In 1926, Congress introduced the "excess of percentage over
cost depletion deferral," a.k.a.
The amount of taxable royalties, but not land lease payments, may be reduced by a depletion deduction, calculated either under the percentage depletion method or the
cost depletion method.
As discussed below, qualification for the bulk sale exception directly affects the taxpayer's ability to use the most advantageous method of calculation for
cost depletion.
There are a number of deductions specific to the oil and gas industry, such as the ability to expense intangible drilling costs (IDCs) and to claim percentage depletion instead of
cost depletion. (23) Oil and gas producers are also eligible for the Section 199 production activity deduction.
The first method is "
cost depletion."
Cost depletion essentially involves recovery of a portion of the taxpayer's adjusted basis each year, based on the amount of oil or gas recovered for that year and the total anticipated production.
Depletion deductions compensate the owner of wasting mineral assets "for the part exhausted in production, so that when the minerals are gone, the owner's capital and his capital assets remain unimpaired."16 There are two different types of depletion:
cost depletion and percentage depletion.
The alternative to percentage depletion is "
cost depletion," which essentially bases the deduction on proration of the investor's basis in the property between the number of oil or gas units sold during the year and the number of estimated units remaining.
Other states require capitalization of intangible drilling costs or the use of
cost depletion. Louisiana and Oklahoma allow taxpayers to use percentage depletion in lieu of
cost depletion.
* Depletion after 1989 is
cost depletion, which had previously been the same method used for regular tax purposes.
Although there are two available methods of depletion,
cost depletion and percentage depletion, generally oil and gas operations may use only the
cost depletion method (Regs.
Examples of category II costs are marketing, advertising, selling, distribution & handling, research, engineering, casualty and theft loss, percentage depletion in excess of
cost depletion, income taxes, general and administrative (overall activities), and bidding expenses.
