Tax Aspects of Oil and GasDrilling Partnerships

Objectives for Investors

1. Cash distributions for the life of the Investment

2. Accelerated write-off in the first year

3. Ability to exclude investment income from taxable income

Tax Considerations Overview

1. Intangible Drilling Costs (“IDC”) IRC Sections 263 (c), 59 (e)

2. Major exception from “passive activity loss rules” by Investor General Partnership (“GP”)

IRC Section 469 (c)(3)

3. Functional Allocation

4. Alternative Minimum Tax

5. Depletion Allowance IRC Sections 611, 613, 613 (c) (6)

1. Intangible Drilling Costs

Intangible Drilling Costs (IDCs): Non-salvageable Value About 75% of the cost to drill and complete a well

Tangible Drilling Costs: Salvageable Value About 25% of the cost to drill and complete a well

1. Intangible Drilling Costs (cont.)

Utilization Investors may deduct 100% of the IDCs in the year of

investment. IRC Section 263 (c)

Investors may amortize the deduction over a 60 month period. IRC Section 59 (e)

1. Intangible Drilling Costs (cont.)

Utilization (cont.)

An investor may also elect to deduct in the year of investment any part of their IDCs and capitalize and deduct the remaining IDCs ratable over a 60-month period.

1. Intangible Drilling Costs (cont.)

In Service Rule:

All wells must be spudded within 90 days following the end of the year of investment in order to be eligible to be fully deductible in the 1st year of investment. IRC Section 461 (i)

1. Intangible Drilling Costs (cont.)

Example:

If you invest during 2010 and a portion of the Program wells are not spudded prior to 12/31/2010 but those wells are spudded before 3/30/2011, rule is satisfied and you may deduct the IDCs on your 2010 tax return

2. Passive Activity

The Rule

An investment in a limited partnership is generally considered a passive activity for the Investor (because of failure to materially participate in operations on a regular continuous, and substantial manner) which is only deductible against other passive income. IRC Section 469

2. Passive Activity (cont.)

The Exception:

By holding an oil and gas working interest through an entity which does not limit liability (electing to be a general partner during the drilling and completion phases) and Investor may take advantage of an exception to the passive loss rules that allows the IDC deductions to be taken against active income.

IRC Section 469 (c)(3)(a)

2. Passive Activity (cont.)

Passive activity loss rules generally do not apply to corporations.

The rules do apply, however, to: A personally owned service corporation, unless the employee-

owners own 10% or less of the stock A closely held C corporation (five or fewer owners). These can

use passive losses to offset taxable income determined without regard to passive income, loss, or portfolio income

Shareholders of S corporations

2. Passive Activity (cont.)

General Partner vs. Limited Partner

Investor General Partners (“GPs”)

may deduct allocated IDCs from their investment against any type of income.

Investor Limited Partners (“LPs”)

may deduct allocated IDCs from the investment against passive income only.

2. Passive Activity (cont.)

General Partner Considerations

The Investor GP must have unlimited liability in order to qualify for the passive loss rules exception under IRC Section 469 (c)(3)(a).

Investment in the Partnership must not be through an entity which limits liability, such as a limited liability company or S corporation.

3. Functional Allocation

Partnership accounting feature that allows disproportionate allocation of revenue and expenses between partners.

The Code requires, however, that the allocation withstand and “economic viability” test that requires value be traded for equal value. IRC Section 704 (b)

3. Functional Allocation (cont.)

Program Sponsors often allocate up to 100% of Intangible Drilling Costs deduction to Investors and receive the Tangible Drilling Cost deduction and a reversionary interest in return.

This can result in the Investor receiving a first year write-off of as much as 100%.

4. Alternative Minimum Tax

IDC deductions are NOT tax preference items (for independent producers). Energy Policy Act of 1992

However; an Investor that reduces Alternate Minimum Taxable Income by more than 40% WILL trigger AMT.

4. Alternative Minimum Tax (cont.)

If you elect to amortize all of your IDCs over 5 years, none of the deduction would be considered excess IDCs.

Post-investment look back allows for tax planning to avoid over investment.

5. Depletion Allowance

Shelters a portion of the revenue stream from an oil and gas investment from income tax.

Partnerships can utilize Percentage Depletion allowance or cost depletion allowance. Generally, Percentage Depletion is the higher of the two for the average Partnership Investor.

5. Depletion Allowance (cont.)

Percentage Depletion, depending on the market price of oil and gas, can fluctuate between 15% and 25%. Currently, the percentage depletion allowance is 15% of gross revenue derived from the investment regardless of remaining basis. IRC Section 613

The AMT preference on percentage depletion was repealed in the Energy Policy Act of 1992

Conclusion

Between 75% and 100% of IDC deduction is available to be written off in year of investment.

Alternatively, part of all of IDCs may be amortized over 60 months.

Generally, not a preference item.

Conclusion (cont.)

IDC deduction may be taken against any income by Investors electing General Partner status.

IDC deduction lowers adjusted gross income and alternative minimum taxable income, and may reduce W-4 withholding and quarterly estimated payments.

Depletion Allowance excludes 15% of gross income from the Investment from taxation.