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Tax Aspects
The following is a summary of certain tax consequences of an investment in the
partnership under the Internal Revenue Code of 1954 as amended "(the code)", and
the applicable regulations and judicial and administrative interpretations. The summary is
subject to changes in the law, regulations and interpretations, some of which may be
applied retroactively. Moreover, controversy and uncertainty exists in many areas of the
federal income tax laws that may affect the partnership.
There can be no assurance that new proposals to increase taxes, limit or defer
deductions, limit or eliminate credits which may presently be afforded to oil and gas
partnerships and or partners, will not alter income tax treatment of such partnership or
partners, and these proposals may have an adverse effect upon participation on the
partnership. A prospective investor should consider ongoing developments in this area
prior to making an investment in the partnership.
Generally, income tax principles are complex and their application will generally vary
from one investor to another. Moreover, other taxes, such as state, local and federal
estate and gift taxes, may affect an investment in the partnership.
This summary is not intended to be all-inclusive or to cover any particular situation
applicable to any particular prospective investor or partner. This summary is more general
in nature and each prospective investor should consult his own tax advisor concerning
federal, state, and local taxes, federal estate and gift taxes, and other taxes, which may
apply to an investment in this partnership.
(1) Tax Incentives and Certain Limitations: Under present federal income tax laws and
regulations, certain incentives are available to oil and gas operations. The principal
incentives unique to oil and gas taxation are: (a) the right to deduct what are referred
to as intangible drilling and development costs incurred in connection with the drilling
and completing of wells: (b) the right to deduct the cost of dry holes; (c) the right to
deduct the depletion of the natural resources in an amount which may be in excess of the
cost of acquiring them. Other tax incentives, not unique to oil and gas operations, are
deductions for business expenses, interest expenses and accelerated depreciation on newly
acquired and placed in service equipment and similar property generally referred to as
fixed assets.
It is not practical, or is it intended, to present a detailed discussion of all of the
tax laws affecting the activities contemplated by this offering. Instead, a summary of the
present tax treatment of various major items of income, costs expenses, credits and
deductions available in connection with the partnership's oil and gas operations is
presented for the consideration of each prospective participant and his tax advisor.
(2) Intangible Drilling and Development Costs (IDC): The code gives the operator of oil
and gas properties the option of electing to charge to capital or to expense intangible
drilling and development costs. The IDC consists of expenditures made by an operator for
wages, fuel, research, site preparation and dozer work, drilling costs, cementing costs,
perforating and logging, frac job, etc., incident to and necessary for the drilling and
preparation of wells for the production of oil or gas. In recent wells drilled by the
operator, Intangible Drilling and Development Costs have been averaging approximately 80%
of the total well cost. The election to currently expense IDCs is binding upon future
years.
If the operator elects to capitalize intangible drilling and development costs and the
well later proves to be nonproductive (dry hole), the operator may elect to deduct such
costs as an ordinary loss. The election, once made, is binding for all years.
(3) Year Of Deduction: The partnership will elect to account under the accrual method of
accounting. As such, the IDC should be deductible in the year in which all events have
occurred which will establish the fact of the liability, provided the amount can be
determined with reasonable accuracy and economic performance has occurred. Under code
section 461, economic performance has occurred with respect to drilling oil and gas wells
if the actual drilling has commenced within ninety days after the partnership year ends.
Therefore, in the event of prepayments of drilling costs, it is the opinion of the
managing general partner that the deduction for IDC would be available in the year paid
providing drilling commences within ninety days after the partnership year ends.
(4) Depreciation: Costs of equipment, such as casing, tubing, tanks, pumping units, and
other types of tangible property and equipment, cannot be deducted currently, but must be
capitalized and depreciated or amortized pursuant to applicable provisions of the code.
These costs should be eligible for accelerated depreciation under the "Modified
Accelerated Cost Recovery System". The Modified Accelerated Cost Recovery System
generally provides for more rapid depreciation. When property that has been depreciated is
disposed of by sale, foreclosure or otherwise, all or a portion of the gain may be subject
to "recapture", i.e., to tax as ordinary income rather than capital gain. A
similar recapture may result upon certain distributions by the partnership.
(5) Depletion: Each partner will be allowed a deduction for cost or percentage depletion
on production from partnership properties subject to the limitations outlined below. Cost
depletion allows the deduction of capitalized costs (such as lease bonuses, other lease
acquisition costs, exploratory charges, legal fees, and certain other capitalized,
nondepreciable costs) of a producing property over its life, by an annual deduction
computed on the basis of actual oil and gas produced each year in relation to estimated
recoverable oil and gas. Percentage depletion, where applicable, is a statutory allowance
equal to a percentage of gross income from the depletable property, but no more than
100.0% of the taxable income from such property (before allowance for depletion), and
65.0% of the taxable income of the partner (before the depletion allowance). Generally,
15% of gross oil and gas revenues is allowed as a deduction to independent producers and
royalty owners with limitations based on average daily production. (Code Sec. 613A (c))
The rate applies to an average daily production of 1,000 barrels of oil and six million
cubic feet of gas. For tax years beginning after December 31, 1997, and before January 1,
2000, the 100.0% taxable income limitation percentage depletion deductions for oil and gas
properties have been temporarily suspended for marginal properties. Also, depletion
deduction percentage of 15% increases for marginal oil and gas properties by 1.0% (up to a
maximum rate of 25.0%) for each one dollar the reference price of crude oil for the
preceding year is less than $20.00 per barrel. Average daily production includes only
actual production and, therefore, does not take lease bonuses or advanced royalties into
account. If the taxpayer's average daily production exceeds the exemption, the percentage
depletion allowable under the small producer exemption with respect to production from
each property must be proportionately reduced.
The Law provides that in the case of a partnership, the depletion allowance shall be
computed by the partners and not by the partnership. Partnership basis in domestic oil or
gas properties is to be allocated to the partners proportionately. Each partner maintains
an individual basis account and computes his own allowance for either percentage depletion
or cost depletion on his interest in partnership domestic oil or gas properties. The Code
provides for certain limitations on the applicability of the small producer exemption. The
deduction resulting from the small producer exemption may not exceed 65.0% of the
taxpayers taxable income from all sources computed without regard to certain deductions.
The foregoing does not purport to be a complete analysis of the complex legislation
relating to the percentage depletion deduction for oil and gas wells. It is recommended
that a prospective partner consult his personal tax advisor with respect to what effect
the limited availability of percentage depletion will have upon the advisability of
acquiring an interest in the partnership.
(6) Recapture of Certain Drilling Costs: The Code provides for the recapture of intangible
drilling and development costs upon certain dispositions (other than by gift, death or
tax-free exchange) of an interest in productive oil or gas properties, or of an interest
in an oil or gas partnership with an interest in productive oil and gas properties. The
amount subject to recapture is the lower of: (a) the amount of gain realized upon the
disposition of the property, or (b) the excess of the previously deducted intangible
drilling and development costs which are allocable to those properties (directly or
through the ownership of an interest in oil and gas partnership) reduced by the amount by
which the depletion deduction would have been increased had such costs been capitalized.
The amount subject to the recapture must be allocated first to the disposed of portion.
(7) Carried Interest Arrangements: The managing general partner intends to enter into
carried interest arrangements whereby the partnership will acquire an undivided interest
in certain leases and agree to pay a proportionate part of the costs of drilling thereon.
The managing general partner will endeavor to structure "carried interests" to
permit the partnership to deduct the share of drilling and completion costs actually paid,
but in certain transactions of this type it may be unable to do so. There can be no
assurance that transactions can be arranged to permit all intangible drilling costs paid
to be deducted and the managing general partner will not refuse to participate in the
development of a lease solely on the basis that a portion of the intangible drilling costs
paid by the partnership may not be deductible.
(8) Reinvestment Revenues And Debt Repayment: A partner's share of net income applied to
the repayment of drilling and completion cost or to the repayment of loans will be
included in his taxable income. Such income may be offset in part by the depletion
deduction by depreciation or other deductions previously deferred. A foreclosure of
pledged properties (wells) in satisfaction of such loans would generally be treated as a
sale of the properties for the amount of the debt. The amount realized upon the sale,
exchange or foreclosure of property owned by the partnership would include any
indebtedness to which the property is subject and, accordingly, may result in the
realization of taxable income even though an economic loss may be suffered thereby. Thus,
a partner may realize an amount of taxable gain in excess of the actual proceeds of such
sale, exchange or foreclosure, and in some instances, the income taxes payable due to such
gain may exceed the actual proceeds received from the partnership upon such a sale,
exchange or foreclosure.
(9) State And Local Tax: In West Virginia, where the partnership will drill wells, a tax
is imposed on the partnership's capital and on oil and gas income. West Virginia imposes a
.75 % tax on average partnership capital determined at the partnership year end. West
Virginia imposes a 5.00 % tax on oil and natural gas gross receipts on wells drilled after
July 1, 1987.
Alternative Minimum Tax (AMT) - The alternative minimum tax as imposed by the code is
basically a recapture mechanism whereby taxpayers who used certain deductions and
exemptions and, as a result of these, had reaped large tax savings. The AMT is the excess
of tentative minimum tax over regular tax. The excess is added to the regular tax
liability to equal the total tax liability. Tentative minimum tax is determined by
adjusting regular taxable income by the amount of tax preference items and special
adjustments and exemptions and multiplying the result by the applicable AMT tax rates. The
tentative minimum tax for noncorporate taxpayers is initially determined as the sum of 26%
of the first $75,000 of Alternative Minimum Taxable Income, (26% of $87,500 if filing
status is married filing separately) and 28% of any additional AMTI. There are special
rules for capital gains. Small corporations, which are defined as a corporation with gross
average annual receipts of five million dollars or less, are not subject to alternative
minimum taxes.
Tax Preference Items (TPI) - Generally, items as defined by the code as tax preference
items are added to regular taxable income. Tax preference items that the managing general
partner believes may affect the partners are listed below:
(a) Depletion - The amount by which the depletion deduction claimed by a taxpayer,
other than an independent oil and gas producer, for an interest in a property that exceeds
the adjusted basis of the interest at year end.
(b) Intangible Drilling Costs (IDC) - The amount by which an integrated oil company's
excess intangible drilling cost is greater than 65% of the taxpayers net income from oil,
gas and geothermal properties. Excess IDC is the excess of the IDC deduction over the
deduction that would have been allowed if the costs had been capitalized and amortized
over a 10 year period and this excess is greater than 65% percent of the net income from
oil, gas and geothermal properties. Independent oil and gas producers are no longer
subject to this preference. Their AMTI, however, may not be reduced by more than 40% of
the AMTI that would otherwise be determined if the taxpayer was subject to this IDC
preference and did not compute an alternative tax net operating loss deduction.
There are other TPI, but the ones described above are, in the opinion of the managing
general partner, the ones that would affect the activities of the partnership.
Adjustments To Selected Tax Items - There are various tax items that are deducted in
arriving at regular taxable income which require adjustments to arrive at alternative
minimum taxable income. The following is not an all-inclusive list of the required
adjustments, but are ones that the managing general partner believes would affect the
activities of the partnership.
(a) Depreciation - For property placed in service after 1986 and before 1999, taxpayers
who, in calculating regular tax liability, depreciate real property under the Modified
Accelerated Cost Recovery System (MACRS) must use Alternative Depreciation System (ADR) in
calculating AMTI. AMT depreciation for deductions for personal property using the MACRS 3,
5, 7 or 10 year recovery period and the 200% double declining balance method must
recompile depreciation for AMTI purposes using the 150% double declining method.
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