Tax Implications & Tax Strategy
for
Energy Sector Investment
Brent Morse
Marvin Morse
Lee Powell
bmorse@morsecapitalpartners.com
804-477-4847
mmorse@morsecapitalpartners.com
918-949-6812
lpowell@morsecapitalpartners.com
804-822-0460
Updated: October 7, 2014
1
The Energy Supply Chain…
The Internal Revenue Code (IRC) provides a number of tax incentives to
encourage investment in and development of oil and gas exploration and
production activities
Upstream
(Energy
Production)
Midstream
(Energy
Infrastructure)
Downstream
(Energy Users)
 Exploration
 Transportation
 Industrial
 Drilling
 Storage
 Commercial
 Processing (Nat Gas)
 Consumer (Refining)
 Measurement
2
What we will cover today
•
Brief update on U.S. energy sector
•
Review of the tax implications of an investment in the energy sector
•
Analysis of applicable IRC sections
•
Explanation of the requirements to claim tax deductions
•
Discussion of expenses, timing and taxes
•
Drill down on tax forms
•
Questions
3
Interesting Trends in Energy
Interesting Trends In Energy
Here we see projections of U. S. energy consumption through 2040 by type of
energy
•
More total energy will be
needed both in the U. S. and
globally
•
EIA forecasts 10 percent
growth in U.S. energy
demand 2011 – 2040
•
Although the share of nonfossil fuels is growing
rapidly, fossil fuels will
continue to play leading
roles through 2040
•
Given expected global
economic and population
growth, energy efficiency
improvements alone will
not be enough in the future
5
Interesting Trends In Energy
Consumption of U.S.-produced energy should continue to increase
•
Key driver today: US based energy users are meaningfully shifting towards
US produced energy (vs. imported)
•
Key driver in future: Greater ability to export U.S.-produced energy
Oil: Domestic vs. Imported
Past (2006)
Domestic
26%
Today (2012)
Potential Future (2020)
Domestic
42%
Imported
74%
Imported
Imported
58%
Domestic
Source: US Energy Information Administration
6
Our Department of Energy announced that the U.S. has hit
another milestone on our path to a more secure energy future.
•
In October 2013, domestic oil production exceeded crude oil imports for the first time since
1995, while petroleum net imports were the lowest since February 1991.
•
For energy, the last two decades have been a story of resurgence and regaining control of our
energy security, and this achievement underscores the changes in how we produce and use
energy.
7
Interesting Trends In Energy
Crude oil production, particularly from tight oil plays, rises sharply
over the next decade
U.S. Energy Administration, Annual Energy Outlook 2013
•
The advent and continuing
improvement of advanced crude
oil production technologies
continue to lift projected
domestic supply
•
The growth results largely from
a significant increase in onshore
crude oil production,
particularly from shale and
other tight formations
•
The sharpest increase of “tight
oil” production occurs by 2020
8
Investment Access to O&G Sector…
Investing in the energy sector…what are the ways investors gain exposure to
the oil and gas industry?
•
Publicly-traded stocks & bonds in oil and gas corporations
•
Mutual Funds that invest in Master Limited Partnerships (MLPs)
•
Exchange-traded Funds & Notes: ETFs and ETNs
• Private Direct-Participation Play (PDPP) in oil and gas
– Own interest in a General Partnership
– The General Partnership pays the bills and collects the revenue
– The Investor deposits checks quarterly and files taxes annually via K-1
•
Direct equity investments in privately-held, energy-related companies
9
Tax Aspects of DPP in Oil and Gas
Here are the key tax aspects
1.
Intangible Drilling Costs (IDC) Deduction
2.
Depletion Allowance
3.
Tax Treatment
4.
Alternative Minimum Tax (AMT)
5.
Tax Strategy
Let’s look at each one in more detail…
10
O&G Investment Incentives…
#1: Intangible Drilling Costs (IDC) tax deduction
•
Ability for investors to deduct the portion of the costs incurred in the drilling
operation
•
Specifically costs that are deemed to be “intangible drilling costs”
•
Of the amount invested, 70 % - 80% deductible from any and all income in the
year of payment
11
O&G Investment Incentives…
What are Intangible Drilling Costs?
•
Costs to develop an oil or gas well for the elements that are not a part of the final
operating well
•
Intangible drilling costs (IDCs) include all expenses made by an operator incidental
to and necessary in the drilling and preparation of wells for the production of oil
and gas, such as:
–
–
–
–
–
–
–
–
•
Survey work
Site preparation
Drainage
Renting drilling rigs
Wages
Fuel
Repairs
Supplies
Broadly speaking, expenditures are classified as IDCs if they have no salvage value
12
O&G Investment Incentives…
13
O&G Investment Incentives…
Requirements to Claim IDC Deductions
FIRST…
Investor must have a “working interest” (WI) in the property
•
WI is direct ownership, entitling the investor to the revenue produced by the oil
and gas wells, and requiring the investor to pay their share of expenses of
operating the wells
•
The General Partnership takes care of paying the bills, making the deposits,
managing the accounting and sending the investors quarterly checks (for their
share of the profits) and K-1’s for filing of taxes
EASY for the investor
14
O&G Investment Incentives…
Requirements to Claim IDC Deductions
These are business entities in which income and losses
pass through to the owners:
1. Sole proprietor
2. Participants in joint ventures
3.Partners in partnerships
4. Shareholders in subchapter S corporations
15
O&G Investment Incentives…
Requirements to Claim IDC Deductions
SECOND…
• Taxpayer must be considered an “active participant” in the
venture
IRC Section 467…Passive Activity Rules
•
Active participation usually requires a taxpayer to spend a significant amount of
time in the activity and/or take part in significant operating decisions
•
May be a problem for many investors…lacking the time or expertise to be an active
participant
•
However…
16
O&G Investment Incentives…
Requirements to Claim IDC Deductions
IRC Section 469 (c) (3) (A)
• When a taxpayer holds a working interest (directly or
indirectly) through an entity that does not limit his liabilities
with respect to that interest…
• The activity will NOT be considered passive, and
• The related losses / deductions will not be limited by these
rules
17
O&G Investment Incentives…
Tax Reform Act of 1986
•
Investment income/expense divided into two baskets:
– Active
– Passive
•
Provides an exception for working interests in natural gas and oil from being part
of the passive income basket
•
If a loss resulted (from expenditures for drilling wells), it was deemed to be an
active loss that could be used to offset active income, as long as the investor’s
liabilities were not limited
18
O&G Investment Incentives…
Let’s review examples of tax returns and note the differences in the investor’s
tax position
EXAMPLE
Total Income
EXAMPLE One
EXAMPLE Two
EXAMPLE Three
$250,000
$250,000
$250,000
$250,000
$0
$150,000
$250,000
$180,000
IDC %
80.00%
80.00%
80.00%
80.00%
IDC $
$0
$120,000
$200,000
$144,000
$250,000
$130,000
$50,000
$106,000
$12,200
$12,200
$12,200
$12,200
$7,800
$7,800
$7,800
$7,800
Total Deductions
$20,000
$20,000
$20,000
$20,000
Taxable Income
$230,000
$110,000
$30,000
$86,000
$52,213
$19,358
$3,611
$13,364
$0
$0
$9,181
$884
$52,213
$19,358
$12,792
$14,248
O&G Investment Deduction
Adjusted Gross Income
Standard Deductions
Exemptions
Regular Tax
Alternative Minimum Tax
TOTAL TAX
19
O&G Investment Incentives…
Alternative Minimum Tax
Excess IDC:
Total IDC
Allowable IDC
AGI
Total IDC
$200,000
x 10%
$20,000
$50,000
$200,000
$250,000
x 40%
$100,000
Includable IDC
Allowable IDC
Taxable IDC
$100,000
$20,000
$80,000
20
O&G Investment Incentives…
Expenses, Timing and Taxes
Usually deduct costs for events that have happened during the tax year
Question:
If taxpayer invests in O&G in early December,
will the operator complete the drilling operation by December 31?
Answer:
Hinges on another unique aspect of the oil and gas industry
21
O&G Investment Incentives…
Expenses, Timing and Taxes
IRC Section 461 (i) (2) (A)
• Provides solution to this timing problem
• Amounts paid for IDC during the tax year are treated as
deductible in the current tax year…
• As long as drilling begins within the first 90 days of the
following year
• So there is a March 31 deadline for drilling to commence on a
well
22
O&G Investment Incentives…
Expenses, Timing and Taxes
YEAR ONE
YEAR TWO
Invest $$
By
December 31
Commit to commence
drilling operation
by March 31
IDC $$ deductible in Year One
23
Tax Aspects of DPP in Oil and Gas
Here are the key tax aspects
1. Intangible Drilling Costs (IDC) Deduction
2. Depletion Allowance
3. Tax Treatment
4. Alternative Minimum Tax (AMT)
5. Tax Strategy
24
O&G Investment Incentives…
#2: Depletion Allowance…an on-going tax
deduction
•
Once production occurs, there is a tax deduction of 15% of gross revenue against
all production of oil and gas… annually
•
It is a direct and on-going break of 15% of income that is not taxed
Percentage Depletion:
1. All mineral resources are permitted to use percentage depletion to
reflect the decreasing value of their resource as it is being produced
2. Originally added to the Tax Code in 1926, the oil and gas percentage
depletion allowance applies ONLY to America’s smaller independent
producers and royalty owners
25
Tax Aspects of DPP in Oil and Gas
Here are the key tax aspects
1. Intangible Drilling Costs (IDC) Deduction
2. Depletion Allowance
3. Tax Treatment
4. Alternative Minimum Tax (AMT)
5. Tax Strategy
26
O&G Investment Incentives…
#3: Tax Treatment
• Operation continues to operate as a general partnership
– Income taxed as ordinary income, less Depletion Allowance
– Subject to SE tax
• May be limited to Medicare percent only
27
Tax Aspects of DPP in Oil and Gas
Here are the key tax aspects
1. Intangible Drilling Costs (IDC) Deduction
2. Depletion Allowance
3. Tax Treatment
4. Alternative Minimum Tax (AMT)
5. Tax Strategy
28
O&G Investment Incentives…
#4: Alternative Minimum Tax Considerations
IRC Section 57 (2) (e): exemption for independent producers
IRC Section 291 (b) (4): definition of one who is not an integrated oil company
• The AMT rule for intangible drilling costs (IDC)
– “Independent producers” as defined by the IRC are exempt from adding intangible
drilling costs back for AMT
– Until the excess intangible drilling exceeds 40% of AMT taxable income, including
100% of IDC
– Then it must be added to the extent it exceeds 40%
• All the potential investors are independent producers
– Have to be an integrated oil company not to be an independent producer
29
Tax Aspects of DPP in Oil and Gas
Here are the key tax aspects
1. Intangible Drilling Costs (IDC) Deduction
2. Depletion Allowance
3. Tax Treatment
4. Alternative Minimum Tax (AMT)
5. Tax Strategy
30
Tax Strategy…connecting the dots
#5: Client Tax Strategy
1. Working with a client in Q3 / Q4 on managing their tax
liability
2. Opportunity to leverage an O&G investment for investment
and tax considerations
3. For an accredited investor
4. With right risk profile for an O&G investment
5. And the right time for an O&G investment
31
Managing individual’s liability…
Addressing your client’s risk profile
• Quite low for individual investor with a minority interest in a
partnership with a minority working interest (WI) in a well
• Chain of liability…extensive liability insurance as required by
state law
– For individual operators (and their subcontractors) at each well site
•
•
•
Our operators coverage includes $5 million in general liability,
$15 million in control of well insurance during drilling operation
In addition: workmen's comp., auto, and special lines coverage for down-hole tools etc.
– Plus our Funds carry additional insurance:
•
•
•
$3 million Umbrella Policy during first year of each Fund
General Liability coverage in amount of $2 million in the aggregate and $1 million per occurrence for life of the
Partnership
With over 100 well participations, no claim to date or any liability
32
Managing individual’s liability…
Addressing your client’s risk profile
• Additional options, as deemed appropriate
1.
Invest as an individual in the General Partnership
2.
Invest at end of Year One, set up LLC for individual early in Year Two
33
Q&A
34
EXAMPLE
35
EXAMPLE
36
EXAMPLE
One
37
EXAMPLE
One
38
EXAMPLE
One
39
EXAMPLE
One
40
EXAMPLE
Two
41
EXAMPLE
Two
42
EXAMPLE
Two
43
EXAMPLE
Two
44
EXAMPLE
Three
45
EXAMPLE
Three
46
EXAMPLE
Three
47
EXAMPLE
Three
48
Presenter Bios…
•
Brent Morse, managing director of Morse Capital Partners, has worked with high-net worth investors and their families for
over 15 years. Prior to starting his firm, Brent was a partner at Cary Street Partners, a regional wealth advisory and
investment banking firm. As Head of Capital Markets Research, Mr. Morse was responsible for manager due diligence of all
asset types, including hedge funds and private equity, as well as asset allocation strategy for the firm.
Prior to Cary Street Partners, Brent worked in Ernst & Young’s Personal Financial Counseling practice helping investors work
through the financial and tax implications of their company retirement and compensation plans including company stock
and option strategies, insurance analysis, cash flow planning and estate plan modeling. He started his career at Scott &
Stringfellow, a regional brokerage firm headquartered in Richmond, Virginia where he focused on investment management
and research as well as obtained his Chartered Financial Analyst (CFA) designation. He graduated from San Diego State
University-California State University.
•
Marvin Morse, Founder of Morse and Co., P.C., Tulsa, OK. Marvin’s oil and gas industry experience includes accounting
and tax services for both individual investors and industry operators since 1971.
A licensed certified public accountant in the State of Oklahoma since 1971., Marvin started Morse and Co., P.C. in 1975 with
a focus on professional accounting, auditing, tax and management advisory services. Marvin has over 38 years of
experience in the areas of attestation services for small - to medium-sized clients and federal and multi-state tax
compliance. In addition, areas of focus include providing management advisory services in the areas of debt financing and
reorganization, acquisitions and sales, cost controls, cash flow projections, and ESOP transactions.
•
Lee Powell , co-founder of Morse Capital Partners Oil and Gas, has twenty-five years of experience in operations in financial
services, manufacturing and nonprofit organizations in both the United States and United Kingdom. He worked at Capital
One Financial Services for ten years, during which time he held a number of operations management positions, with a
principal focus on leading large start-up and turnaround programs. His previous professional experience includes
management consulting and product marketing.
Lee earned an MBA from the Mason Graduate School of Business at the College of William and Mary. He also earned his
bachelor’s degree from the College of William and Mary. Lee is an Investment Advisor Representative, and he has earned a
Series 65 License.
49