|By Casey Sullivan, CFP®|
As Certified Financial Planners™ serving hundreds of families in the southeast, our clients frequently ask for ways to reduce their income taxes. Depending on their situation, we discuss retirement plan strategies, gifting strategies, business structures, and tax efficient portfolios. We believe one of the most under used and effective tax reduction strategies for accredited investors are Oil and Gas Drilling Partnerships.
We are experiencing an American energy renaissance. With historic volumes of proven oil and natural gas reserves, the USA is poised to become a net energy exporter by 2022, according to the U.S. Energy Information Administration. To encourage investment in domestic energy production, the federal government grants direct investments in to oil and gas production very meaningful tax benefits.
Properly structured oil and gas partnerships allow retail investors to reap tax benefits by investing alongside energy companies in domestic oil and gas wells. The tax deductions flow through to their personal tax returns. When used as part of a comprehensive wealth and tax management strategy, an oil or gas drilling partnership investment can be a powerful tool to reduce taxes while creating a long term tax advantaged income stream.
An important consideration is the cash on cash return of the well. In other words, you want the well to pay you back. Thus every partnership must be vetted as not all are created equal. A good partnership should return the initial investment in 5-7 years, and continues producing an income stream for 20 years or more.
Per the Internal Revenue Code, tax deductions from an oil/gas partnership investment are:
1. Intangible Drilling Cost (IDC) – These may be expensed in the current tax year and may be used to offset ANY type of gain. This is an above line deduction like a charitable donation, which means gross adjusted income is reduced before any other calculations happen. In our experience, IDC deductions can be in the range of 70-85% of your total investment. These numbers can vary with each partnership.
2. Percentage Depletion Allowance deduction. This is what makes the oil and gas income tax advantaged. Once the well generates revenue, 15% of the gross income is offset by the depletion allowance for the life of the partnership.
3. Depreciation on well equipment. This is now accelerated and allows an additional 10% of your investment to be deducted by the second year. (Tax Cuts and Jobs Act 2017)
Besides lowering this years income taxes, oil and gas partnerships have other benefits including:
1. Lowering the alternative minimum tax (AMT). Since IDC’s are an above the line deduction, they can lower alternative minimum taxable income without generating a tax preference.
2. Roth IRA conversions. If you want to convert a traditional IRA or old 401k to a Roth IRA, the conversion triggers previously deferred taxes. An oil/gas partnership creates a tax loss to offset the taxes triggered by the conversion.
3. Estate planning benefits. The IRS allows a discounted valuation for certain securities when calculating gift taxes. Per the IRC, an oil and gas partnership receives a significant discount for being a minority interest and another discount for lack of marketability. Investors can buy partnership units, use the up-front tax deductions and then gift the units to heirs at the greatly discounted valuation, effectively moving a large portion of the investment amount tax-free to heirs and provide them with tax-advantaged income.
If your income is over $250K this year or your situation could benefit from the estate and tax strategies discussed, we may be able to help you. Please call our office at 770-771-5812 to discuss if an oil and gas partnership makes sense for your personal situation. Always consult your tax professional. We are happy to discuss this with them and run a no-cost tax analysis.