Intangible drilling cost (IDC) is a significant tax benefit for oil companies, allowing them to deduct the expenses associated with drilling wells in the United States. Typically, businesses in the oil and gas industry can subtract expenses from their revenues to calculate their taxable income.
Under income tax regulations, oil and gas producers must subtract their expenses over the same period as profits when spending to secure future profits. This means that the cost of drilling developmental or exploratory wells must be deducted as the natural resource is being extracted from the well.
However, there is an exception to this general rule for intangible drilling costs. Intangible drilling costs can be fully deducted at once by independent producers. On the other hand, corporations have been limited since 1986 to deducting only 70 percent of their intangible drilling costs at once, with the remaining 30 percent spread over five years.
In this article, we will define intangible drilling costs and explain how they operate.
What Are Intangible Drilling Costs?
Expenses incurred in the process of preparing and drilling oil and gas wells that are non-salvageable are referred to as intangible drilling costs (IDC). These costs can include wages, repairs, supplies, fuel, surveying, and ground clearing, and typically account for 60 to 80 percent of the overall drilling cost.
To account for the risks involved in drilling developmental wells, the income tax code has long allowed for the deduction of intangible drilling costs.
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How Does IDC Work?
Oil exploration and production companies are permitted to deduct their intangible drilling costs. Large companies are restricted to deducting 70 percent of their IDCs in the first year of exploration, with the remaining 30 percent spread over the next five years. To calculate the yearly deduction, this remaining percentage should be divided by five.
When submitting their paperwork for the year, companies can deduct their IDCs by including them in their Form 1040, which is their annual tax return for the year in which the costs were incurred.
Is IDC Deductible?
Intangible drilling costs are deductible in full during the first year of production, regardless of whether the well strikes oil or not, as long as it is operational by March 31 of the following year.
In addition, investors have the option to amortize their costs over a period of five years instead of deducting them all at once. Under IRS regulations, intangible drilling costs may qualify for significant ordinary income tax deductions.
General partners who invest in these costs can use them to offset their ordinary income or capital gains, while limited partners can offset passive income with them.
The federal Form 1040 considers intangible drilling costs as an above-the-line deduction that decreases both the adjusted taxable income and gross income.
Who Qualifies for IDC?
The US government provides tax incentives for intangible drilling costs in order to encourage investment in oil and gas exploration, particularly for wells located both onshore and offshore within the United States. This tax deduction is considered one of the most significant tax breaks available in the oil industry.
Why Is IDC Important?
The significance of intangible drilling costs lies in their ability to enable oil producers to quickly recover their investment costs and reinvest in exploration and future production endeavors. IDCs have proven instrumental in facilitating the investment of substantial sums in the search for new energy sources, allowing producers to recoup their investments within a year or up to sixty months.
Conclusion
Going for a complete deduction of intangible drilling cost is a wise decision for any investor, given the rise in compliance costs as production grows.
However, identifying the exact percentage and evaluating the corresponding tax implications may not always be straightforward. Hence, it is advisable for investors and oil producers to carefully evaluate their options before making a decision.
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Sources:
“Intangible Drilling Costs (IDC),” Investopedia, https://www.investopedia.com/terms/i/intangible-drilling-costs.asp
“The Tax Break-Down: Intangible Drilling Costs,” Committee for a Responsible Federal Budget, https://www.crfb.org/blogs/tax-break-down-intangible-drilling-costs
“Tangible And Intangible Drilling Cost Deductions,” Favor Wealth, https://www.favorwealth.com/blog/tangible-and-intangible-drilling-cost-deductions”
Intangible Drilling Costs for Independent Oil and Gas Producers,” Hanson & Co, https://www.hanson-cpa.com/intangible-drilling-costs/