By: Jack Hollander, Executive Vice President of APX Energy
It’s that time of year when advisors are working with clients reviewing their investments, rebalancing their portfolios, and implementing year-end tax strategies. One asset class that becomes a topic of conversation between many financial advisors and their clients is investing in an oil and gas drilling program. While a program’s economics are critical to the decision-making process, the tax benefits that complement the economics are also essential to understand and consider.
There is more to the tax savings opportunities provided by an oil and gas drilling program than people realize. Advisors that recommend such programs for their accredited clients know that the investment can provide a significant deduction that offsets ordinary income right up until the end of the year.
Often advisors will recommend an oil and gas investment for those converting a traditional IRA to a Roth IRA to offset the phantom income resulting from the conversion. Since the enactment of the Tax Cuts and Jobs Act (TCJA) in September of 2017, advisors use an oil and gas investment to replace lost state and local tax (SALT) deductions that are limited to $10,000. The oil and gas deduction derived from the pass-through of intangible drilling costs is an “above the line” deduction. It does not matter if the client takes the standard deduction or itemizes deductions, which is very restrictive as to what can be deducted.
Most investments made into a drilling program are made as a general partner. However, those with passive income can invest as a limited partner, and now the pass-through of the intangible drilling costs will be characterized as a passive loss that can be used to offset passive income. A lost planning opportunity is with closely held C corporations. These corporations have more than 50 percent ownership by five or fewer shareholders. The business can invest in the drilling program as a limited partner and offset their business income. Just be sure the entity is on a calendar, not a fiscal year for tax reporting purposes.
The CARES Act that was signed into law in March of this year has itself created some planning opportunities with clients. One of its provisions is to repeal the excess loss limit of $250,000 for a single filer or $500,000 for joint filers for tax years 2018, 2019, and 2020. This limitation was enacted as part of the TCJA and applies where the amount of total deductions attributable to all trades or businesses exceed total gross income and gains attributable to those trades or businesses.
An investment in an oil and gas drilling program as a general partner is included in this calculation as it is deemed to be an investment into a trade or business. If a client’s only trade or business activity in 2018 or 2019 was from making a general partner investment into a drilling program and the deduction or loss that year exceeded the $250,000 or $500,000 limitation, then the client should look to amend their tax returns for those years.
Another serious discussion an advisor may want to have with clients is what to do with required minimum distributions. The CARES Act allows for required minimum distributions (RMD) to not be taken in 2020. If the new administration is going to raise taxes, should a distribution be made this year? If so, that is where an oil and gas drilling program’s tax benefit can help offset the income associated with the RMD.
For older clients, consider having the client invest in the oil and gas program. After benefiting from the substantial first-year deduction, they can gift the partnership interest to a child or grandchild who can benefit from the partially sheltered distributions for many years.
Now that the election is over, advisors are planning the next steps to take for clients. For those in the energy sector, it appears it is going to be déjà vu all over again with the next administration. It has been well documented that the President-Elect has an agenda that does not favor the fossil fuel industry.
The goal is to transition away from the oil industry and replace it with renewable energy over time. There has been talk to ban fracking and to eliminate energy subsidies. The so-called subsidies of expensing the intangible drilling cost deduction and the depletion allowance have been part of the tax law for over 100 years.
Lodged in the Revenue Act of 1913 were federal tax incentives for oil and natural gas development, from exploration to production. A statute passed three years later ensured drillers could expense “intangible drilling costs,” such as those incurred when a company decides to develop a new well. The deduction was justified because lawmakers said it would attract investments in US production.
Tax incentives increased during the 1920s. In 1926, Congress passed the oil depletion allowance, allowing producers to deduct more than a quarter of their gross revenues. To repeal or keep this deduction has been debated for decades by different administrations.
The argument made in 1926 that the provisions attract investments in US production was also made by President Eisenhower in 1957 where he commented that “there must certainly be an incentive in this country if we are going to continue the exploration for gas and oil that is so important to our economy.”
And here we are in 2020. It is time for the industry to get ready for the battle that has taken place for decades about energy tax incentives. While there is certainly a place for renewable energy, eliminating or curtailing oil and gas supplies by reducing capital investment, eliminating subsidies, and more government regulation will drastically set back US oil and gas production. Ultimately, it drives up oil and gas prices and makes the US more dependent on oil imports from countries that may or may not be US allies.
This article is for information purposes only and is not intended to provide and should not be relied on for tax, financial, or accounting advice. Consult your own tax, financial, and accounting advisors before engaging in any transaction.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.