on Form 6251.