Oil and Gas Tax Issues. Don Nestor, CPA Ryan Nestor, CPA, CGMA Bill Phillips, CPA J. Marlin Witt, CPA, CFP

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1 Oil and Gas Tax Issues Don Nestor, CPA Ryan Nestor, CPA, CGMA Bill Phillips, CPA J. Marlin Witt, CPA, CFP Arnett Carbis Toothman llp 2018

2 Depletion and Ways to Compute What is depletion and what is its significance? Types of Depletion % Depletion Cost Depletion Production Curve life of the well 2

3 Must Have an Economic Interest Must have the following to deduct Depletion: Direct interest in the minerals in place Direct economic interest in the income from the production of the minerals Palmer v Bender US Supreme Court 3

4 % Depletion Example Gross income (after royalties) $30,000 Expenses $28,000 Net income $2,000 % Depletion Rate 15% $30,000 x 15%= $ 4,500 % Depletion Before Limitation 4

5 Cost Depletion Example Cost-Original $10,000 Accumulated (2,500) 12/31/18 Production in ,000 mcf 5,000 mcf 10,000-2,500 50,000 x 5,000 = $750 5

6 Reserves Included in Cost Depletion Calculation Reserves should include Proven Reserves (developed and undeveloped) Probable or Prospective Reserves. Revenue Procedure provides a safe harbor to avoid IRS challenge Make an election to use 105% of Proven Reserves May become more common with Marcellus & Utica due to bonus payments, lower gas sales prices, and increased expenses 6

7 Production Curve Example (Conventional Well) Year Production Curve Rate % to 5 9,8,7 6 to 10 6,6,5,4,4 11 to to 20 2 Cost of property $10,000 Year of Production 4 $10,000 x 8%= $800 Depletion based on production curve 7

8 Revising Your Reserve Study? Is Now a Good Time to Consider Revising Reserve Estimates? Potential Income Tax Consequences Increase in cost depletion (lower total reserves) Potential Financial Statement Consequences Lower reserves decreases the value of your company and makes it less likely to receive a loan from a financial institution. Loan covenant violations Properties could be impaired 8

9 Depletion Code Sections IRC Section 611-Basic authorization IRC Section 612-Cost Depletion IRC Section 613-Percentage Depletion 9

10 Depletion - Final Thoughts Calculate the greater of Cost vs. % Depletion Reduce depletable basis by the greater of cost or % depletion Make a separate property election Consider Annual Reserve Study Consider making the 105% Safe Harbor Election Must have an Economic Interest to deduct Depletion % Depletion is limited by Net Income per property 10

11 Watch out for the Alternative Minimum Tax (AMT) 11

12 AMT in General (Individuals) Start with taxable income Add back certain items (ie preference IDC and excess accelerated depreciation; taxes deducted on Schedule A) Less an exemption ($109,400 for 2018) Tax at 26 or 28 percent Pay if greater than regular tax Can generate credits to carryover Cannot be reduced by Marginal Well Credits 12

13 Excess and Tax Preference IDC Gross oil and gas income $100,000 Deductions Royalties 18,750 Operating Expenses (1) 66,910 IDC 152,542 Depletion 12,187 Total Deductions 250,389 Net Income (150,389) Add back IDC 152,542 Deduct S/L 120 month IDC Amortization (2) (2,542) Net oil and gas income (389) X 65% (252) Total IDC Expensed 152,542 Less S/L 120 month Amortization (2,542) Excess IDC 150,000 Less 65% of net oil and gas income 0 Preference IDC $150,000 (1) Including Depreciation section 179 deduction or Bonus Depreciation (2) Well Placed into production on October 31 13

14 Repeal of AMT Preferences - Other IDC AMT w/o IDC Preference AMT with IDC Preference Taxable Income $300,000 $120,000 Preference IDC 150, ,000 * Personal Exemption 7,800 7,800 Standard Deduction 12,200 12,200 Alternative Minimum Taxable Income (AMTI) Alternative Tax 470, ,000 IDC Exclusion (40% AMTI) (188,000) (116,000) * AMT IDC Tax Preference (-0-) $34,000 14

15 AMT Final Thoughts Plan amount of well investment to avoid preference IDC (40% of income as a guide) Capitalize preference IDC under IRC section 59(e) if necessary Use 150% declining balance to depreciate assets to avoid depreciation adjustments 15

16 Basics of Basis S Corporations Require Cash Contributions Partnership Entities Allow Loan Guarantees Percentage Depletion Deduction in Excess of Basis Allowed unless Property Has Depletable Basis within Entity 16

17 Basics of Basis (continued) S Corporation Example Beginning of Year Tax Basis $100,000 Net Income for the Year $ 50,000 Tax Basis Before Distributions $150,000 Distribution to Shareholder ( 140,000) Tax Basis After Distribution $ 10,000 % Depletion Available to Shareholder $ 15,000 Fully Deductible if no Depletable Basis of Assets Inside S Corporation 17

18 Active vs Passive Deductions Passive deductions can only be taken against passive income. Working interest exception still alive. Internal Revenue Code Section 469(c)(3) Limited Partnership & LLC interests are considered passive. Exception for properties previously treated as non-passive. Treasury Reg (c)(6) Important factor given NIIT (Net Investment Income Tax) on passive income. 18

19 Production Activities Deduction Repealed New Section 199A covered later 19

20 Net Operating Losses Before TCJA (2017 tax years and earlier) Federal carry back 2 years and forward 20 May elect to forgo carryback period Corporations - Form 1139 Individuals - Form 1045 After TCJA (after 2017 tax year) Covered later Be aware of state differences 20

21 Repair Regs Materials and Supplies Reg. section Dispositions/General Asset Accounts Reg. sections 1.168(i)-1 and -8 Capital Expenditures in General Reg. section 1.263(a)-1 Costs to Acquire or Produce Tangible Property Reg. section1.263(a)-2 Costs to Improve Tangible Property Reg. section 1.263(a)-3 21

22 Repair Regs Overview The regulations provide rules in the following five general areas: Materials and supplies Capital expenditures in general (including the de minimis safe harbor) Costs to acquire or produce tangible property Costs to improve tangible property Dispositions of MACRS property and general assets accounts 22

23 Repair Regs Common Issues Annual Elections: De minimis safe harbor Election to capitalize and depreciate rotable spare parts Conformity to book treatment for repairs/improvements Partial asset dispositions Accounting Method Changes Treatment of materials and supplies Write-off of previously capitalized repairs Late partial disposition elections Fiscal year taxpayers 23

24 Purchase and Sale of Properties

25 Purchase and Sale of Properties Understand what you are buying or selling. Corporation stock. Partnership or LLC interests. Assets and other operating rights. ROW and Damage payments. Proper allocation can result in tax savings. Buyer and seller need to agree on allocation. The contract should include the allocations. 25

26 Purchase and Sale of Properties Corporation stock Seller- gain taxes at capital gains rates. Buyer- no step up in basis of underlying assets. Section 338(h)(10) election. Partnership or LLC interests Seller-probably mostly ordinary gain depending on allocation. Buyer-gets basis step up in assets(if elected) and additional deductions as a result. 26

27 Purchase and Sale of Properties Assets and other operating rights. Producing wells Seller-probably ordinary income. Buyer-allocate between tangible and reserve value. Deep rights Seller-capital gain treatment if structured properly. Buyer-lease costs written off as wells are drilled or through depletion. 27

28 Purchase and Sale of Properties Assets and other operating rights(continued). Operating rights Seller-capital gains treatment. Buyer-write off over 15 years. Royalties Seller-capital gains treatment. Buyer-write off through depletion. Leases Seller-capital gain treatment if structured properly. Buyer-lease costs written off as wells are drilled or through depletion. 28

29 Purchase and sale of Properties Allocation Discussion Example Taxpayer Selling of All Oil and Gas Business Items Being Sold: Trucks, ATVs, and other vehicles original cost $450,000, undepreciated book value $100,000 Various Equipment - Original cost $300,000, fully depreciated 500 Producing Wells - IDC expenses, tangible equipment fully depreciated, no basis in lease costs. Annual net income from WI, $250,000 4,000 acres deep rights all HBP, no wells drilled Royalties and Overrides - $100,000 annually Operating Contracts - annual net income from operations, $500,000 29

30 Purchase and Sale of Properties Right of Way Permanent or well into the future-capital gain treatment. May be able to offset against basis in that portion of the property. Temporary-ordinary income. Damages Capital gain. May be able to offset against basis in that portion of the property. Be careful of damage payments received in advance. 30

31 Purchase and Sale of Properties Allocation of Purchase Price producing wells Tangible Equipment Depreciated over 7 Years, Section 179 deduction or bonus depreciation. Reserves Written off through depletion. Try to maximize allocation to equipment based on age of wells purchased. 31

32 Purchase and Sale of Properties Maximizing Depreciation Deductions Change in Depreciation Method Changing life of an asset Filing Form 3115 Beginning Depreciation(Rev. Ruling Downhole casing must be capitalized. Depreciation begins when well is completed and made capable of production. 32

33 Purchase and Sale of Properties Sale of Leases and deep rights Lessor Treatment of Receipts Lease bonus as ordinary income. Lease bonus as capital gain. Separate property election under 614. Dispose of all non-operating interests. Sell everything. Production payments for 90% or less of expected production What Not To Do Dudek Case 33

34 Like Kind Exchange (IRC Section 1031) Transaction is a sale or exchange. Property held for productive use in a trade or business or for investment. Property has to be like kind. Gain will generally be deferred if requirements are met. Only applies to real estate after 2017 Be careful of mixed property 34

35 Sale or Exchange Direct exchange Deferred exchange 45 and 180 day requirements. Qualified intermediary. Multiple party exchange. 35

36 Purpose of Holding Property Trade or business Investment Does not include: Property held for personal use Inventory property Partnership interests Securities 36

37 Like-kind Nature or character of property Real estate Improved or unimproved Personal property generally not available after

38 Structuring of Deals

39 Structuring of Deals Income for Services (Revenue Ruling 83-46) Receipt of Property Separate from Drill Site (Revenue Ruling ) Carried Interests 39

40 Income for Services A corporation, an attorney & an employee of a corporation receive royalties for performing various services Each must include in income the FMV of the override received Using a profits interest in a partnership may be one way to avoid immediate income recognition 40

41 Receipt of Property Separate from Drill Site (Rev Rul ) Y (owned lease) entered into an agreement with X to drill a well X received entire working interest in the drill site plus an undivided one-half interest in the remaining acreage Y received a 1/16 th royalty from the well drilled with the option to convert it to a 50% working interest after payout Drill site pooling of interests not taxable Other acreage each recognized income based on the FMV 41

42 Receipt of Property Separate from Drill Site (illustration) Drill Site Other Acreage 42

43 Carried Interests Carrier agrees to drill, complete and equip the well Carried party receives a working interest Transfer of interest must be after payout 43

44 Net Investment Income Surtax 44

45 3.8% Medicare Surtax - Overview Investment Income Beginning with the 2013 tax year, a new 3.8% Medicare surtax will apply to all taxpayers whose income exceeds a certain threshold amount ($250,000 MFJ; $200,000 Single.) This new surtax will, in essence, raise the marginal income tax rate for affected taxpayers. Thus, a taxpayer in the 37% tax bracket (i.e. the highest marginal income tax rate in 2018) would have a marginal rate of 40.8%! 45

46 3.8% Medicare Surtax - Overview APPLICATION TO INDIVIDUALS The Medicare Surtax is equal to: 1. Net investment Income 1. Net Investment Income OR 3.8% X the lesser of 2. The OR excess (if any) of - Modified Adjusted Gross Income (MAGI) - - Threshold Modified amount Adjusted Gross Income (MAGI) - Threshold Amount 2. The excess (if any) of 46

47 3.8% Medicare Surtax - Overview APPLICATION TO ESTATES AND TRUSTS The Medicare Surtax is equal to: 3.8% X the lesser of 1. Net Undistributed investment net Income investment income for such taxable year OR 2. The The excess excess (if (if any) any) of of - Modified Adjusted Adjusted Gross Income Gross Income (as defined in (MAGI) section 67) for such taxable year, over - Threshold the dollar amount at which the highest tax bracket in section 1(e) begins for such a taxable year 47

48 3.8% Medicare Surtax - Overview Three critical terms associated with the 3.8% Medicare Surtax: Net Investment Income Threshold Amount Modified Adjusted Gross Income (MAGI) 48

49 3.8% Medicare Surtax - Overview NET INVESTMENT INCOME Includes: Interest Dividends Annuity Distributions Rents Royalties Income derived from passive activity Net capital gain derived from the disposition of property Does NOT Include: Salary, wages, or bonuses Distributions from IRAs or qualified plans Any income taken into account for selfemployment tax purposes Gain on the sale of an active interest in a partnership or S corporation Items which are otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt bonds, capital gain excluded under IRC 121, and veterans benefits 49

50 3.8% Medicare Surtax - Overview Types of Income Subject to Surtax Subject to Surtax: Taxable Interest Dividends Annuity Income Passive Royalties Rents Exempt from Surtax: Wages Exempt Interest Active Royalties IRA Distributions 401(k) Distributions Pension Income RMDs Social Security Income 50

51 3.8% Medicare Surtax - Exclusions Gross income normally subject to the surtax is excepted from the surtax if it is derived in the ordinary course of a trade or business (other than securities) Section 162 definition of trade or business applies which is not passive under Sec

52 3.8% Medicare Surtax - Issues Self Rental Rules recharacterizes income not activity self rentals deemed trade or business under Regs Real Estate professional may be subject to surtax if activity does not rise to Trade or Bus Grouping only helps with passive, properly grouped activities treated as trade or business Sale of assets not subject if assets used in T or B Working capital invested in T or B maybe subject 52

53 Summary of NII Timing of AGI and Investment income to reduce 3.8% tax Structure of investment and level of participation to reduce Net Investment Income Interaction with Self Employment vs NII Passive activities and grouping opportunities 53

54 Estates and Trusts 54

55 Estate Planning Ideas Overview of estate tax regime Planning techniques to reduce estate taxes The importance of Value in estate planning Ways to saving you money 55

56 Tools to Work With Exemption - $11,180,000 for 2018 Portability of Exemption Annual Exclusion $15,000 Martial Deduction Charitable Deduction Educational Expenses Valuation Very Important Current Industry Conditions May Create Low Valuations Weigh Estate Tax Against Loss of Step Up in Basis 56

57 Leveraging the exemption Assets included at Fair Market Value Willing Buyer and willing seller standard Limitations affect value Minority interest and control affect value 2704 temporary regulations threat Transfer before value is created/growth 57

58 Ways to reduce taxes Reduce your estate by: Spending it Give it away to family or charity Transfer through planned gift/strategy Pay special attention to Valuation plan transfers before value accumulates risk reduces value 58

59 Trusts Trusts are often used to create and preserve estate planning opportunities Classic trusts - Family, Martial, and GST trusts Intentionally Defective Grantor Trusts (IDGT) Installment sale to IDGT Grantor Retained Annuity Trust Charitable trusts 59

60 Thank You 60