Oil and Gas Case

G&G costs

are considered inherently capital in nature and must be added to the tax basis of property

acquired or retained. A reconnaissance G&G survey to locate portions of the project area having the

greatest potential for containing oil and gas is done. All costs are initially allocated to a single project and

any further costs to evaluate an area are capitalized to that area of interest. No deduction if only a part

of an area of interest is acquired. If the survey does not result in property acquisition, the costs can be

written off in the same year.

Acquisition costs:

paid by the lessee should be capitalized and added to the

basis of the property acquired. One such cost is the lease bonus paid by the lessee to the lessor. Other

costs include: broker fees, legal fees and filing fees. These costs are recovered through cost depletion or

percentage depletion along with capitalized G&G, shooting rights, test-well contributions, etc. In the case

of a subleased producing property, the new WI must apportion the consideration paid between the

leasehold and equipment. When the cash consideration exceeds the depreciable basis of the equipment,

the excess is considered as a lease bonus and treated as ordinary income; otherwise the excess

equipment basis is depleted along with that interest in the interest retained.

Drilling operations:

tax

treatment depends on whether the producer is an independent or integrated producer (an entity that

has refining or retailing activities on the side). Independent producers must have refining or retailing

activities below the maximum amount. A refiner exceeds 75,000 bbl/day. If an election is made in the

first tax return to expense IDC then all IDC may be expensed by the taxpayer with the exception of

integrated producers, who must capitalize 30% of IDC incurred on productive wells. Most important

consideration is the proper separation of drilling costs between 1.) IDC and 2.) Lease and well

equipment. Lease and well equipment must be capitalized and recovered through depreciation.

Equipment costs must be capitalized and include all tangible property costs before and after the

Christmas tree and intangible costs after the Christmas tree. IDC is any expenditure that does not have a

salvage value and necessary for the drilling of wells.

Equipment costs:

lease and well equipment

installed or constructed must be capitalized. These costs are normally recovered through depreciation.

Production operations:

revenue arising from the production and sale of oil and gas products is ordinary

income. The revenue paid to the royalty interest owner is royalty expense and taxable income to the

owner. Ordinary and necessary business expenses incurrent in lifting the oil and gas and treating it for

sale are deductible as necessary and reasonable operating expenditures. Leasehold costs are recovered

through cost depletion or percentage depletion. Depreciable property such as tangible assets and

intangible costs after the Christmas tree can be recovered using depreciation methods. Lease and well

equipment is depreciated over a seven-year period using a 200% declining balance method.

Percentage

depletion:

must be taken when allowed and if greater than cost depletion. Allowed only for royalty

interest owners and independent producers of oil and gas and does not apply to companies with

integrated functional areas. Computed by multiplying the gross revenues by 15% as established by

federal statutes. The amount of oil or gas depleted cannot exceed 1,000 barrels of oil or 6,000 Mcf of

gas. It is deducted from the capitalized leasehold costs and elected capitalized IDC. It may be taken even

if all capitalized costs have been recovered. Cost depletion is limited to the amount of capitalized costs.

CHAPTER 12

Pooling:

If separate properties are combined before reserves are discovered.

Unitization:

Id separate

properties are combined after the development of all or some of the properties.

Joint Operating

Agreements:

1.) Joint ventures; in an undivided interest, the parties share the interest in an entire lease.

A company having a 50% undivided interest in a 640 acre lease owns a 50% interest in the entire 640

acres. Divided interest is where a company owns a 100% interest in 320 acres carved out of a 640 acre

lease. Companies in a joint venture of undivided interests may acquire an undivided interest in a

property when it is initially acquired. Companies having divided interest before unitization or pooling will

have an undivided interest after the properties are pooled or unitized. 2.) Legal partnerships are done

under laws of a particular state to achieve certain income tax or legal objectives. 3.) Jointly