Monday, April 5, 2010

Income Tax Returns for Oil and Gas Producers: Computing the IDC Preference in the Alternative Minimum Tax

John T. Bradford

It’s the time of the year when many oil and gas producers begin to gather the information necessary to prepare their corporate and partnership federal income tax returns.  For some producers currently deducting intangible drilling and development costs (IDC), the IDC preference in the rules implementing the Alternative Minimum Tax (AMT) can present a number of computational issues.  Several of those issues are mentioned below.

 

To start, independent producers and integrated oil companies annually can elect under section 59(e) of the Internal Revenue Code (Code) to capitalize some or all of their IDC and recover the capitalized amount over a 60-month period instead of deducting the IDC currently.  IDC capitalized and amortized pursuant to this election is not considered in the IDC preference computation for AMT purposes.  So independent producers and integrated oil companies must determine whether making this election is beneficial in the overall AMT computation.  Independent producers consider this election in conjunction with a beneficial exclusion described below.

 

IDC deducted currently is subject to the IDC preference under section 57, but independent producers receive an important benefit for this computation.  The IDC preference generally is excluded from the Alternative Minimum Taxable Income (AMTI) computation for independent producers, but the reduction in AMTI by reason of this exclusion cannot exceed 40 percent of the AMTI for the year that would have resulted had the exclusion not applied.  Thus, independent producers deducting IDC currently still need to compute the IDC preference to determine, what amount, if any, is added back to regular taxable income to compute AMTI.

 

The IDC preference is computed with respect to all of the oil and gas properties of the taxpayer, and is the amount by which the amount of the “excess intangible drilling costs” arising in the taxable year is greater than 65 percent of the taxpayer’s “net income from oil, gas, and geothermal properties.”  Thus, the IDC preference is minimized by decreasing “excess intangible drilling costs” and increasing “net income from oil, gas, and geothermal properties,” whenever possible.

 

Note that in determining the amount of “excess intangible drilling costs,” IDC incurred in drilling a “nonproductive well” is excluded.  The Code and regulations sections dealing with the IDC preference do not define a “nonproductive well,” but clearly a well plugged and abandoned prior to completion meets the definition.  However, legislative history to the IDC preference and other Code and regulations sections referring to “nonproductive wells” indicate that the definition of a “nonproductive well” should include more than just a well that is plugged and abandoned with no production.  Indeed, these authorities indicate that a well not expected to produce oil or gas in commercial quantities also should be considered a “nonproductive well.”

 

The last issue concerns the computation of “net income from oil, gas, and geothermal properties.”  Section 57 provides that the starting point for this computation is the amount of gross income from the independent producer’s oil and gas properties as determined for purposes of computing the percentage depletion deduction.  All deductions allocable to the oil and gas properties reduced by the amount of “excess intangible drilling costs” are subtracted from this amount of gross income to arrive at “net income from oil, gas, and geothermal properties.”  The issue here is determining those deductions that are not allocable to the oil and gas properties and excluding those deductions from the computation.  There is little direct guidance from the courts and the IRS on this issue, but legislative history to the IDC preference indicates that the rules for computing “taxable income from the property” for percentage depletion purposes are to be applied.  Over the years, the courts and the IRS have addressed what kinds of deductions are excluded in computing “taxable income from the property.”  For example, deductions for charitable contributions and some kinds of insurance can be excluded.  Other deductions more closely related to the producer’s business, however, need to be reviewed more closely.

 

Conclusion

 

Oil and gas producers deducting IDC currently should determine whether any wells completed in 2009 can be considered “nonproductive wells” for purposes of the IDC preference in the AMT.  Producers also should consider whether any of their 2009 deductions can be excluded from the computation of “net income from oil, gas, and geothermal properties” for IDC preference purposes.

 

For more information, please contact John T. Bradford at jtbradford@liskow.com or go to www.liskow.com.