For many taxpayers, the decision to participate in an oil and/or natural gas drilling program is a near year-end event. However, waiting until the last few days of the year could put the desired current-year deduction for intangible drilling costs at risk.
Most of the participation in oil and/or natural gas drilling is handled through partnerships. The participating taxpayers contribute cash to a new partnership and in return they hold an interest in that partnership. The partnership then pays the driller pursuant to a prepaid turnkey drilling contract under which the drilling is to commence as soon as possible and the amount paid is not refundable.
The tax rules under Internal Revenue Code Section 461 provide an “economic performance test” that must be met in order for prepaid intangible drilling costs to be deductible. Generally, economic performance occurs when the service, property or use of property is provided. However, for “tax shelter” investors, the intangible drilling cost deduction is permitted for prepaid costs where economic performance occurs within 90 days after the close of the tax year. That is March 31, 2013 for tax year 2012 drilling programs. For this purpose, “economic performance” with respect to drilling an oil or natural gas well is deemed to occur when the drilling of the well is commenced.
A 2012 United States Tax Court case (CALTEX Oil Venture, et.al.) considered the question of when the drilling is “commenced” for purposes of the economic performance rules. The Tax Court dismissed the taxpayer’s argument that drilling commenced with the acquisition of drilling permits and site preparation. Instead, the Tax Court held that commencement of drilling occurs, within the meaning of the statute, when a drill bit actually penetrates the ground. In drilling terminology, that point in time is known as spudding the well.
Therefore, in order for a tax shelter investor to obtain a 2012 deduction for intangible drilling costs related to drilling an oil or natural gas well, the payment for the partnership interest must:
- be in the hands of the partnership in time to
- allow the partnership to pay the driller before year-end under a non-refundable turnkey drilling contract, and
- the driller must actually spud the well before March 31, 2013
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