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

Bit Cuttings

Drill Stem

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)

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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.

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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

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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