The following discussion of oil & gas tax matters is taken - literally (copied & pasted) - straight from the IRS's own website (www.irs.gov), and represents our attempt to comb through that website and restate here some of the more critical aspects of our government's view of investing in the domestic oil & gas business.

Intangible Drilling Costs

"The costs of developing oil, gas, or geothermal wells are ordinarily capital expenses. You can usually recover them through depreciation or depletion. However, you can choose to deduct intangible drilling costs (IDCs) as a current business expense. These are certain drilling and development costs for wells in the United States in which you hold an operating or working interest. You can deduct only costs for drilling or preparing a well for the production of oil, gas, or geothermal steam or hot water.

You can choose to deduct only the costs of items with no salvage value. These include wages, fuel, repairs, hauling, and supplies related to drilling wells and preparing them for production. Your cost for any drilling or development work done by contractors under any form of contract is also an IDC. However, see Amounts paid to contractor that must be capitalized, next.

You can also choose to deduct the cost of drilling boreholes to determine the location and delineation of offshore hydrocarbon deposits if the shaft is capable of conducting hydrocarbons to the surface on completion. It does not matter whether there is any intent to produce hydrocarbons.

If you do not choose to deduct your IDCs as a current business expense, you can choose to deduct them over the 60-month period beginning with the month they were paid or incurred.

Amounts paid to contractor that must be capitalized. Amounts paid to a contractor must be capitalized if they are either:

How to make the choice. You choose to deduct IDCs as a current business expense by taking the deduction on your income tax return for the first tax year you have eligible costs. No formal statement is required. If you file Schedule C (Form 1040), enter these costs under "Other expenses."

Energy credit for costs of geothermal wells. If you capitalize the drilling and development costs of geothermal wells that you place in service during the tax year, you may be able to claim a business energy credit. See Form 3468 for more information.

Nonproductive well. If you capitalize your IDCs, you have another option if the well is nonproductive. You can deduct the IDCs of the nonproductive well as an ordinary loss. You must indicate and clearly state your choice on your tax return for the year the well is completed. Once made, the choice for oil and gas wells is binding for all later years. You can revoke your choice for a geothermal well by filing an amended return that does not claim the loss.

Costs incurred outside the United States. You cannot deduct as a current business expense all the IDCs paid or incurred for an oil, gas, or geothermal well located outside the United States. However, you can choose to include the costs in the adjusted basis of the well to figure depletion or depreciation. If you do not make this choice, you can deduct the costs over the 10-year period beginning with the tax year in which you paid or incurred them. These rules do not apply to a nonproductive well.

Exploration Costs

"The costs of determining the existence, location, extent, or quality of any mineral deposit are ordinarily capital expenses if the costs lead to the development of a mine. You recover these costs through depletion as the mineral is removed from the ground. However, you can choose to deduct domestic exploration costs paid or incurred before the development stage began (except those for oil, gas, and geothermal wells).

How to make the choice. You choose to deduct exploration costs by taking the deduction on your income tax return or on an amended income tax return for the first tax year for which you wish to deduct the costs paid or incurred during the tax year. Your return must adequately describe and identify each property or mine, and clearly state how much is being deducted for each one. The choice applies to the tax year you make this choice and all later tax years.

Partnerships. Each partner, not the partnership, chooses whether to capitalize or to deduct that partner's share of exploration costs.

Reduced corporate deductions for exploration costs. A corporation (other than an S corporation) can deduct only 70% of its domestic exploration costs. It must capitalize the remaining 30% of costs and amortize them over the 60-month period starting with the month the exploration costs are paid or incurred. The 30% the corporation capitalizes cannot be added to its basis in the property to figure cost depletion. However, the amount amortized is treated as additional depreciation and is subject to recapture as ordinary income on a disposition of the property. See Section 1250 Property under Depreciation Recapture in chapter 3 of Publication 544.

These rules also apply to the deduction of development costs by corporations. See Development Costs, later.

Recapture of exploration expenses. When your mine reaches the producing stage, you must recapture any exploration costs you chose to deduct. Use either of the following methods.

You also must recapture deducted exploration costs if you receive a bonus or royalty from mine property before it reaches the producing stage. Do not claim any depletion deduction for the tax year you receive the bonus or royalty and any later tax years, until the depletion you would have deducted equals the exploration costs you deducted.

Generally, if you dispose of the mine before you have fully recaptured the exploration costs you deducted, recapture the balance by treating all or part of your gain as ordinary income.

Under these circumstances, you generally treat as ordinary income all of your gain if it is less than your adjusted exploration costs with respect to the mine. If your gain is more than your adjusted exploration costs, treat as ordinary income only a part of your gain, up to the amount of your adjusted exploration costs.

Foreign exploration costs. If you pay or incur exploration costs for a mine or other natural deposit located outside the United States, you cannot deduct all the costs in the current year. You can choose to include the costs (other than for an oil, gas, or geothermal well) in the adjusted basis of the mineral property to figure cost depletion. (Cost depletion is discussed in chapter 10.) If you do not make this choice, you must deduct the costs over the 10-year period beginning with the tax year in which you pay or incur them. These rules also apply to foreign development costs.

Development Costs

"You can deduct costs paid or incurred during the tax year for developing a mine or any other natural deposit (other than an oil or gas well) located in the United States. These costs must be paid or incurred after the discovery of ores or minerals in commercially marketable quantities. Development costs include those incurred for you by a contractor. Also, development costs include depreciation on improvements used in the development of ores or minerals. They do not include costs for the acquisition or improvement of depreciable property.

Instead of deducting development costs in the year paid or incurred, you can choose to treat them as deferred expenses and deduct them ratably as the units of produced ores or minerals benefited by the expenses are sold. This choice applies each tax year to expenses paid or incurred in that year. Once made, the choice is binding for the year and cannot be revoked for any reason.

How to make the choice. The choice to deduct development costs ratably as the ores or minerals are sold must be made for each mine or other natural deposit by a clear indication on your return or by a statement filed with the IRS office where you file your return. Generally, you must make the choice by the due date of the return (including extensions). However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). Clearly indicate the choice on your amended return and write "Filed pursuant to section 301.9100-2." File the amended return at the same address you filed the original return.

Foreign development costs. The rules discussed earlier for foreign exploration costs apply to foreign development costs.

Reduced corporate deductions for development costs. The rules discussed earlier for reduced corporate deductions for exploration costs also apply to corporate deductions for development costs.

Sale of property interest. If you sell your complete interest in oil, gas, or mineral rights, the amount you receive is considered payment for the sale of section 1231 property, not royalty income. Under certain circumstances, the sale is subject to capital gain or loss treatment on Schedule D (Form 1040). For more information on selling section 1231 property, see chapter 3 of Publication 544.

If you retain a royalty, an overriding royalty, or a net profit interest in a mineral property for the life of the property, you have made a lease or a sublease, and any cash you receive for the assignment of other interests in the property is ordinary income subject to a depletion allowance.

Part of future production sold. If you own mineral property but sell part of the future production, you generally treat the money you receive from the buyer at the time of the sale as a loan from the buyer. Do not include it in your income or take depletion based on it.

When production begins, you include all the proceeds in your income, deduct all the production expenses, and deduct depletion from that amount to arrive at your taxable income from the property. 

Royalties

"Royalties from copyrights, patents, and oil, gas, and mineral properties are taxable as ordinary income.

You generally report royalties in Part I of Schedule E (Form 1040). However, if you hold an operating oil, gas, or mineral interest or are in business as a self-employed writer, inventor, artist, etc., report your income and expenses on Schedule C or Schedule C-EZ (Form 1040).

Oil, gas, and minerals. Royalty income from oil, gas, and mineral properties is the amount you receive when natural resources are extracted from your property. The royalties are based on units, such as barrels, tons, etc., and are paid to you by a person or company who leases the property from you.

Depletion. If you are the owner of an economic interest in mineral deposits or oil and gas wells, you can recover your investment through the depletion allowance. For information on this subject, see chapter 10 of Publication 535, Business Expenses.

Sale of property interest. If you sell your complete interest in oil, gas, or mineral rights, the amount you receive is considered payment for the sale of section 1231 property, not royalty income. Under certain circumstances, the sale is subject to capital gain or loss treatment on Schedule D (Form 1040). For more information on selling section 1231 property, see chapter 3 of Publication 544. If you retain a royalty, an overriding royalty, or a net profit interest in a mineral property for the life of the property, you have made a lease or a sublease, and any cash you receive for the assignment of other interests in the property is ordinary income subject to a depletion allowance.

Part of future production sold. If you own mineral property but sell part of the future production, you generally treat the money you receive from the buyer at the time of the sale as a loan from the buyer. Do not include it in your income or take depletion based on it.

When production begins, you include all the proceeds in your income, deduct all the production expenses, and deduct depletion from that amount to arrive at your taxable income from the property.

Mineral Property

"The term "mineral property" means each separate interest you own in each mineral deposit in each separate tract or parcel of land. You can treat two or more separate interests as one property or as separate properties. See section 614 of the Internal Revenue Code and the related regulations for rules on how to treat separate mineral interests.

Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits).

There are two ways of figuring depletion on mineral property.

Generally, you must use the method that gives you the larger deduction. However, unless you are an independent producer or royalty owner, you generally cannot use percentage depletion for oil and gas wells. See Oil and Gas Wells, later.

Lessor's Gross Income

"A lessor's gross income from the property that qualifies for percentage depletion usually is the total of the royalties received from the lease. However, for oil, gas, or geothermal property, gross income does not include lease bonuses, advanced royalties, or other amounts payable without regard to production from the property.

Bonuses and advanced royalties. Bonuses and advanced royalties are payments a lessee makes before production to a lessor for the grant of rights in a lease or for minerals, gas, or oil to be extracted from leased property. If you are the lessor, your income from bonuses and advanced royalties received is subject to an allowance for depletion.

Figuring cost or percentage depletion. To figure cost depletion on a bonus, multiply your adjusted basis in the property by a fraction, the numerator of which is the bonus and the denominator of which is the total bonus and royalties expected to be received. To figure cost depletion on advanced royalties, use the computation explained earlier under Cost Depletion, treating the number of units for which the advanced royalty is received as the number of units sold.

To figure percentage depletion (for other than gas, oil, or geothermal property), any bonus or advanced royalty payments are part of your gross income from the property.

Terminating the lease. If you receive a bonus on a lease that expires, terminates, or is abandoned before you derive any income from the extraction of mineral, include in income for the year of expiration, termination, or abandonment, the depletion deduction you took. Also increase your adjusted basis in the property to restore the depletion deduction you previously subtracted.

For advanced royalties, include in income for the year of lease termination, the depletion claimed on minerals for which the advanced royalties were paid if the minerals were not produced before termination. Increase your adjusted basis in the property by the amount you include in income.

Delay rentals. These are payments for deferring development of the property. Since delay rentals are ordinary rent, they are ordinary income that is not subject to depletion. These rentals can be avoided by either abandoning the lease, beginning development operations, or obtaining production.

Cost Depletion

"To figure cost depletion you must first determine the following.

Basis for depletion. To figure the property's basis for depletion, subtract all the following from the property's adjusted basis.

1.       Amounts recoverable through:

a.    Depreciation deductions,

b.    Deferred expenses (including deferred exploration and development costs), and

c.    Deductions other than depletion.

2.       The residual value of land and improvements at the end of operations.

3.       The cost or value of land acquired for purposes other than mineral production.

Adjusted basis. The adjusted basis of your property is your original cost or other basis, plus certain additions and improvements, and minus certain deductions such as depletion allowed or allowable and casualty losses. Your adjusted basis can never be less than zero. See Publication 551, Basis of Assets, for more information on adjusted basis.

Total recoverable units. The total recoverable units are the sum of the following.

1.       The number of units of mineral remaining at the end of the year (including units recovered but not sold).

2.       The number of units of mineral sold during the tax year (determined under your method of accounting, as explained next).

You must estimate or determine recoverable units (tons, pounds, ounces, barrels, thousands of cubic feet, or other measure) of mineral products using the current industry method and the most accurate and reliable information you can obtain.

Number of units sold. You determine the number of units sold during the tax year based on your method of accounting. Use the following table to make this determination.

The number of units sold during the tax year does not include any for which depletion deductions were allowed or allowable in earlier years.

Figuring the cost depletion deduction. Once you have figured your property's basis for depletion, the total recoverable units, and the number of units sold during the tax year, you can figure your cost depletion deduction by taking the following steps.

Percentage Depletion

"To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year.

Gross income. When figuring your percentage depletion, subtract from your gross income from the property the following amounts.

A bonus payment includes a bonus for either a mineral lease or an oil and gas lease.

 Use the following fraction to figure the part of the bonus you must subtract.

For oil and gas wells and geothermal deposits, gross income from the property is defined later under Oil and Gas Wells. For property other than a geothermal deposit or an oil and gas well, gross income from the property is defined later under Mines and Geothermal Deposits.

Taxable income limit. The percentage depletion deduction cannot be more than 50% (100% for oil and gas property) of your taxable income from the property figured without the depletion deduction.

Taxable income from the property means gross income from the property minus all allowable deductions (excluding any deduction for depletion) attributable to mining processes, including mining transportation. These deductible items include the following.

The following rules apply when figuring your taxable income from the property for purposes of the taxable income limit.

For tax years beginning after 1997 and before 2002, percentage depletion on the marginal production of oil or natural gas is not limited to taxable income from the property figured without the depletion deduction.

Oil and Gas Wells

Generally, only independent producers and royalty owners can claim percentage depletion for any oil or gas well. However, if you are not an independent producer or royalty owner, you may be able to claim percentage depletion for the following items.

For information on the depletion deduction for these items, see Natural Gas Wells, later.

Independent Producers and Royalty Owners

If you are an independent producer or royalty owner, you figure percentage depletion using a rate of 15% of the gross income from the property based on your average daily production of domestic crude oil or domestic natural gas up to your depletable oil or natural gas quantity. However, certain refiners and retailers, as explained next, and certain transferees of proven oil and gas properties, as explained later, cannot claim percentage depletion. For information on figuring the deduction, see Figuring percentage depletion, later.

Refiners who cannot claim percentage depletion. You cannot claim percentage depletion if you or a related person refines crude oil and you and the related person refined more than 50,000 barrels on any day during the tax year.

Related person. You and another person are related persons if either of you holds a significant ownership interest in the other person or if a third person holds a significant ownership interest in both of you.

For example, a corporation, partnership, estate, or trust and anyone who holds a significant ownership interest in it are related persons. A partnership and a trust are related persons if one person holds a significant ownership interest in each of them.

For purposes of the related person rules, significant ownership interest means direct or indirect ownership of 5% or more in any one of the following.

Any interest owned by or for a corporation, partnership, trust, or estate is considered to be owned directly both by itself and proportionately by its shareholders, partners, or beneficiaries.

Retailers who cannot claim percentage depletion. You cannot claim percentage depletion if both the following apply.

1.       You sell oil or natural gas or their by-products directly or through a related person in any of the following situations.

a.    Through a retail outlet operated by you or a related person.

b.    To any person who is required under an agreement with you or a related person to use a trademark, trade name, or service mark or name owned by you or a related person in marketing or distributing oil, natural gas, or their by-products.

c.    To any person given authority under an agreement with you or a related person to occupy any retail outlet owned, leased, or controlled by you or a related person.

2.       The combined gross receipts from sales (not counting resale) of oil, natural gas, or their by-products by all retail outlets taken into account in (1) are more than $5 million for the tax year.

For the purpose of determining if this rule applies, do not count the following.

Sales through a related person. You are considered to be selling through a related person if any sale by the related person produces gross income from which you may benefit because of your direct or indirect ownership interest in the person.

You are not considered to be selling through a related person who is a retailer if all the following apply.

Transfers. You cannot claim percentage depletion if you received your interest in a proven oil or gas property by transfer after 1974 and before October 12, 1990. For a definition of the term "transfer," see section 1.613A-7(n) of the regulations.

Figuring percentage depletion. Generally, as an independent producer or royalty owner, you figure your percentage depletion by computing your average daily production of domestic oil or gas and comparing it to your depletable oil or gas quantity. If your average daily production does not exceed your depletable oil or gas quantity, you figure your percentage depletion by multiplying the gross income from the oil or gas property by 15%. If your average daily production of domestic oil or gas exceeds your depletable oil or gas quantity, you must make an allocation as explained later under Average daily production exceeds depletable quantities.

In addition, there is a limit on the percentage depletion deduction. See Taxable income limit, later.

Average daily production. Figure your average daily production by dividing your total domestic production for the tax year by the number of days in your tax year.

Partial interest. If you have a partial interest in the production from a property, figure your share of the production by multiplying total production from the property by your percentage of interest in the revenues from the property.

You have a partial interest in the production from a property if you have a net profits interest in the property. To figure the share of production for your net profits interest, you must determine your percentage participation (as measured by the net profits) in the gross revenue from the property. To figure this percentage, you divide the income you receive for your net profits interest by the gross revenue from the property.

Example. John Oak owns oil property in which Paul Elm owns a 20% net profits interest. During the year, the property produced 10,000 barrels of oil, which John sold for $200,000. John had expenses of $90,000 attributable to the property. The property generated a net profit of $110,000 ($200,000 - $90,000). Paul received income of $22,000 ($110,000 / .20) for his net profits interest.

Paul determined his percentage participation to be 11% by dividing $22,000 (the income he received) by $200,000 (the gross revenue from the property). Paul determined his share of the oil production to be 1,100 barrels (10,000 barrels / 11%).

Depletable oil or natural gas quantity. Generally, your depletable oil quantity is 1,000 barrels. Your depletable natural gas quantity is 6,000 cubic feet multiplied by the number of barrels of your depletable oil quantity that you choose to apply. If you claim depletion on both oil and natural gas, you must reduce your depletable oil quantity by the number of barrels you use to figure your depletable natural gas quantity. If you are involved in marginal production, see section 613A(c) of the Internal Revenue Code to figure your depletable oil or natural gas quantity.

Example. You have both oil and natural gas production. To figure your depletable natural gas quantity, you choose to apply 360 barrels of your depletable oil quantity. Your depletable natural gas quantity is 2.16 million cubic feet of gas (360 / 6000). You must reduce your depletable oil quantity to 640 barrels (1000 - 360).

You must allocate the depletable oil or gas quantity among the following related persons in proportion to each entity's or family member's production of domestic oil or gas for the year.

For purposes of this allocation, a related person is anyone mentioned under Related persons in chapter 12 except that item (1) in that discussion includes only an individual, his or her spouse, and minor children.

Members of the same controlled group of corporations are treated as one taxpayer when figuring the depletable oil or natural gas quantity. They share the depletable quantity. Under this rule, a controlled group of corporations is defined in section 1563(a) of the Internal Revenue Code, except that the stock ownership requirement in that definition is "more than 50%" rather than "at least 80%."

Gross income from the property. For purposes of percentage depletion, gross income from the property (in the case of oil and gas wells) is the amount you receive from the sale of the oil or gas in the immediate vicinity of the well. If you do not sell the oil or gas on the property, but manufacture or convert it into a refined product before sale or transport it before sale, the gross income from the property is the representative market or field price (RMFP) of the oil or gas, before conversion or transportation.

If you sold gas after you removed it from the premises for a price that is lower than the RMFP, determine gross income from the property for percentage depletion purposes without regard to the RMFP.

Gross income from the property does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property.

Average daily production exceeds depletable quantities. If your average daily production for the year is more than your depletable oil or natural gas quantity, figure your allowance for depletion for each domestic oil or natural gas property as follows.

1.    Figure your average daily production of oil or natural gas for the year.

2.    Figure your depletable oil or natural gas quantity for the year.

3.    Figure depletion for all oil or natural gas produced from the property using a percentage depletion rate of 15%.

4.    Multiply the result figured in (3) by a fraction, the numerator of which is the result figured in (2) and the denominator of which is the result figured in (1). This is your depletion allowance for that property for the year.

Taxable income limit. If you are an independent producer or royalty owner of oil and gas, your deduction for percentage depletion is limited to the smaller of the following.

You can carry over to the following year any amount you cannot deduct because of the 65%-of-taxable-income limit. Add it to your depletion allowance (before applying any limits) for the following year. 

Temporary suspension of taxable income limit for marginal production. For tax years beginning after 1997 and before 2002, percentage depletion on the marginal production of oil or natural gas is not limited to taxable income from the property figured without the depletion deduction. For information on marginal production, see section 613A(c)(6) of the Internal Revenue Code.

Partnership Income

"A partnership is generally not a taxable entity. The income, gains, losses, deductions, and credits of a partnership are passed through to the partners based on each partner's distributive share of these items.

Partner's distributive share. Your distributive share of partnership income, gains, losses, deductions, or credits is generally based on the partnership agreement. You must report your distributive share of these items on your return whether or not they are actually distributed to you. However, your distributive share of the partnership losses is limited to the adjusted basis of your partnership interest at the end of the partnership year in which the losses took place.

Partnership agreement. The partnership agreement usually covers the distribution of profits, losses, and other items. However, if the agreement does not state how a specific item of gain or loss will be shared, or the allocation stated in the agreement does not have substantial economic effect, your distributive share is figured according to your interest in the partnership.

Partnership return. Although a partnership generally pays no tax, it must file an information return on Form 1065, U.S. Return of Partnership Income. This shows the result of the partnership's operations for its tax year and the items that must be passed through to the partners.

Partnerships and S Corporations

Generally, each partner or shareholder, and not the partnership or S corporation, figures the depletion allowance separately. (However, see Electing large partnerships must figure depletion allowance, later.) Each partner or shareholder must decide whether to use cost or percentage depletion. If a partner or shareholder uses percentage depletion, he or she must apply the 65%-of-taxable-income limit using his or her taxable income from all sources.

Partner's or shareholder's adjusted basis. The partnership or S corporation must allocate to each partner or shareholder his or her share of the adjusted basis of each oil or gas property held by the partnership or S corporation. The partnership or S corporation makes the allocation as of the date it acquires the oil or gas property.

Each partner's share of the adjusted basis of the oil or gas property generally is figured according to that partner's interest in partnership capital. However, in some cases, it is figured according to the partner's interest in partnership income.

The partnership or S corporation adjusts the partner's or shareholder's share of the adjusted basis of the oil and gas property for any capital expenditures made for the property and for any change in partnership or S corporation interests.

Each partner or shareholder must separately keep records of his or her share of the adjusted basis in each oil and gas property of the partnership or S corporation. The partner or shareholder must reduce his or her adjusted basis by the depletion he or she takes on the property each year. The partner or shareholder must use that reduced adjusted basis to figure cost depletion or his or her gain or loss if the partnership or S corporation disposes of the property.

Reporting the deduction. Information that you, as a partner or shareholder, use to figure your depletion deduction on oil and gas properties is reported by the partnership or S corporation on line 25 of Schedule K-1 (Form 1065) or on line 23 of Schedule K-1 (Form 1120S). Deduct oil and gas depletion for your partnership or S corporation interest on Schedule E (Form 1040). The depletion deducted on Schedule E is included in figuring income or loss from rental real estate or royalty properties. The line instructions for Schedule E explain where to report this income or loss and whether you need to file either of the following forms.

Electing large partnerships must figure depletion allowance. For partnership tax years beginning after 1997, an electing large partnership, rather than each partner, generally must figure the depletion allowance. The partnership figures the depletion allowance without taking into account the limits on the amount of production and taxable income. Also, the adjusted basis of a partner's interest in the partnership is not affected by the depletion allowance.

An electing large partnership is one that meets both the following requirements.

Disqualified partners. An electing large partnership does not figure the depletion allowance of its disqualified partners. The disqualified partners must figure it themselves, as explained earlier.

All the following are disqualified partners.