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DEVELOPMENT OF OIL AND GAS PROPERTIES

PATRICK HENNESSEE

THE NATURE OF IDC


EXPENDITURES
WITHOUT A SALVAGE VALUE FOR DRILLING & PREPARATION FOR PRODUCTION

IDC DEFINED
REG. SEC. 1.612-4

EXPENDITURES MADE BY AN OPERATOR FOR WAGES, FUEL, REPAIRS, HAULING, SUPPLIES, ETC., THAT ARE (1) INCIDENT TO AND NECESSARY FOR THE DRILLING OF WELLS AND THE PREPARATION FOR PRODUCTION OF OIL OR GAS AND (2) DO NOT HAVE A SALVAGE VALUE.

DRILLING TO TOTAL DEPTH

CEMENTING CASING

Fracking & Perforating the formation

COMPLETING THE
WELL

Oil

Drilling Mud

Drill Stem

Bit Cuttings

Drill Bit

DRILLING

How Wells Are Completed


Evaluate Formation Isolate the Formation Stimulate Well Install Production Equipment

WELL LOGGING

Self Potential

Resistivity

Drill Stem Packer

Formation Tester

DRILL STEM TEST

Cement

Drilling Mud

Casing

CEMENTING

Oil Flows

Hydraulic Pressure Fractures Rock

Sand lodges in fractures

HYDRAULIC FRACTURING

WORKOVER COSTS
REMEDIAL OPERATION TO INCREASE PRODUCTION IN A PRODUCING WELL
GENERALLY:
COSTS FOR IMPROVING, MAINTAINING, OR SUSTAINING PRODUCTION FROM CURRENTLY PRODUCTIVE RESERVOIRS = OPERATING EXPENSE COSTS TO OBTAIN PRODUCTION FROM NEW RESERVOIR = IDC

OFFSHORE DRILLING

OFFSHORE MOBILE RIGS

OFFSHORE MOBILE RIGS


ISSUE: G&G VS. IDC IF WELL COULD ACTUALLY PRODUCE OIL IF DESIRED TREAT AS IDC
STANDARD OIL CO., 68 TC 325 SUN COMPANY, 74 TC 1481

OFFSHORE DRILLING PLATFORMS

OFFSHORE DRILLING PLATFORMS


IDC
COSTS OF DESIGNING AND CONSTRUCTING THE PLATFORM TRANSPORTING THE PLATFORM TO THE SEA NO DEDUCTION FOR ACTUAL MATERIALS USED IN CONSTRUCTION

Problem 1
Classify the expenditures in problem 1 as:
Leasehold costs (capital expenditures) Intangible Drilling Costs (IDC) Lease and well equipment (Eq.) Lease operating costs (LOE)

____ ____ ____ ____ ____ ____


____ ____ ____ ____ ____ ____ ____ ____

1. 2. 3. 4. 5. 6.

____

Research of lease location by engineer, geologist, etc. Administrative costs in connection with drilling contracts. Surface casing. Cost of switcher, pumper, and gauger to operate the wells. Cost of minor repair of pumps, tanks, etc. Equalization payments of a unitization when paid in connection with equipment. 7. Survey and seismic costs to locate a well site on leased property. 8. Costs of drilling. 9. Grading, digging mud pits, and other dirt work to prepare drill site. 10. Geological and geophysical expenditure leading to the acquisition or retention of an oil and gas property. 11. Expenses in connection with leasing the property from the landowner. 12. Cost of constructing roads or canals to drill site. 13. Surface damage payments to landowner around the drill site. 14. Crop damage payments to landowner due to transporting the drilling rig to and from the drill site. 15. Cost of well casing.

____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

16. Grading existing roads in order to transport oil to the refinery. 17. Treat-o-lite and other materials and supplies consumed in operating the lease. 18. Salt water disposal equipment and well. 19. Costs of setting the rig on drill site. 20. Transportation costs of moving rig. 21. Technical services of geologist, engineer, and others engaged in drilling the well. 22. Legal costs of securing lease and clearing title. 23. Legal fees incurred to obtain access to the property and to obtain easements, etc. 24. Drilling mud, fluids, and other supplies consumed in drilling the well. 25. Transportation of drill pipe and casing. 26. Cementing of the casing (but not the casing itself). 27. Rent of special equipment and tanks to be used in

____
____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

28. Transportation of tubing to supply yard but not from supply yard to well. 29. Cost of production tubing. 30. Pulling sucker rods, pump, and cleaning the well. 31. Utilities to run pump. 32. Severance taxes on oil produced. 33. Cost of well head and "Christmas Tree." 34. Perforating the well casing. 35. Logging costs. 36. Costs of removing rig from location. 37. Dirt work in cleaning up the drill site. 38. Lease bonus paid to landowner. 39. Purchase price of an existing lease. 40. Costs of pumps and motors including transportation. 41. Cost of tanks, flow lines, treaters, separators, etc., including transportation. 42. Depreciation on equipment used on the lease. 43. Rental on lease equipment. 44. Dirt work for tanks and production equipment.

____ 45. Cost of acidizing, fracturing the formation, and other completion cost. ____ 46. Seismic work to determine the size of the reservoir or reserves. ____ 47. Legal fees incurred in drafting contracts, division orders, etc. ____ 48. Travel incurred in acquiring lease. ____ 49. Swabbing costs to complete the well. ____ 50. Wells drilled for pressurizing the producing zones such as water flooding. ____ 51. Laying pipelines, including dirt work and easements. ____ 52. Salaries for painting and cleaning on the lease. ____ 53. Installation costs of tanks and production equipment. ____ 54. Construction costs of trucks turnaround pad and overflow pits at new tank battery. ____ 55. Bottom-hole contribution. ____ 56. Costs of plugging the well if dry. ____ 57. Costs of drill stem tests. ____ 58. Open hole testing. ____ 59. Rental payments to mineral owner when not based on production. ____ 60. Remaining basis in equipment which is transferred to another person under any type of reversionary agreement.

THE ELECTION
DEDUCT IN 1ST YEAR IDC IS INCURRED

NO FORMAL STATEMENT REQUIRED BUT MAKE ONE

STATEMENT
TAXPAYER HEREBY ELECTS TO
EXPENSE ALL INTANGIBLE

DRILLING AND DEVELOPMENT


COST OF OIL AND GAS WELLS UNDER THE AUTHORITY OF SEC. 263(c) AND REG. SEC. 1.612-4(a).

PARTNERSHIP
PARTNERSHIP MAKES THE ELECTION NOT THE INDIVIDUAL PARTNERS

TO BE SAFE:
ATTACH A STATEMENT TO THE 1065

SECOND ELECTION
USED ONLY WHEN TAXPAYER ELECTED TO CAPITALIZE IDCs ELECTION TO EXPENSE DRY HOLES
STATEMENT ON THE RETURN
FIRST YEAR TAXPAYER DRILLS A DRY HOLE

IDC - PROBLEM 2 Kyle O'Tracy invested $10,000 in an oil and gas venture on December 18, 19X6. $7,000 of this represented IDC, $2,500 was for equipment and $500 was for leasehold cost. The well was completed on December 28, 19X6 as a producer. This was the first time Kyle had invested in an oil and gas well. Kyle started to file his tax return for 19X6 (at 8:00 p.m., April 15, 19X7) when his good friend Mable called and invited him to a party that started at 9:00 p.m. Kyle, being more of a party animal than Spuds Mckinsey quickly completed Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return and dropped it in the mail on his way to the party. What is Kyle' status regarding his IDC election when he finally files his return on August 15, 19X7?

IDC - PROBLEM 3 Sean Patrick, an individual (who has never been involved in the oil and gas business before) acquired an oil and gas lease from his brother on March 20, 19X6. Sean decided to develop the property late in 19X6 and a well was spudded in on December 18, 19X6. By the end of the year Sean, a cash basis taxpayer, had spent $28,000 in drilling cost. The well was completed by mid January of 19X7. Sean spent a total of $178,000 in drilling and completion cost and $42,000 in equipping the well. Because Sean had very little taxable income in 19X6, he decided to expense the entire well in 19X7. Therefore, on his 19X6 return, Sean had reported nothing regarding his oil and gas activities. What do you think Sean's status regarding the IDC election is at this point?

SECTION 59(e) ELECTION


ONLY IF TAXPAYER HAS ELECTED TO EXPENSE IDC
THIS ELECTION IS USED TO CAPITALIZE ANY AMOUNT OF IDC
AND AMORTIZE OVER 5 YEARS

AMOUNT CAPITALIZED IS NOT TAX PREFERENCE IDC


PARTNER MAKES ELECTION

INTEGRATED OIL COMPANIES


MUST CAPITALIZE 30% OF THEIR DOMESTIC IDC AMORTIZE THIS OVER 60 MONTHS
BEGINNING WITH THE MONTH THAT COSTS ARE INCURRED OR PAID

Electing Large Partnerships


1997 Act - Simplification Electing Large Partnerships -- 100
Depletion AMT Section 29 Credit IDC Generally same as before - partnership level Disqualified Person - retailer, refiner
Permitted to make their own 59(e) election

FOREIGN IDCs
CAPITALIZE ALL PRODUCTIVE IDC
AMORTIZE OVER 10 YEARS OR

RECOVER ADD TO COST BASIS AND USE COST DEPLETION TO

WHEN TO DEDUCT IDC


GENERAL RULES
ACCRUAL BASIS
DEDUCT IN YEAR INCURRED

CASH BASIS
DEDUCT IN YEAR PAID IF COST HAVE BEEN INCURRED

PREPAID IDC
IMPORTANT FACTORS
NOT A MERE DEPOSIT NOT RESULT IN A MATERIAL DISTORTION OF INCOME BONAFIDE BUSINESS PURPOSE MUST BE REASONABLE AMOUNT LEGALLY REQUIRED TO MAKE THE PREPAYMENT HELPFUL TO HAVE A DATE WHEN DRILLING IS TO BEGIN HELPFUL IF ALL WORKING INTEREST OWNERS PARTICIPATE IN THE PREPAYMENT HELPFUL IF CONTRACT IDENTIFIES THE WELLS TO BE DRILLED

PREPAID IDC TO A TAX SHELTER MAY BE DEDUCTED WHEN:


CASH IS PAID & IT IS NOT RAISED BY LOANS SECURED BY THE TAX SHELTERS ASSETS OR LOANS ARRANGED BY PERSONS INVOLVED WITH THE TAX SHELTER

AND
IF THE WELL IS SPUDDED DURING THE FIRST 90 DAYS OF THE FOLLOWING YEAR.

TAX SHELTER DEFINED


AN ENTERPRISE (other than a C Corp.) REQUIRED TO BE REGISTERED WITH STATE OR FEDERAL AGENCIES; A PARTNERSHIP THAT 35% OF ITS LOSSES ARE ALLOCABLE TO LIMITED INTEREST; OR AN ENTITY OR PLAN WHO'S PRINCIPAL PURPOSE IS AVOIDANCE OR EVASION OF TAXES

IDC - PROBLEM 4 Elizabeth paid $40,000 for a limited partnership interest in a drilling program set up by Big Oke Oil Company which also became general partner. In December 19X7, Elizabeth's $40,000 investment was used to make four different types of prepayments: 1. Prepayments were made to independent third parties under footage and daywork drilling contracts. The amounts paid were based on estimates of how much it would cost to drill the well on a cost per foot or per day basis. The partnership had the right to cancel the contract at any time. If it did so, it would be entitled to a refund of the repayment reduced by whatever amount the contractor had by then earned under the contract for services actually performed.

IDC - PROBLEM 4 -- continued 2. Prepayments were made to independent third parties under turnkey drilling contracts. These contracts were for a flat fee and were not refundable. If, however, a well was canceled, the prepaid amount was to be applied to the drilling of a different well.

3. Prepayments were made to independent third parties on well servicing contracts. The amount of the prepayment was based on an estimate of the service to be provided under the contract. The contracts could be canceled at any time, in which case the prepayment was refundable except to the extent earned by the contractor at that time.

4. Prepayments were made to Big Oke under a contract requiring Big Oke to supervise the drilling of the wells provided for in the turnkey, footage and daywork contracts. The prepayment was based on an estimate of the work to be done by Big Oke. These prepayments were not refundable.
Work on most of the wells called for under the turnkey, footage, and daywork contracts was not commenced until the following year. The IRS will concede that all prepayments involved will qualify as IDC. Can Elizabeth (who is on the cash basis as is the partnership) can claim the entire amount of her $40,000 investment as a deduction on her 19X7 return?

IDC - PROBLEM 5 On December 18, 19X6, Kyle O'Tracy, cash basis, calendar year taxpayer, paid $150,000 to Big Oke Partnership (also cash basis, calendar year entity) for a 20% limited partnership interest. Kyle's $150,000 was raised as follows: .....$50,000 was his own money. .....$50,000 from a loan arranged by Big Oke's general partner. .....$50,000 for a loan from Penny Square Bank (an unrelated third party. The well was spudded in on March 1, 19X7. Big Oke paid the $150,000 to the drilling contractor on a turnkey contract with a valid business purpose by the end of 19X6. Can Kyle deduct any or all of the $150,000 payment in 19X7?

WHO CAN DEDUCT IDC?


ONLY WORKING INTEREST OWNERS

DURING THE COMPLETE PAYOUT PERIOD MUST PAY FOR THE IDC
AND ONLY FOR THE COST ATTRIBUTABLE TO THEIR FRACTIONAL SHARE

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