9.16 Oil and Gas Percentage Depletion
Small independent producers and royalty owners generally are allowed to deduct percentage depletion at a 15% rate for domestic oil and gas production. The deduction is subject to a taxable income limit.
The 15% rate applies to a small producer exemption that equals the gross income from a maximum daily average of 1,000 barrels of oil or 6 million cubic feet of natural gas, or a combination of both. Gross income from the property does not include advance royalties or lease bonuses that are payable without regard to the actual production.
The depletable natural gas quantity depends on an election made annually by independent producers or royalty owners to apply part of their 1,000-barrel-per-day oil limitation to natural gas. The depletable quantity of natural gas is 6,000 cubic feet times the barrels of depletable oil for which an election has been made. The election is made on an original or amended return or on a claim for credit or refund. For example, if your average daily production is 1,200 barrels of oil and 6.2 million cubic feet of natural gas, your maximum depletable limit is 1,000 barrels of oil, which you may split between the oil and gas. You could claim depletion for 500 barrels of oil per day and for 3 million cubic feet of gas per day: 3 million cubic feet of gas is the equivalent of the remaining 500 barrels of oil limit (500 barrels × 6,000 cubic feet depletable gas quantity equals 3 million cubic feet of gas).
Transferees receiving “proven” properties after 1974 and before October 12, 1990, are not allowed percentage depletion unless the transfer was made because of the death of the prior owner, a tax-free transfer to a controlled corporation, a transfer between commonly controlled corporations, or changes in beneficiaries of a trust where the changes are due to births, adoptions, or deaths within a single family.
Ineligible retailers and refiners.
Percentage depletion cannot be claimed by a producer who owns or controls a retail outlet for the sale of oil, natural gas, or petroleum products unless gross sales of oil and gas products are $5 million or less for the tax year, or if all sales of oil or natural gas products occur outside the United States and none of the taxpayer’s domestic production is exported. Bulk sales of oil or natural gas to industrial or utility customers are not to be treated as retail sales.
Percentage depletion also is not allowed to a refiner who refines (directly or through a related person) more than 75,000 barrels of crude oil on any day during the year. The limit is based on average (rather than actual) daily refinery runs for the tax year.
Figuring average daily domestic production.
Average daily production is figured by dividing your aggregate production during the taxable year by the number of days in the taxable year. If you hold a partial interest in the production (including a partnership interest), production rate is found by multiplying total production of such property by your income percentage participation in such property.
The production over the entire year is averaged regardless of when production actually occurred. If average daily production for the year exceeds the 1,000-barrel or 6-million-cubic-feet limit, the exemption must be allocated among all the properties in which you have an interest.
Taxable income limits on percentage depletion.
The percentage depletion deduction for a small producer or royalty owner may not exceed the lesser of (1) 100% of the taxable income from the property before the depletion allowance or (2) 65% of your taxable income from all sources computed without regard to the depletion deduction allowed under the small producer’s exemption, the deduction for production activities, any net operating loss carryback, and any capital loss carryback.
The above 100% limit was suspended for production from marginal production properties for taxable years starting after 1997 and before 2008, and for taxable years beginning in 2009 through 2011. At the time this book went to press, the suspension of the 100% limit had not been extended to 2012; see the e-Supplement at jklasser.com for a legislation update.
Limitations where family members or related businesses own interests.
The daily exemption rate is allocated among members of the same family in proportion to their respective production of oil. Similar allocation is required where business entities are under common control. This affects interests owned by you, your spouse, and minor children; by corporations, estates, and trusts in which 50% of the beneficial interest is owned by the same or related persons; and by a corporation that is a member of the same controlled group.
Depletion for marginal production.
For independent producers and royalty owners with production from “marginal” wells, the 15% depletion rate is increased by 1% for each whole dollar that the “reference price” (the average annual wellhead price as estimated by the IRS) of domestic crude oil for the previous year was below $20 per barrel. However, since the reference price in recent years has been substantially over $20 per barrel, the basic 15% rate has applied for marginal production and this is likely to remain the case for the foreseeable future given high crude oil prices.