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How oil and gas working interest investments work

The working interest owner needs your money. You want to invest your money in natural resources with the opportunity for a high return. It is a match made in heaven. The oil and gas industry has been very creative at balancing the need for development money and the desire for a higher investment return.

So, how does an oil and gas working interest work?

Oil and Gas Investors and Working Interest

It happens every day. A working interest owner has a great tax property that is ready for development but doesn’t have the funds to get started. That’s where you come in. To speed things along, the working interest owner conveys part of their working interest share to outside investors in return for cash to be used in the drilling and development. As the investor, more often than not, you agree to pay more than your share of the drilling and completion costs to be able to participate in the production.

This type of arrangement is commonly referred to as a "third-for-a-quarter-deal." The typical arrangement was based on an investor agreeing to pay one-third of the drilling and development costs, and in return, they would receive one-fourth of the working interest owner's ownership share. Theoretically, the working interest owner transfers 100% of the costs of the drilling and development to an investor (or group of investors) and in return only gives up 75% of the working interest ownership.

Let’s assume you are the investor and you enter into a deal to pay for 100% of development in exchange for 75% of the working interest. You invest $600,000. As the investor, you will get to expense up to 75% of the intangible drilling and development costs (IDCs) related to this working interest. If the whole $600,000 is related to IDCs, your allowable deduction is $450,000. The IDC deduction is limited to your ownership in the working interest.

When do I get the deduction?

Many times the investment is made right before year-end and the drilling program has not commenced. Generally, accrual basis taxpayers who have elected to expense IDCs must determine when the liability accrues and deduct all costs incurred or accrued through the end of the tax year, even if the well is not completed.

Most individual investors are cash basis taxpayers. As such, the costs are normally deductible in the year paid if they were incurred during that year or in a prior year. This is where it gets really interesting. Investors have learned about prepaid IDCs (more to follow on this subject in our next post). Aggressive taxpayers attempt to prepay their costs at year end and take the deduction in the current year.

Can I prepay next year’s IDC and take a deduction?

Yes you can, if you follow the rules. Cash basis taxpayers do this by cash prepayments and accrual basis taxpayers use contracts and other arrangements that allow them to deduct the contract amount well before actual payments are made.

This has led to many court cases, revenue rulings and private rulings on the subject. In the Examination of Tax Shelters Handbook of the IRS, the following guidelines were developed for determining whether prepaid IDC is deductible:

  • Prepayment must be made to the drilling contractor.
  • There must be a legally enforceable obligation to make the prepayment by a specific date.
  • The prepayment must be required of all working interest holders.
  • The amount of the prepayment must be determined at arm's length and should be reasonable, considering the amount the drilling contractor will earn under the contract.
  • There must be a legitimate business purpose for the prepayment.
  • The drilling should be completed within a reasonable period of time after the prepayment. This period would depend on the area and the depth of the wells involved.
  • The drilling contract should specify the location of the well or wells.

These requirements are just the first step. Depending on the type of taxpayer you are, your method of accounting and a special status as a tax shelter, you may have different hurdles to cross before you can deduct any prepaid items. Connect with our team to learn more

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