Energy Taxation
& Offering
Structure
Developments
Brad Updike, Mick & Associates
Wally Kunzman, Kunzman & Bollinger
Jack Hollander, Atlas Energy
Brett Evans, Hull Evans & Kob
Energy Taxation & Offering
Developments
• Tax Fundamentals
• Tax Program/Investment Pitfalls
• Tax Legislative Developments
• Program Structure (Public vs. Private)
• General Solicitation
• 1031 Issues
• Marketing Issues (Rule 2210, RN 13-18)
• RIA Participation in DPPs
• Issuer Exemption
Programs Having Varying Tax
Consequences
Sources of Income
- Active (Wages, Managed Businesses, SSI, Pensions)
- Passive (Non-Managed Businesses, Most Rental Activities)
- Portfolio (Dividends, Bond Interest, Royalties)
- Capital Gains (Portfolio or Passive)
- Self Employment Income Presents Additional Planning Opportunities
Must Understand Client’s Income on Multiple Levels Because Tax Features
Vary By Program
- Drilling Programs (Depletion, IDC Follow the GP/LP Election)
- Royalties (Depletion, Portfolio Income, Not UBTI in RIA, No IDC)
- Producing WI (Passive Income Generator for LP investor)
- Hybrid Production/Lease Development (Some IDC, Cap Gains)
- §1031 Direct Ownership Programs (Tax Deferral vs. Load Adjusted
IRR; Does the Economics Justify the Investment?)
Drilling Program Use of Capital
Falls Into Four Buckets
Intangible Drilling Costs (55% to 65% of Program Cap Ex
Tangible Equipment (15% to 20% of Program Cap Ex)
Offering Expenses (10% to 13% of Program Cap Ex)
Leasehold Costs (5% to 15% of Program Cap Ex)
Program Cap Ex = Investors + Sponsor Capital
Amount of General Partner Capital Varies by Sponsor And
Sponsor Contribution Facilitates Functional Allocations
Extent/Timing of Deductions Follow Use of Funds
Why Deductions Can Vary From Program to Program
Functional Allocations Require Substantial Economic Effect
Intangible Drilling Cost Deductions
• Are Non-Salvageable Costs Incurred in Drilling Wells (e.g.,
Rig Time, Drilling Fluids, Operator Supervision)
• Are Associated With Drilling, Completion, and Work Over
Activities
• Can Be Up To 100% of the Investor Capital
• Investor Election To Expense OR Amortize Over 60 Months
• Timing of Deduction is Tied to the Commencement of
Drilling (Need Non-Refundable Payment to Operator by
Dec. 31 of Investment Year and Commencement of
Drilling Within First 90 Days of Following Year for the UpFront Deduction)
GP/LP Election and Conversion
• You Must Pay Attention to the Client’s Income
• GP Election Needed To Use IDC Against Active and Self
Employment Income
• Some Programs Will Let You Bifurcate the Election But Once
A GP Always A GP For Tax Purposes
• GP’s Are Liable for Partnership Liabilities Incurred Prior To
Conversion To LP Status
• Conversion Should Occur After All Development Activities
Are Finished (See, Treas. Reg. 1.469-1T(e)(4)(iii) (e.g. 2)
(if economic performance relative to the IDC is deemed to
occur when interest is passive, you could have passive IDC
deductions).
• LP Election by a Closely Held C-Corporation
Tax Structure/Investment Pitfalls
• Must Match Income to the GP/LP Election Decision
(Planning)
• Drilling Ahead of the Raise
• Taking Away the “At-Risk” Element (e.g., Premature
Conversion of the GP Interest Falls Here)
• Paying IDC With Leverage (What Constitutes a Payment
for Economic Performance Purposes, Structure)
90-Day Rule-What Constitutes Drilling?
Caltax Oil Venture, et. al., v. Commissioner of Internal
Revenue U.S. Tax Court, Jan. 2012 Doc. No. 3793-08
• IDC Was Prepaid in 1999 on a Turnkey Contract by Cash
and Notes
• Some Permitting Activities Occurred Before March 31, 2000
• The Drill Bit Did Not Land in the First 90 Days of Year
Following the Investment Year
• IRS Says You Have to Spud to Deduct in Year of Investment
• Taxpayer Says “Commencement of Drilling” Can Include PreDrilling Activities (e.g., Permits, Surveys, Location Building)
• A CCH Tax Manual Excerpt Points Out That the Word
“Spudding” was not Used in the Primary Rule Language of
IRC 461(i).
Caltax Oil Venture, et. al., v. Commissioner (Cont.)
• IRS Gets a Victory at the Tax Court Level
• Tax Court Construes the “Commencement of Drilling” Term
by its Plain Meaning in Webster’s 3rd Dictionary
• You Could Have Different Results Across the Federal Circuits
• Don’t Oversell the First Year IDC Deduction
Side Note: Notice the long and drawn out progression of the problem
from 1999 when the deduction was taken until 2012 when the Tax
Court’s ruling came out; 6-year SOL for material understatement
of income per IRC 6501(a).
Case is on appeal to the 3rd Federal Circuit.
Be Careful About Making Energy Investments With
Qualified Money
• Unrelated Business Taxable Income (“UBTI”) Could Apply
• Drilling Programs Typically Not Suited for IRAs and Other
Qualified Plans (You Normally Want to Match IDC With
Income of Taxpayers in Higher Tax Brackets)
• IRA Custodians Treat UBTI Exposure Differently
• Royalties Could Make Sense Depending on Investor’s
Financial Circumstances
• Sect. 512(b) Lists Non-UBTI Income Sources
Recent Tax Developments
New Tax Rates
Married Filing Jointly
• $0 to $8,925 = 10% rate
• $8,926 to $36,250 = 15%
• $36,251 to $87,850 = 25%
• $87,851 to $183,250 = 28%
• $183,251 to $398,350 = 33%
• $398,351 to $400,000 = 35%
• $400,001 and above = 39.6%
Single Filers
• $0 to $8,925 = 10% rate
• $8,926 to $36,250 = 15%
• $36,251 to $87,850 = 25%
• $87,851 to $183,250 = 28%
• $183,251 to $398,350 = 33%
• $398,351 to $400,000 = 35%
• $400,001 and above = 39.6%
Bonus Depreciation
New Medicare Tax
IDC Discussions
Public vs. Private (NASAA Guidelines)
General Solicitation
Historically Engrained In Oil & Gas (Unfortunately)
Requirements
Will It Affect Energy Program Quality?
Energy Programs Can
Sometimes Cater to § 1031
Planning
§1031 Going In and At Exit:
- Royalties
- Mineral Interests
- Leasehold Interests
- Working Interests in Producing Wells
- Direct Interest in Pipelines (state law applies)
§1031 at Exit:
- Working Interests in To-Be Drilled Wells
No §1031 Treatment
- Partnerships and LLC Interests
- Most Production Payments
Like-Kind Exchange Treatment Not Applicable to Partnership
Interests; but May Apply to One of the Above Held in a
Single Member LLC
1031 Developments
Structure: Avoid P’ship Characteristics
Control:
Title:
1-Year Management Contracts & JOA
Ability to Sell
Manager Removal
Direct Title Preferable
Subscription/
Participation Agreement:Elect out of P’ship Status
Tangible Equipment Cost
Deductions
• Applies to Salvageable Equipment (e.g., Pipe, Separators,
Tanks)
• Historically 7-Year Deduction With Higher Accelerated
Deduction in First 2-3 Years (MACRS)
• Tangible Equipment is Typically 15-35% of the Total
Drilling and Completion Costs
• 2010 Tax Act Allows For 50% Bonus Depreciation for
Equipment Placed in Service in 2013
Depletion Allowance
• A Somewhat Similar in Concept to Depreciation for
Real Estate
• Cumulative Depletion Can Exceed Client’s Basis
• Shelters 15% of Oil, Gas and Royalty Cash Flow
from Taxation
• Not an AMT Preference Item
Alternative Minimum Tax
Opportunities and Pitfalls
• AMT Review Pre-Investment Offers Planning Opportunities
(i.e., High Real Estate and State Income Taxes)
• Excess IDC = [IDC Deducted-IDC Amortized Over 10 Years] –
65% Net Income From Oil & Gas
• IDC From Non-Productive Wells Excluded
• Applies if Excess IDC Exceeds 40% of Alternative Minimum
Taxable Income
• Quick Test: Did You Reduce Alternative Minimum Taxable
Income 40% or More?
• Does not Apply if Investor Capitalizes and Deducts IDC’s Over
60 Months
Questions?