TR-41 APA Tax Study Guide

APA Tax Study Guide
TRAINING & REFERENCE MATERIAL TR-41

Publication Date --- April 2001

Approved by the COPAS Board of Directors

Copyright 2001by the Council of Petroleum Accountants Societies, Inc. (COPAS)

TABLE OF CONTENTS

I. INTRODUCTION ..................................................................................................... 3
II. CHAPTERS, REVIEW QUESTIONS AND ANSWERS......................................... 5
A. CHAPTER 1 KINDS OF PROPERTY INTERESTS ...................................... 5
B. CHAPTER 2 THE PROPERTY UNIT........................................................... 11
C. CHAPTER 3 CONVEYANCES..................................................................... 15
1. Sales or Exchanges ...................................................................................... 15
2. Leases or Subleases...................................................................................... 15
3. Sharing Arrangements ................................................................................. 16
D. CHAPTER 4 TREATMENT OF COSTS....................................................... 19
1. Uniform Capitalization Rules ...................................................................... 19
2. Geological and Geophysical Costs .............................................................. 19
3. Delay Rentals ............................................................................................... 22
4. Lease Bonuses .............................................................................................. 22
5. Intangible Drilling Costs .............................................................................. 22
6. Service Wells ............................................................................................... 23
7. Overhead Costs and Allocation ................................................................... 23
8. Abandonment Costs ..................................................................................... 24
E. CHAPTER 5 DEPRECIATION AND AMORTIZATION ............................ 29
1. Units of Production Depreciation ................................................................ 29
2. Cost Depletion ............................................................................................. 29
3. Percentage Depletion ................................................................................... 30
F. CHAPTER 6 RECAPTURE RULES ............................................................. 35
1. Intangible Drilling Costs and Depletion ...................................................... 35
2. Depreciation ................................................................................................. 35
G. CHAPTER 7 ALTERNATIVE MINIMUM TAX ......................................... 39
H. CHAPTER 8 TAX CREDITS ........................................................................ 43
1. Enhanced Oil Recovery Credit .................................................................... 43
2. Nonconventional Fuel Credit ....................................................................... 43
3. Foreign Income Tax ..................................................................................... 44
J. CHAPTER 9 LOSS LIMITATIONS .............................................................. 47
1. At-Risk Provisions ....................................................................................... 47
2. Passive Activities ......................................................................................... 47
K. CHAPTER 10 SUBCHAPTER K ELECTION .............................................. 51
L. CHAPTER 11 GAS BALANCING METHODS ........................................... 55

III. GLOSSARY ............................................................................................................ 69
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"COPAS and the APA Board of Examiners encourage APA candidates to study all of the
material in the reference outline. Study guides are designed to assist the candidates study for the
APA exam. The study guides are not replacements for the study materials. The study guides
may not be inclusive of all material covered on the exams. For a complete list of study material,
APA candidates should refer to the reference outline for each module, contained in the COPAS
APA Accreditation Information handbook."

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I. INTRODUCTION

This document provides an overview of the tax treatment of some items of income and
expense relative to the petroleum industry. It is intended as a study guide for candidates
taking the Tax Section of the Accredited Petroleum Accountant (APA
) Exam.

The United States currently levies no special federal tax on income from petroleum
production, as some other countries do. Instead, income is taxed within the regular
income tax system.

Under tax law, some revenues and costs receive special treatment because they are
unique to the industry. Other revenues and costs not unique to oil and gas production still
receive special treatment. These special rules were created to recognize the risk
associated with petroleum exploration and production, and to recognize that the products
produced are nonrenewable. Also, some items of income and expense have a treatment
for tax that is different from GAAP (Generally Accepted Accounting Principles)
accounting.

The topics discussed in this publication were selected by the national Tax Committee of
the Council of Petroleum Accountants Societies
(COPAS). The committee members

defined the basic content with which an accountant in the tax department of an oil and
gas company should be familiar. All areas tested by the Tax Exam are discussed in this
study guide.

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II. CHAPTERS, REVIEW, QUESTIONS AND ANSWERS

A. CHAPTER 1 KINDS OF PROPERTY INTERESTS

The United States is one of the few countries in the world where ownership of minerals in
place is not held solely by the government. And, under U.S. property law, surface rights
and mineral rights are divisible; that is, the owner of the surface can be different from the
owner of the minerals. Additionally, the mineral rights themselves are divisible.
Understanding the different types of property ownership is key to understanding income
tax treatment of various revenues and expenses.

The fee simple interest includes ownership of the surface and subsurface rights and, to an
extent, a limited amount of airspace over the land. All ownership interests in a mineral
property are in some manner derived from this basic interest. Typically the owner of a
fee simple interest will lease or sell his mineral rights rather than develop them himself.

Minerals is the term commonly used to describe all rights to oil and gas (and solid
minerals) in the ground. The owner of minerals can sell them outright. In most cases,
however, the minerals are leased to one or more others who will develop the property.

Example: Janet Smith inherited a 640-acre farm from her great-grandfather, who had
acquired the land as a homestead in 1890. She has a fee simple interest, so she owns the
surface as well as the minerals.

She might sell 100% of her minerals in 320 acres or 50% of her minerals in the entire 640
acres. Or she could lease a share of a particular formation, limited to above or below a
specific depth. She can also sell or lease a part or all of the surface. The minerals can be
assigned for a limited time, which is called a term lease, or they can be assigned in
perpetuity.

When the owner of the minerals enters into a lease, two kinds of property interests are
created. The royalty interest is retained by the assignor and is referred to as a non-
operating interest because the royalty owner has no responsibility for developing or
operating the property. The holder of the royalty interest is entitled to a specified portion
of the oil and gas produced, in kind or in value, free of the costs of exploration,
development, and production.

The remainder of the interest in the minerals is called the working or operating interest
and is held by the assignee of the lease. The working interest represents an interest in the
minerals burdened by the cost of exploration, development and production. The working
interest owner can assign all or a portion of his interest to others to share the cost and risk
of development.

The working interest owner may also create other non-operating interests to further
spread the cost of exploration and development. These new interests may be retained by
the working interest owner when he assigns his operating interest to someone else. Or
the non-operating interest can be carved out and assigned to others while the working
interest owner retains the burden of development.

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There are three common types of non-operating interests created from the working
interest. An overriding royalty interest (ORI) is similar to a regular royalty interest in
that the owner has a right to minerals in place and is entitled to a percentage of
production, free of development and operating expenses. An overriding royalty,
sometimes called an override, differs from a landowners royalty in that its life is limited
to the life of the working interest from which it is created.

A net profits interest entitles the owner to a specified amount of production measured by
the net profits from operation of the property. The owner of this interest has no
obligation to pay for development or production costs if the share of production
attributable to this interest is not sufficient to pay those costs. If no net profits exist, the
holder of the interest receives no payment. It is essential that the document creating this
interest clearly specify the method by which the net profit is to be calculated.

A production payment entitles the holder to a specified percentage of production for a
limited period of time, or until a defined amount of money has been received, or until a
certain number of units of production has been received. At the time it is created, this
interest must have a projected life shorter than the life of the operating interest from
which it was created. The owner of a production payment has no responsibility for the
costs of development and production. This type of interest is commonly used in
financing arrangements.

Example: Black Oil Company believes that there is a small oil reservoir on Janet Smiths
farm and wants to drill two wells there. Janet agrees to lease 160 acres to Black. In
return, she will receive one-eighth of all of the production from the wells. Janet now
owns a royalty interest and Black holds all of the working interest in the lease.

Before the wells can be drilled, Black has some financial problems. Green Oil Company
offers to develop the lease on Janets farm. Black transfers all of its working interest to
Green in exchange for one-sixteenth of the production from the lease. Black now owns
an overriding royalty interest, and Green holds the working interest.

To raise cash for the drilling, Green Oil sells a $50,000 production payment to First
National Bank. The bank agrees to take one-eighth of the production as its sole source of
repayment until the $50,000 plus interest has been paid. First National owns a production
payment since it can look only to proceeds from the sale of production for repayment of
the loan.

Additionally, Green Oil receives $50,000 from its major stockholder Harold Blue in
exchange for two % of the profit from the wells. As a result of this transaction, Mr. Blue
owns a net profits interest in the 160 acres.

An economic interest is more difficult to define. For federal income tax purposes, an
economic interest is possessed in every case in which the taxpayer has acquired by
investment any interest in minerals in place. . .and secures, by any form of legal
relationship, income derived from the extraction of the mineral. . .to which he must look
for a return of his capital. The determination of whether a property interest is an
economic interest is important because the owner of an economic interest is taxed on
production income and is entitled to the deduction for depletion on that production.

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For tax purposes an economic interest must meet the following four requirements:

1. The interest must represent a capital interest in the minerals in place.
2. The interest must provide the right to share in the minerals produced.
3. The interest owner must look only to proceeds from the sale of production for
a return of his capital.
4. The interest held must exist in some form of a legal relationship, e.g., an
equitable right rather than a recorded right of ownership is sufficient.

A royalty interest, a working interest, an overriding royalty interest and a net profits
interest are all economic interests. The holder of a production payment also possesses an
economic interest. However, in 1969 legislation, Congress mandated that most
production payments be treated the same as a purchase money mortgage, i.e., a loan.
Exceptions to the loan treatment are when the production payment proceeds are pledged
to the development of the property burdened by the production payment, or if the
production payment is retained by the lessor in a leasing transaction. In the above
examples, Janet Smith, Black Oil Company, Green Oil Company, First National Bank
and Harold Blue all have an economic interest in the 160-acre lease.

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CHAPTER 1 REVIEW QUESTIONS

1. Black Gold Oil Company has leased 320 acres from the Francis family, which had
a fee simple interest in the property. Black Gold transfers all of its working
interest to Eagle Petroleum in exchange for one-sixteenth of the future production,
with no obligation to participate in the costs of development. Black Gold now
owns:

A. A working interest
B. A royalty interest
C. An overriding royalty interest
D. A net profits interest

2. Which of the following interests has a life longer than the working interest?

A. Net profits interest
B. Production payment
C. Overriding royalty interest
D. Fee simple interest

3. To be entitled to the depletion deduction, the interest owner must possess which
type of interest?

A. Term interest
B. Economic interest
C. Partnership interest
D. Interest in perpetuity

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ANSWERS TO CHAPTER 1 REVIEW QUESTIONS

1. C
2. D
3. B

Page 10

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B. CHAPTER 2 THE PROPERTY UNIT

The significance of the unit-of-property concept for federal income tax purposes cannot
be overstated. It is the cornerstone of U.S. oil and gas taxation. Almost all tax
accounting for petroleum activity is done on a property-by-property basis. Unfortunately,
the law says very little in defining property. The Internal Revenue Code merely states
that

. . . the term property means each separate interest owned by the taxpayer in each
mineral deposit in each separate tract or parcel of land.

As a general rule, each type of interest (working, royalty, overriding royalty, net profits
or production payment) is treated as a separate property, unless the same type of interest
is acquired at the same time from the same assignor in tracts of land that are
geographically contiguous. Tracts are considered to be contiguous if they share a
common border. If tracts touch only at a corner, they are adjacent, not contiguous.
Offshore leases, which under federal law must be bid separately, are considered separate
property, even if they are contiguous.

If the taxpayer acquires more than one operating interest in a tract, he must combine the
interests and treat them as a single property unless an election is made to treat them as
separate properties. If the taxpayer acquires more than one non-operating interest in a
tract, he may only combine them into one property with the permission of the Internal
Revenue Service. Operating and non-operating interests may never be combined.

Example: Big Oil Company is the operator of the River Lease and holds an overriding
royalty interest as well as a working interest in the wells. Small Oil Company, a non-
operator in the lease, sells its working interest as well as its overriding royalty interest to
Big Oil.

Unless it makes an election to account for them separately, Big Oil will combine the two
working interests into one. Conversely, unless it receives permission from the IRS to
combine them, Big Oil will account for its two overriding royalty interests separately.

Special rules apply to unitizations and poolings. Under these rules, separate operating
interests participating in these arrangements are treated as one property for the period of
such participation.

A clear understanding of the concept of property is essential for purposes of determining
a number of tax consequences, including the following:

1. Depletion is calculated on a property-by-property basis.
2. Intangible drilling costs (IDC) are calculated on a property-by-property basis.
3. Geological and geophysical costs are accounted for on a property-by-property
basis.
4. The property concept is important in determining the tax consequences of
certain sharing arrangements.
5. The property concept affects the timing and amount of the worthlessness
deduction.

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6. Gain and loss on disposition are calculated on a property-by-property basis.
7. Tax consequences of pooling and unitization agreements are affected by the
property concept.
8. Application of the at-risk rules utilizes the property concept.

Clearly, the property unit can affect the nature, timing, and availability of income and
deductions.

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1. Coyote Production Company owns a working interest and an overriding royalty
interest in the Sand Dune Lease. It acquires an additional working interest and
another royalty interest in the lease. In the absence of an election with the IRS,
Coyotes depletion schedule will show which of the following?

A. Two working and two overriding royalty interests
B. One working interest and two overriding royalty interests
C. Two working interests and one overriding royalty interest
D. One working interest and one overriding royalty interest

2. Generally, each type of interest is treated as a separate property unless four
circumstances exist. Which of the following conditions would not allow two
interests to be combined?

A. The interests are of the same type
B. The interests are acquired at the same time
C. The interests are acquired from the same assignor
D. The interests are in lands which are geographically adjacent

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1. B
2. D

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C. CHAPTER 3 CONVEYANCES

Ownership of minerals may be acquired through a sale or exchange, lease or sublease, or
a sharing arrangement. Classification of the acquisition transaction is critical since the
parties may realize significantly different income tax consequences from the three
different types of transactions.

For example, income from a sale or taxable exchange could constitute capital gain.
Consideration received in connection with a lease or sublease of minerals is considered a
lease bonus, which is ordinary income. And a sharing arrangement involving a cash
consideration is usually not a taxable transaction, and no income or gain is recognized.
However, if the party receiving the cash does not expend the full amount on the intended
purpose and does not return the excess not expended, he recognizes income on the excess
cash retained.

Classifying assignments of interests depends first upon the type of consideration moving
between the parties. Second, it depends upon the type of interest transferred or retained.

1. Sales or Exchanges

A transaction will be treated as a sale or exchange in the following two circumstances if
the consideration received is cash or its equivalent, and the consideration is not pledged
for the exploration or development of the property:

1. When the owner of any type of interest assigns all of his interest or a
fractional interest identical, except as to quantity, with the fractional interest
retained

2. When the owner of a working interest assigns any type of continuing non-
operating interest in the property and retains the working interest

Example: In the first instance above, if Sam owns the working interest in a lease and
assigns all of it to Janet for cash, he has made a sale. Also, if Sam transfers one-third of
his working interest to Janet for cash, he has made a sale because the interest Sam
retained is the same type that Janet now owns, even though the quantities are different.

The second category above describes transactions in which various interests are carved
out of the working interest. It is necessary that the carved out interest be continuing. If
Sam, who owns the working interest, carves out an overriding royalty or net profits
interest and assigns it to Janet for cash, he has made a sale. However, if he carves out a
production payment, which is not a continuing interest, he has not made a sale but has
created a mortgage loan on the property.

2. Leases or Subleases

A transaction will be classified as a lease or a sublease when the owner of operating
rights assigns all or a part of those rights and retains a continuous non-operating interest.

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The owner may receive cash or its equivalent or he may receive no immediate
consideration. The assignment of any type of interest other than working interest is not a
lease or sublease.

Example: Sam owns the minerals in a lease and assigns operating rights to Janet for
cash. If he retains a royalty interest, he has created a lease. If Janet then assigns her
working interest to Bob and retains an overriding royalty interest, she has created a
sublease.

3. Sharing Arrangements

In the two preceding sections it was noted that the principal consideration for an
assignment was cash or its equivalent. If, however, the principal consideration for an
assignment is the assumption by the assignee of all or some part of the burden of
development of the property, the transaction is classified as a sharing arrangement.

Example: Sam owns all the working interest in a lease and wants Janet to share the risk
of drilling and development. He assigns part of his working interest to her in exchange
for cash to be used exclusively for development of the property. This transaction is not a
sale or a lease but a sharing arrangement.

A farmout is a form of sharing arrangement under which the working interest owner, or
farmor, assigns all or part of his working interest to another party in exchange for that
partys agreement to drill a well on the lease. The operating interest acquired in a
farmout generally continues until the second party, or farmee, obtains complete payout of
his investment in the well. After payout, a portion of the transferred interest generally
reverts to the original owner.

Because a farmout is a sharing arrangement, the farmor has no gain or loss on the transfer
of his interest to the farmee. If the farmee pays for costs attributable to an operating
interest retained by the farmor, the farmee must capitalize as leasehold cost that portion
of IDC and equipment costs applicable to the portion of the working interest retained by
the farmor. The capitalized cost is recovered through depletion.

In some sharing arrangements a carried interest is created. This happens when the
agreement provides that the operator will carry the previous working interest owner by
paying a disproportionate share of the development expenses. When the operator or
carrying party has been fully reimbursed out of future production, a fraction of the
operating interest will revert to the carried party. The carried and carrying parties then
share all future income and expense.

In a carried interest situation, the carrying party is entitled to all income and deductions
applicable to its working interest prior to payout. At conversion of interest to the carried
party, the carrying party must transfer his remaining depreciable basis, attributable to the
working interest surrendered, to the leasehold costs of its continuing interest.

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1. Black Gold Oil Company transfers one-third of its working interest in the Cactus
Lease to Eagle Production for cash, which Black Gold uses to pay employee
Christmas bonuses. This transaction would be classified as a

A. Sale
B. Sublease
C. Sharing arrangement
D. Production payment

2. In the first question, if Black Gold uses the cash to drill a well on the Cactus
Lease, the transaction would be classified as a

A. Sale
B. Sublease
C. Sharing arrangement
D. Production payment

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1. A
2. C

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D. CHAPTER 4 TREATMENT OF COSTS

1. Uniform Capitalization Rules

The Tax Reform Act of 1986 enacted Section 263A for the purpose of providing a single
comprehensive set of rules to govern the capitalization of costs of producing, acquiring,
and holding property . . . The uniform capitalization rules (UCR) apply to both direct
and indirect costs allocable to real and tangible personal property produced or acquired
for resale.

The regulations do not provide guidelines as to the application of these rules to the oil
and gas industry. They do, however, specifically exclude intangible drilling, exploration,
and development costs from the UCR to the extent that these costs are allowable as a
deduction, including any portion that is capitalized and amortized.

Many in the industry would argue that costs subject to UCR such as direct material costs,
direct labor costs, and indirect costs are already being capitalized under prior law or fall
under the intangible costs exception. The Internal Revenue Service would likely require
capitalization of the overhead allocated to drilling and development and interest directly
traceable to drilling and development costs.

As there are not yet any detailed guidelines for the industry in accounting for UCR and as
companies may account for UCR in various ways, an awareness of this issue is sufficient
for the purposes of this study guide.

2. Geological and Geophysical Costs

Oil and gas exploration costs would normally include those items referred to in the
industry as G&G expenses. Included would be costs for geologists, aerial
photography, surface and subsurface mapping, logging, core holes, magnetic surveys,
gravimetric surveys, and seismic surveys. In general, G&G costs that lead to acquisition
of a property must be capitalized as a part of the cost of the property. Costs not leading
to property acquisition may be deducted in the year of abandonment of the acquisition
project.

An exploration program is conducted in three distinct phases. First the project area
(general geographical area of exploration) is selected. A reconnaissance-type survey is
conducted over the project area to yield data that will afford a basis for identifying
specific geological features with sufficient mineral producing potential to merit further
exploration.

In the second phase an area of interest is selected. Rev. Rul. 77-188 states Each
separable noncontiguous portion of the original project area in which such a specific
geological feature is identified is a separate area of interest. The original project area is
subdivided into as many small projects as there are areas of interest located and identified
within the original project area.

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Third is the selection of properties to be acquired. This selection is generally based on
detailed and intensive exploratory surveys designed to reveal dependable subsurface data.
These surveys could include seismic studies and core sample analysis.

How are these G&G expenditures to be allocated among the properties surveyed? First,
all costs incurred in the selection of the project area are assigned directly to the project
area.

Next, the project area costs must be allocated to the areas of interest identified. If one
area is identified, all project area costs are allocated to that area of interest. If more than
one area is found, the project costs are divided equally among the identified areas of
interest.

Then the project costs plus the specific costs incurred to survey each area of interest are
combined. This total cost is allocated to the individual properties located within the area
of interest, as follows:

1. If one property is acquired, all costs are capitalized for that property.

2. If more than one property is acquired, costs are allocated among the properties
based on acreage acquired.

3. If no property is acquired, costs are deducted. (The IRS currently does not
allow an acreage allocation for property not acquired.)

Capitalized G&G costs are expensed over the life of the property through cost depletion.

G&G costs incurred to determine the optimal drill site for a well on a property are treated
as intangible drilling costs.

Example: White Oil Company incurred $120,000 in costs for a seismic survey on the
project area mapped below. Three areas of interest, Reservoirs 100, 200 and 300, were
identified. Additional costs were incurred for detailed studies of each area of interest. As
a result of these studies, Leases A, D, G, H and J were acquired. (Assume that each lease
has equal acreage.) The entries to account for the G&G expenses are as follows:

1) Project Area Cost $120,000
Cash $120,000
Record seismic costs.

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2) Reservoir 100 Leasehold $ 40,000
Reservoir 200 Leasehold $ 40,000
Project Area Costs $120,000
Allocate project area costs equally to areas of interest.

3) Reservoir 100 Leasehold $ 20,000
Cash $ 90,000
Record costs for detailed surveys on areas of interest.

4) Lease A Leasehold $ 30,000
Lease D Leasehold $ 30,000
Lease G Leasehold $ 30,000
Lease H Leasehold $ 30,000
Lease J Leasehold $ 30,000
Allocate area of interest costs to leases acquired.

5) G&G Expense $ 60,000
Expense G&G costs for leases not acquired.

A

G J
B E H K
C F I L
300
100
200

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3. Delay Rentals

A delay rental is a payment for the privilege of deferring development of a property.
These costs are usually expressed as a fixed sum per acre and payable at the end of each
year during the primary lease term. A delay rental is basically treated like rent for
income tax purposes, since it accrues with the passage of time.

The Internal Revenue Service has said that delay rentals should be capitalized as pre-
production costs. Industry has replied that pre-production costs are expended for projects
which are certain to be completed. Delay rentals only insure the opportunity for
development of a property and only for a definite period of time.

4. Lease Bonuses

A lease bonus is a payment made by the lessee or sublessee to the lessor or sublessor as
consideration for granting a lease. It is usually a fixed sum per acre and may be paid in a
lump sum or in installments. These payments are regarded as advance royalties for
income tax purposes.

5. Intangible Drilling Costs

For tax purposes, costs incurred in developing a property are divided into two categories:

1. Tangible equipments costs

2. Intangible drilling and development costs (IDC)

Because the tax treatment of these costs differs significantly, it is important that they be
properly classified.

Tangible equipment costs are those incurred to purchase equipment of a type ordinarily
considered to have a salvage value. Tools, surface and production casing, wellhead
equipment, tanks, pumps, separators and other machinery would be classified as tangible
equipment. This also includes the cost of casing, even though it is cemented in the well
to such an extent that it has no net salvage value. These costs must be capitalized and
expensed over the life of the equipment through depreciation.

Intangible drilling costs are those expenditures made for wages, fuel, repairs, hauling,
supplies, etc., incident to and necessary for the drilling of wells and the preparation of
wells for the production of oil or gas. IRS regulations also include costs incurred to (1)
drill, shoot, or clean a well; (2) prepare the site for drilling, including ground clearing,
drainage, road construction, and surveying and geological work; and (3) construct the
physical facilities necessary to drill and prepare the well for production.

In order to recognize the high risks involved in drilling exploratory and development
wells, taxpayers are allowed to make a binding one-time election to expense IDC. This
option applies to drilling and development expenditures that have no salvage value.

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However, integrated oil companies are required to capitalize 30% of their IDC even after
making the election, with this 30% of costs deducted ratably over 60 months.

All taxpayers must capitalize foreign IDC and recover its cost either through depletion
deductions or through straight-line amortization over 10 years.

Another election is available each year to those taxpayers who have elected to currently
deduct IDC. They may capitalize all or a portion of IDC incurred in that tax year, and
recover that cost through straight-line amortization over a five-year period.

If a taxpayer has decided to capitalize his IDC, the regulations grant an option to either
capitalize or expense the cost of dry holes. If expensed, the deduction would be taken in
the year that the well is plugged.

The costs of installing salvageable items required to complete the well are also treated as
IDC subject to the election. The IRS has ruled that a well is complete when the casing,
including the Christmas tree, has been installed. The costs of installing production and
treating facilities beyond the wellhead equipment are not considered IDC.

6. Service Wells

Frequently wells other than oil and gas wells are drilled in exploration and development
activities. Such wells are known as service wells. If the service well is incident to the
drilling of an oil and gas well or the preparation of a well for production and does not
have a salvage value, the cost of the well is classified as IDC.

Injection wells put water or gas back into a producing formation. Costs for drilling and
completing these wells are accounted for in the same manner as producing wells.

Water wells that are drilled to provide fresh water for the drilling of producing wells are
eligible for the IDC election. The water well is considered incident to and necessary for
drilling the oil and gas well.

Salt water disposal wells are drilled to dispose of salt water that may be produced with
hydrocarbons. As these wells are not incident to and necessary for preparing wells for
production, the costs must be capitalized as lease and well equipment and recovered
through depreciation.

If a supply well is drilled to obtain water for use in a secondary or tertiary recovery
project; it is not a well drilled to prepare a well for production. As a result, the cost is
capitalized and depreciated. A supply well drilled to obtain carbon dioxide for tertiary
recovery is accorded the same treatment.

7. Overhead Costs and Allocation

For depletion purposes, the producing property must usually bear a portion of all items of
expense generally included within what the regulations refer to as general and financial
overhead. Some expenses considered a part of overhead are trade association dues,
some interest expense, some items of miscellaneous expenses, salaries of officers, general

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office expenses, capital stock taxes, legal expenses, contributions to a nonqualified
pension plan, and expenses incurred in connection with tax controversies. Overhead
expenses must be allocated among multiple properties in a reasonable manner.

8. Abandonment Costs

Taxpayers are generally allowed to deduct, as an ordinary loss, the adjusted basis of those
interests in oil and gas properties that have become totally worthless during the taxable
year. There are two requirements that must be met in order for this loss to be allowed.

1. The loss must be evidenced by a closed and completed transaction; i.e., the
taxpayers interest in the whole property must be completely worthless. If one
well on a lease is abandoned but others are still producing, the loss will not be
allowed.

2. The loss must be fixed by an identifiable event. For example, a lessee who
fails to pay delay rentals to the lessor would give evidence that the lessee finds
no future value in the property. Also, some event could cause the property to
lose its sale value in the ordinary channels of trade. Possible events causing
this loss in value could be exhaustion of oil and gas under the property or the
proven nonexistence of oil and gas.

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1. Which of the following petroleum industry costs has been specifically excluded
from the Uniform Capitalization Rules?

A. Lease and well equipment
B. Overhead allocated to drilling
C. Intangible drilling costs
D. Direct labor costs

2. Which of the following is NOT one of three phases of a petroleum exploration
program?

A. Selection of project areas
B. Selection of areas of interest
C. Selection of properties
D. Selection of first exploratory drill site

3. Which of the following statements regarding delay rentals is NOT true?

A. The cost is usually expressed as a fixed sum per acre.
B. It is due at the beginning of each year during the primary lease term.
C. For taxes purposes it is treated like rent.
D. It is a payment for the privilege of deferring development of a property.

4. All of the following costs would be classified as intangible drilling costs
EXCEPT:

A. Labor to plumb the tank battery
B. Labor to install wellhead
C. Labor to cement surface casing
D. Labor to build the location

5. Costs for drilling and completing an injection well are accounted for in what
manner?

A. These costs are capitalized as lease and well equipment and depreciated using
the units of production method.
B. These costs are eligible to be expensed in total under the IDC election.
C. These costs are capitalized as leasehold costs and recovered through
depletion.
D. These costs are accounted for in the same manner as producing wells.

Page 26
6. Which of the following statements is true regarding a deduction for
abandonment?

A. The taxpayers interest in the whole property must be completely worthless.
B. The loss is capital, not ordinary, in nature.
C. The loss must be fixed by an identifiable event.
D. Both A and C.

Page 27

1. C
2. D
3. B
4. A
5. D
6. D

Page 28

Page 29
E. CHAPTER 5 DEPRECIATION AND AMORTIZATION

1. Units of Production Depreciation

Historically, the unit of production method has normally been used to depreciate oil and
gas well improvements. The computation is essentially the same as that for cost
depletion, since it allocates the depreciable cost over the taxable years in which the oil
and gas are extracted.

S = Mineral units sold during the year
R = Mineral units estimated recoverable at the beginning of the year
B = Remaining basis in depreciable property

Annual depreciation expense = (S/R) X (B)

2. Cost Depletion

The extraction of minerals reduces the capital investment of those having an interest in
those resources. As compensation for this reduction, a reasonable deduction for depletion
is allowed in computing taxable income. In many respects, the depletion deduction is
similar to the deduction allowed for the cost of goods sold in a manufacturing business.
The deduction allows for the tax-free return of capital consumed in the production of
mineral income.

The following requirements must be met for a taxpayer to be entitled to a depletion
deduction:

1. The taxpayer must have an economic interest in the minerals in place.

2. The taxpayers investment must generally be in a natural deposit.

3. The natural deposit must contain an exhaustible amount of minerals.

4. The minerals must be extracted and actually or constructively sold.

S = Mineral units sold during the year
R = Mineral units estimated recoverable at the beginning of the year
B = Remaining basis in depletable property

Annual cost depletion expense = (S/R) X (B)

The estimated recoverable reserves to be used in this computation include not only
proved reserves but also probable or prospective reserves. The number of units sold
during the year is determined by reference to the taxpayers method of accounting, i.e.,
cash or accrual.

If both oil and gas are produced from the property, depletion may be calculated on the
major product. Or units of gas may be converted to equivalent barrels (BOE) by dividing
MCFs of gas by six.

Page 30

Both cost depletion and percentage depletion are calculated each year for each property,
and the proper deduction is the larger of the two.

3. Percentage Depletion

Where cost depletion allocates the depletable basis in the property to the units of minerals
sold during the year, percentage depletion equates depletion to a specified percentage of
the gross income from the property. The deduction is available to independent producers
and royalty owners but may not be taken by integrated oil companies, that is, those who
are retailers and/or refiners as well as producers. It is also limited to domestic oil and gas
wells.

Percentage, or statutory, depletion is generally allowable at a rate of 15% of gross income
from the property limited to 100% of the taxable income from the property. The
percentage depletion deduction is further limited to 65% of the total taxable income
(before the percentage depletion deduction) of the taxpayer. Also, it can be calculated on
no more than the average of 1000 equivalent barrels sold daily during the tax year.

Example: Brown Oil Company is an independent producer. It owns 100% of the
working interest in the University Lease. Consider the following facts regarding the lease
for 20XX:

Produced: 7400 BO Gross income from the lease: $180,000
Sold: 7200 BO Net income from the lease: $ 32,000
Remaining reserves @ 01/01/XX: 36,000 BO
Remaining depletable basis: $140,000
Taxpayers taxable income before depletion: $40,000

What is the correct depletion deduction for the year?

First, calculate cost depletion: (7200 BO/36,000BO) X $140,000 = $28,000

Next, calculate percentage depletion: ($180,000) X 15% = $27,000

Compare the percentage depletion to the net income from the property and take the
smaller amount.
$27,000 < $40,000; use $27,000

Then compare this to 65% of the taxpayers taxable income and take the smaller amount.

($40,000) X 65% = $26,000

$26,000 < $27,000

Percentage depletion = $26,000

Page 31
The larger of the computed percentage depletion or cost depletion, or $28,000 cost
depletion, is the correct deduction.

For marginal oil and gas production, the rate will be increased one percentage point for
each whole dollar that the reference price of crude oil for the preceding calendar year is
below $20 per barrel. The maximum rate for marginal production is limited to 25 %.
Also, there is no net income from the property limitation on the amount of depletion
available during the years 1998-2001. This occurred by the passage of a two-year bill,
and then an extension of that bill for an additional two years. Therefore, this beneficial
provision for marginal production could be modified after 2001. Depletion from
marginal wells is still subject to the 65% of total taxable income (before the percentage
depletion deduction) limitation.

Marginal production includes oil and gas produced from stripper well properties. These
wells produce 15 or less equivalent barrels per day per producing well. Stripper well
classification is re-determined annually. Marginal production also includes production
from a property substantially all of which is heavy crude oil (weighted average gravity of
20 degrees API or less).

Example: The average production from the Sunflower No. 1 is 3 barrels of oil and 66
MCF of gas per day during the year. Is this a stripper, or marginal, well?

First, divide the MCFs of gas by 6 to convert it to equivalent barrels. 66/6 = 11 barrels
Then add equivalent barrels to actual barrels. 11 + 3 = 14 equivalent barrels per day
The well qualifies for the marginal well rate for percentage depletion calculations.

Percentage depletion is allowed only to those who are entitled to cost depletion, based on
the requirements stated above. The depletable basis in the property, if any, is reduced by
the amount of depletion claimed, whether cost or percentage. Unlike cost depletion,
percentage depletion is not limited to the depletable basis in the property. It may be
claimed as long as the property generates gross income.

Page 32

1. Consider the following information regarding a transfer pump whose useful life is
expected to equal that of the lease on which it is installed.

Annual production: 6900 BO Annual sales: 7200 BO
Estimated recoverable reserves @ 01/01/XX: 30,000 BO
Cost of pump: $12,000
Fair market value of pump: $8,000
Accumulated depreciation: $6,000

The depreciation deduction for the year, calculated using the units of production
method, is:

A. $1440
B. $1380
C. $1920
D. $480

2. Buffalo Oil Company owns 100% of the working interest in the Little Big Horn
Lease. Consider the following facts for the year ended 12/31/XX.

Annual production: 72,000 BO Annual sales: 70,000 BO
Estimated recoverable reserves @ 12/31/XX: 908,000 BO
Remaining depletable basis: $100,000

What is the cost depletion deduction?

A. $7709
B. $7143
C. $7930
D. $7347

3. Indian Operators, an independent, owns 100% of the working interest in the
Apache Lease. Consider the following facts for the year ended 12/31/XX.

Annual production: 4380 BO Annual sales: 4200 BO
Estimated recoverable reserves @ 12/31/XX: 8800 BO
Regular depletion rate: 15%
Marginal depletion rate: 18%
Lease gross income: $100,000
Lease net income: $20,000

What is the percentage depletion deduction?

A. $15,000
B. $3,000
C. $3,600
D. $18,000

Page 33

1. A
2. B
3. D

Page 34

Page 35
F. CHAPTER 6 RECAPTURE RULES

1. Intangible Drilling Costs and Depletion

When an oil and gas property is disposed of at a gain, IDC or depletion may need to be
recaptured as ordinary income.

For properties placed in service prior to 1987, the amount subject to recapture is the
lesser of (1) the IDC previously deducted (subject to certain adjustments) or (2) the gain
realized.

For properties placed in service after 1986, the amount subject to recapture as ordinary
income is the lesser of (1) the IDC and depletion (but not percentage depletion in excess
of the propertys tax basis) or (2) the gain realized.

2. Depreciation

When gain is recognized on the disposition of real or personal property for which
depreciation deductions have been taken, part of all of these deductions must be
recaptured as ordinary income. The amount of ordinary income that results is the lesser
of (1) prior depreciation subject to recapture or (2) the gain realized.

All of the depreciation deductions claimed for personal property are subject to recapture.
For most types of real property held by corporations, recapture applies only to the extent
that the deductions claimed exceed the amount that would have been allowable if the
straight line method had been used. Individuals generally have to pay a tax rate of 25%
of depreciation recapture (computed similarly to personal property recapture) on the
disposition of real property.

Page 36

1. Which of the following statements regarding recapture rules is NOT true?

A. When a property is disposed of at a gain, IDC may be recaptured as
ordinary income.
B. All of the depreciation deductions claimed for real property by a
corporate taxpayer are subject to recapture.
C. All of the depreciation deductions claimed for personal property are
subject to recapture.
D. When a property is disposed of at a gain, depletion may be recaptured
as ordinary income.

Page 37

1. B

Page 38

Page 39
G. CHAPTER 7 ALTERNATIVE MINIMUM TAX

For many years Congress has been concerned that some taxpayers, through the use of
special deductions and tax deferral techniques, were not paying their fair share of taxes.
As a result of this concern, Congress imposed an alternative minimum tax (AMT) on
individuals, corporations, and certain other entities.

The law provides that the AMT will be computed by adding or subtracting adjustments
and preference items to or from regular taxable income. If the AMT calculated on the
adjusted taxable income is larger than the regular tax, the excess will be the AMT
liability.

Taxpayers in the petroleum industry should be aware of the following significant oil- and
gas-related items which may be taken into account in computing alternative minimum
taxable income.

1. Excess intangible drilling costs

2. Adjusted current earnings adjustment

Without question the AMT has affected the value of IDC as a tax incentive. Taxpayers
engaged in oil and gas activity must carefully review the AMT provisions to be sure that
the deductions that are contemplated will actually have the benefit anticipated.

Page 40

1. Which of the following statements regarding the alternative minimum tax is true?

A. In computing the AMT, percentage depletion in excess of basis may be taken
into account.
B. Congress imposed the AMT only on corporate entities.
C. Excess intangible drilling costs may be taken into account in computing AMT.
D. Total tax due is determined by adding together the regular tax and alternative
minimum tax.

Page 41

1. C

Page 42

Page 43
H. CHAPTER 8 TAX CREDITS

1. Enhanced Oil Recovery Credit

A 15% credit is allowed for certain enhanced, i.e., tertiary, oil recovery project costs.
The deductions for such costs will be reduced by the amount of the credit.

In order to qualify for the credit a project must meet all of the following requirements:

1. The project is reasonably expected to result in more than an insignificant
increase in the amount of crude oil that ultimately will be recovered.

2. The project is located within the United States.

3. The first injection of liquids, gases, or other matter occurs after December 31,
1990.

4. The project is certified by a petroleum engineer.

The costs that will qualify for the credit when incurred by the owner of an operating
interest are tangible property, IDC, and tertiary injectant expenses.

2. Nonconventional Fuel Credit

A nonrefundable credit is allowed for the production and sale of energy from alternative
sources. Generally, the credit is equal to $3.00 (adjusted for inflation) for each
equivalent barrel of fuel sold during the year. (The credit for gas from tight formations is
not adjusted for inflation.)

Fuels eligible for the credit include the following:

1. Oil from shale and tar sands

2. Gas from geopressured brine, Devonian shale, coal seams, and tight
formations

3. Gas from biomass

4. Synthetic fuels produced from coal

To receive the credit, the fuel production must occur within the United States or one of its
possessions. Also, it must be sold to an unrelated person. Many other restrictions apply
and are outside the scope of this discussion.

Page 44
3. Foreign Income Tax

Oil and gas taxpayers are subject to the foreign tax credit rules that apply to other
taxpayers. In addition, they are subject to special rules and limitations that do not affect
taxpayers in other industries.

Income derived outside the United States may be subject to taxation in the source country
as well as in the U.S. So it is possible to be taxed twice on the same income unless some
provision is made to allow credit against U.S. tax for taxes paid in the source country.

Each year the taxpayer may choose whether to treat qualifying foreign taxes as a
deduction or as a credit against U.S. taxes paid. Sometimes what is called an income tax
would not qualify as creditable when it is in fact payment for goods, services, or the right
to extract minerals. Additionally, the distinction between an income tax on profits and a
royalty paid to a foreign government has been the subject of substantial controversy.

Because of the detailed rules and limitations regarding the calculation of the foreign
credits, a taxpayer contemplating foreign exploration and development activities must be
sure that these rules are thoroughly understood.

Page 45
REVIEW QUESTIONS FOR CHAPTER 8

1. In order to qualify for the enhanced oil recovery credit a project must meet all of
the following requirements EXCEPT:

A. The project is reasonably expected to result in more than an insignificant
increase in the amount of reserves ultimately recovered.
B. The project must be certified by the Bureau of Land Management.
C. The project is located in the United States.
D. The first injection occurs after December 31, 1990.

2. Which of the following is NOT eligible for the nonconventional fuel credit?

A. Coal seam gas
B. Gas from biomass
C. Heavy oil (less than 20 degrees API)
D. Gas from geopressured brine

3. Which of the following statements regarding the foreign income tax credit is true?

A. Oil and gas taxpayers are not subject to the foreign tax credit rules that apply
to other taxpayers.
B. Certain qualifying foreign taxes may be taken both as a deduction and as a
credit.
C. Payment for the right to extract minerals in a foreign country is considered an
income tax.
D. Payment for goods and services in a foreign country is not considered an
income tax.

Page 46

1. B
2. C
3. D

Page 47
J. CHAPTER 9 LOSS LIMITATIONS

1. At-Risk Provisions

The Internal Revenue Code prohibits the deduction of a loss from the separate activity of
exploring for, or exploiting, oil and gas resources if the loss exceeds the total amount a
taxpayer has at risk for such an activity. Under the rules a taxpayer generally is at risk
for an activity to the extent of:

1. Cash and the adjusted tax basis of other property contributed to the activity.

2. Personal indebtedness incurred in connection with the activity.

3. The fair market value of assets (other than those used in the activity) securing
debt incurred in connection with the activity.

2. Passive Activities

There are significant limitations on the use of losses and credits from passive activities.
This type of activity is defined as the conduct of any trade or business in which the
taxpayer does not materially participate throughout the year; that is, he must be involved
in the activity on a regular and continuous basis.

Since a limited partner may not participate in the business on a regular basis, a limited
partnership interest is a passive interest. Any loss generated from that entity may be used
only to offset income from other passive activities. Unused losses can be carried forward
indefinitely and are allowed in full on disposition of the entire interest in the activity.

An exception to the passive loss rules is provided for working interest owners unless the
interest is held in a form that limits the owners liability regarding activities relating to
the interest. So if a working interest is held in a general partnership the general partners
can deduct losses from a working interest against other types of income.

Passive losses from working interest activities cannot be offset against income from
nonoperating interests since income from nonoperating interests is treated as portfolio
income, not passive income.

Careful attention must be given to these rules to avoid unanticipated consequences.

Page 48

1. A taxpayer may not deduct a loss from the separate activity of exploring for, or
exploiting, oil and gas resources if the loss exceeds:

A. The taxpayers total portfolio income
B. The taxpayers total passive income
C. The amount the taxpayer has at risk
D. The average of the taxpayers oil and gas income for the three prior years

2. Which of the following statements regarding passive activities is NOT true?

A. A loss from a passive activity can offset portfolio income but not active
income.
B. A limited partnership interest is a passive interest.
C. An exception to the passive loss rules is available to working interest owners
whose liability is not limited in regard to activities relating to the interest.
D. Passive losses from working interest activities cannot be offset against royalty
income.

Page 49

1. C
2. A

Page 50

Page 51
K. CHAPTER 10 SUBCHAPTER K ELECTION

Subchapter K of the Internal Revenue Code governs the taxation of partnerships.
Taxpayers who are participants in a joint venture or other unincorporated organization
may elect to be excluded from partnership treatment if the organization is created for (1)
investment purposes only and not for the active conduct of a business, or (2) for joint
production, extraction, or use of property, but not for the purpose of selling services or
property produced or extracted. This second provision was written into the Code
specifically to cover the joint operation of oil and gas producing properties through Joint
Operating Agreements.

Participants in an oil and gas joint venture usually qualify for this election as long as
they:

1. Own the property as co-owners

2. Have the right to separately take production in-kind or to dispose of their
share of oil and gas produced

3. Do not jointly sell the oil and gas extracted (each participant is allowed to
delegate authority to dispose of its production to another party.)

The election to be excluded from the provisions of Subchapter K can be made by
attaching an election to a partnership tax return filed for the first year of operations. In
the absence of an election, it is deemed to have been made for the first taxable year of the
organization if it can be shown from facts and circumstances that it was the intent of
members of the organization to be excluded. All participants must agree to make the
election. The standard Joint Operating Agreement used in the industry includes a section
electing to be excluded from Subchapter K.

There are several significant effects of such an election; among them, making the election
eliminates the need for filing partnership returns. Also, the working interest owners can
elect different tax treatments on their own separate returns for the propertys operations.

In some instances, the owners might want to make special allocations of income and
expense. This would require them to be treated as a partnership under Subchapter K.

Page 52

1. Which of the following statements regarding the Subchapter K election is NOT
true?

A. Participants in a joint venture can qualify if they own the property as co-
owners.
B. The election must be made in writing by April 15
th
following the first year of
operations.
C. Making the election eliminates the need for filing partnership tax returns.
D. One advantage of making the election is the opportunity for owners to choose
different tax treatments for the propertys operations.

Page 53

1. B

Page 54

Page 55
L. CHAPTER 11 GAS BALANCING METHODS

Working interest owners in gas wells frequently enter into a gas balancing agreement
where, although each owner retains the right to take its share of production in-kind,
provisions are made to deal with an imbalance in takes. Imbalances may arise due to a
number of circumstances such as a lack of market share, a lack of regulatory approvals,
or contract delays. The agreement specifies the accounting method for dealing with
imbalances.

Two methods of gas balancing are acceptable for producers subject to a Joint Operating
Agreement that elect to be excluded from the partnership provisions of Subchapter K.
These methods are cumulative gas balancing and annual gas balancing. The cumulative
method is required unless advance permission is received from the IRS to use the annual
balancing method.

Under the cumulative balancing method, each producer recognizes gross income based
on his total sales of gas from the property including any sales of gas taken from another
producers share of the reserves. A deduction is allowed to the overproducer in the year a
balancing payment is made to an underproducer. Similarly, the underproducer
recognizes income for his own sales and for any balancing payments received. Depletion
deductions and nonconventional fuel tax credits are allowed on sales during a year but
not to exceed the owners remaining percentage share of total gas in the reservoir.

The regulations contain a broad anti-abuse rule under which the IRS may deny the
Subchapter K election in situations where producers using the cumulative method have
arranged the taking of production with a principal purpose of shifting income, deductions,
and credits.

Under the annual balancing method, each interest owner accounts for gas sales based on
his relative ownership rights under the Joint Operating Agreement and his current share
of gas produced from the reservoir. Any imbalances related to a Joint Operating
Agreement must be eliminated annually through a balancing payment. Current
regulations do not provide specific guidance in accounting for sales, balancing payments,
production credits, and depletion deductions for those electing this method. Producers
requesting permission to adopt the annual balancing method must explain how these
items will be reported.

Page 56
REVIEW QUESTIONS FOR CHAPTER 11

1. Which of the following statements regarding the annual gas balancing method is
true?

A. Any imbalances must be eliminated when the well is plugged.
B. Current regulations provide specific guidance in accounting for sales and
depletion.
C. This method is required unless prior permission is received from the IRS.
D. Each owner accounts for gas sales based on his ownership rights and his
current proportionate share of gas produced.

Page 57

1. D

Page 58

Page 59
SAMPLE TEST

1. Fee simple interest includes ownership of which of the following?

A. Surface rights, subsurface rights and airspace
B. Mineral interest only
C. Working and royalty interest
D. Subsurface rights only

2. When the owner of minerals enters into a lease, what two kinds of interests are
created?

A. Surface and subsurface interests
B. Royalty and working interests
C. Overriding royalty and working interests
D. Surface and leasehold interests

3. Which of the following types of interest is NOT created from the working
interest?

A. Overriding royalty interest
B. Net profits interest
C. Production payment
D. Royalty interest

4. An economic interest must meet four requirements. Which of the following is
NOT one of the requirements?

A. The interest must represent a capital interest in the minerals in place.
B. The interest must provide the right to share in the minerals produced.
C. The interest owner must look to net profits from the property for a return
of his capital.
D. The interest must be held in a legal relationship.

5. What is the term describing two tracts of land that share a common border?

A. Adjacent
B. Connected
C. Contiguous
D. Annexed

6. What is the term describing two tracts of land that share only a corner?

A. Adjacent
B. Contiguous
C. Annexed
D. Indexed

Page 60
7. If a taxpayer acquires more than one operating interest in a tract, he must:

A. Account for them separately unless he receives IRS permission to combine
them.
B. Account for them separately unless he has made the binding election to
combine all interests in a tract.
C. Combine the interests unless he makes an election to treat them separately.
D. Combine the interests for the first tax year only.

8. Separate operating interests are always treated as one property when the owner is
participating in what type of arrangement?

A. Downhole commingling
B. Surface commingling
C. Unitization
D. Offshore joint venture

9. An operating and a non-operating interest can only be combined in what
circumstance?

A. During the time the property is a part of a unit
B. When a net profits interest is being calculated
C. They can never be combined.
D. Until a production payment has been retired

10. Which of the following statements about conveyances is true?

A. A sharing arrangement involving a cash consideration will never result in
a taxable transaction.
B. Cash received as a lease bonus could be taxed as capital gain income.
C. Cash received for the sale of a working interest could be taxed as capital
gain income.
D. None of the above statements is true.

11. When the owner of the working interest assigns any type of continuing non-
operating interest in the property for cash and retains the working interest, the
transaction is called:

A. A lease
B. A sale
C. A sharing arrangement
D. A contribution of capital

12. To be classified as a lease, the lessor assigns:

A. Royalty interest
B. Working interest
C. Overriding royalty interest
D. Net profits interest

Page 61
13. If the assignor transfers working interest in exchange for cash and the cash is
pledged to development of the lease, the transaction is classified as:

A. A sale
B. A sublease
C. An exchange
D. A sharing arrangement

14. Which of the following statements regarding the Uniform Capitalization Rules is
true?

A. The regulations provide specific guidance for the oil and gas industry.
B. The regulations specifically exclude intangible drilling costs.
C. The regulations do not require capitalization of allocated overhead.
D. The rules apply only to costs associated with the production of tangible
personal property.

15. Which of the following expenses is not initially capitalized as geological and
geophysical cost?

A. Costs to survey a project area
B. Costs incurred to select areas of interest
C. Costs to determine the optimal drill site for a well
D. Costs incurred to select properties to be acquired

16. G&G costs that do not lead to acquisition of a property are:

A. Capitalized as part of the area of interest leasehold cost and expensed
through depletion ratably over 60 months
B. Expensed in the year paid or incurred
C. Capitalized initially and then expensed in the year that the associated
project area is determined to be completely worthless
D. Capitalized through allocation to the properties that are acquired

17. Sandy Oil Company incurs G&G costs of $120,000 to survey a project area.
Three areas of interest are identified as follows:
Cactus Area, 320 acres
Sand Dune Area, 160 acres
Arroyo Area, 160 acres
What portion of these costs is allocated to the Cactus Area?

A. $120,000
B. $60,000
C. $40,000
D. $32,000

Page 62
18. Which of the following statements about delay rentals is true?

A. It is a payment for the privilege of deferring development of a property.
B. It is usually expressed as a variable sum per acre, declining with each year
of the primary term of the associated lease.
C. The IRS believes it should be capitalized as a pre-production cost.
D. Both A and C.

19. The payment made by the lessee to the lessor as consideration for granting a lease
is called:

A. Prepaid royalty.
B. Intangible leasehold cost.
C. Lease rental.
D. Lease bonus.

20. For tax purposes, costs incurred in developing a property are divided into what
two categories?

A. Drilling and production
B. Tangible and intangible
C. Before casing point and after casing point
D. Pre-production and production

21. Which of the following statements is NOT true regarding the election to expense
intangible drilling costs?

A. Integrated oil companies are required to capitalize 40% of IDC expense
even after making the election.
B. The amount capitalized by an integrated oil company is deducted ratably
over 60 months.
C. This election is binding on independent producers.
D. The election does not apply to foreign IDC.

22. Roadrunner Oil Company incurred the following costs in drilling and completing
the Big Bucks Well No. 1:

Surface casing $ 50,000
Production casing $100,000
Cementing surface casing $ 10,000
Cementing production casing $ 25,000
Building the location $ 20,000
Hauling casing $ 2,000
Dirt work to build drilling location $ 2,000
Dirt work to build pad for production tanks $ 2,000
Labor to install the wellhead $ 5,000
Labor to install the tank battery $ 5,000

Page 63

The total which should be classified as IDC is:

A. $ 64,000
B. $ 96,000
C. $ 47,000
D. $117,000

23. The cost of which of the following service wells is classified as IDC?

A. Salt water disposal well
B. Water well to support secondary recovery
C. Gas injection well
D. Water well to support drilling

24. For depletion purposes, which of the following expenses would NOT be included
in overhead?

A. Officers salaries
B. Legal expenses
C. Severance tax
D. Miscellaneous expense

25. Which of the statements regarding abandonment costs is true?

A. Taxpayers are allowed to deduct, as a capital loss, the adjusted basis of
those interests that have become worthless during the taxable year.
B. A partial deduction is allowed for the plugging of one well on a multi-well
lease.
C. For a loss to be allowed, it must be fixed by an identifiable event.
D. The IRS lists three requirements that must be met for a loss to be allowed.

26. What type of depreciation is common to the oil and gas industry?

A. Straight line
B. 150% declining balance
C. Units of production
D. 200% declining balance

27. Which of the following is NOT a true requirement for a taxpayer to be entitled to
a depletion deduction?

A. The taxpayer must have an economic interest in the minerals in place.
B. The taxpayers investment must generally be in a natural deposit.
C. The natural deposit must contain an exhaustible amount of minerals.
D. The minerals must be extracted, whether or not they are actually sold.

Page 64
28. Consider the following facts concerning the Jones No. 1 for the tax year, owned
100% by an independent producer.

Production: 11,000 BO Sales: 10,000 BO
Remaining Recoverable Reserves at 12/31/XX: 33,000 BO
Remaining Depletable Basis: $100,000

What is the cost depletion deduction?

A. $25,000
B. $23,256
C. $25,581
D. $22,727

29. Which of the following statements is true regarding the depletion deduction
calculation?

A. Only proved reserves are included in the remaining reserves at the
beginning of the year.
B. If both oil and gas are produced, depletion may be calculated on the major
product.
C. Both cost depletion and percentage depletion are calculated each year, and
the proper deduction is the larger of the two.
D. Both B and C are correct.

30. Which of the following statements regarding percentage depletion on marginal
wells is NOT true?

A. The maximum rate is limited to 28%.
B. A well producing 15 or fewer equivalent barrels per day is classified as
marginal.
C. Marginal production also includes production from a well substantially all
of which is heavy crude oil.
D. The deduction is only available for domestic production.

31. When an oil and gas property is disposed of at a loss, which of the following costs
must be recaptured?
A. Cementing of surface casing
B. Straight-line depreciation on the tank battery
C. Percentage depletion taken in excess of basis
D. None of the above

32. Which of the following items would NOT be taken into account in computing the
Alternative Minimum Tax?

A. Excess intangible drilling costs
B. Percentage depletion in excess of basis
C. Adjusted current earnings adjustment
D. None of the above

Page 65

33. Which of the following statements regarding the enhanced oil recovery credit is
true?

A. A 20% credit is allowed for certain enhanced oil recovery project costs.
B. Qualifying expenses include secondary injectant expenses.
C. The project must be certified by a petroleum geologist.
D. The project must be located within the United States.

34. Fuels eligible for the nonconventional fuel credit are:

A. Oil from shale and tar sands
B. Synthetic fuels produced from agricultural by-products
C. Gas from tertiary recovery projects
D. Both A and B

35. Which of the following is NOT true regarding the U.S. credit for foreign income
tax paid?

A. If a taxpayer chooses to pay U.S. income tax on foreign income, he will
not be taxed by any foreign country with which the U.S. has a tax
abatement treaty.
B. Each year the taxpayer may choose whether to treat qualifying foreign
taxes as a deduction or as a credit.
C. Oil and gas taxpayers are subject to the same foreign tax credit rules that
apply to other taxpayers.
D. It can be difficult to distinguish between an income tax on profits and a
royalty paid to a foreign government.

36. A limited partnership interest is a/an
A. Active interest
B. Passive interest
C. Net profits interest
D. Portfolio interest

37. An oil and gas taxpayer cannot deduct a loss if it exceeds the total amount he has
at risk. He is generally at risk to the extent of:

A. The fair market value of property contributed to the activity
B. Cash contributed to the activity
C. His personal net worth
D. Both A and B

Page 66
38. Which of the following is NOT a requirement for participants in a joint venture
who want to be excluded from partnership treatment?

A. They must own the property as co-owners.
B. They have the right to separately take production in-kind.
C. They may not delegate the authority to dispose of production to the
operator.
D. They may not jointly sell the oil and gas extracted.

39. Which of the following statements regarding gas balancing is true?

A. The annual gas balancing method is required by the IRS, absent
permission.
B. The cumulative gas balancing method is required by the IRS, absent
permission.
C. The look-back gas balancing method is required by the IRS, absent
permission.
D. There are three gas balancing methods which may receive IRS approval.

40. Consider the following facts regarding the Canyon Lease, owned 100% by an
independent producer, for the tax year 20XX:

Gross income from the property: $150,000
Gross production from the property: 36,000 MCF
Compressor rental expenses: $36,000
Severance taxes: $15,000
Ad valorem taxes: $10,000
Pumper wages, benefits, and transportation $3,000
Chemicals $2,000

What is the percentage depletion deduction for this lease?

A. $12,600
B. $15,000
C. $22,500
D. $30,000

Page 67
ANSWERS TO SAMPLE TEST

1. A
2. B
3. D
4. C
5. C
6. A
7. C
8. C
9. C
10. C
11. B
12. B
13. D
14. B
15. C
16. C
17. C
18. D
19. D
20. B
21. A
22. A
23. D
24. C
25. C
26. C
27. D
28. D
29. D
30. A
31. D
32. B
33. D
34. A
35. A
36. B
37. B
38. C
39. B
40. C

Page 68

Page 69
III. GLOSSARY

ADJACENT LAND TRACTS - Tracts that geographically touch only at a corner.

ANNUAL GAS BALANCING METHOD - A method whereby each interest owner
accounts for gas sales based on his relative ownership rights under the Joint
Operating Agreement and his current share of gas produced from the reservoir each
year. Some agreements may require annual cash settlements for any imbalance.

AREA OF INTEREST A separate noncontiguous area within a project area that, for
tax purposes, has been identified in a G&G survey as having specific geological
features that warrant further analysis.

CARRIED INTEREST - Created when one or more parties agree to pay a
disproportionate share of the development expenses

CONTIGUOUS LAND TRACTS - Tracts that geographically share a common border.

CUMULATIVE GAS BALANCING METHOD A method whereby each producer
recognizes gross income based on his total sales of gas from the property including
any sales of gas taken from another producers share of the reserves and over/under
produce positions are settled at the end of the properties commercial life.

DELAY RENTAL - A payment, made during the primary term of a lease, for additional
time in which to utilize the land. It does not depend on oil or gas produced, does not
exhaust substance of land, and resembles a bonus payment, which is an advance
royalty.

ECONOMIC INTEREST Represents an interest in the minerals in place. The interest
owner may only look to its share of production proceeds for a return of capital. This
interest must exist in some form of a legal relationship including royalty interest,
working interest, overriding royalty interest and/or net profits interest.

EQUIVALENT BARRELS or BARRELS OF OIL EQUIVALENT (BOE)
Converts all hydrocarbons to a single unit of measurement base on their equivalent
energy content. Under the standard energy conversion 6 MCF of gas is equivalent to
1 barrel of oil.

FARMOUT - A form of sharing arrangement under which the working interest owner, or
farmor, assigns all or part of his working interest to a second party, or farmee, in
exchange for that partys agreement to drill a well on the lease.

Page 70
FEE SIMPLE INTEREST A fee simple is an estate limited absolutely to a person and
his/her heirs and assigns forever without limitation or condition. A fee simple estate is
one in which the owner is entitled to the entire property, with unconditional power of
disposition during his/her life, and descending to his/her heirs and legal
representatives upon his death.

GEOLOGICAL AND GEOPHYSICAL COSTS (G&G) - Costs for processes which
look for surface or subterranean indications of formations, faults or other geological
structures which are of a type in which experience has shown the possibility of
mineral deposits in commercial quantities.

INJECTION WELLS Service wells drilled to put water or gas back into a producing
formation as part of a secondary recovery effort.

INTANGIBLE DRILLING COSTS Any cost which in itself has no salvage value and
is incident to and necessary for the drilling of wells and the preparation of wells for
the production of oil or gas. An exception to the no salvage value rule is casing.

LEASE BONUS - A payment made by the lessee or sublessee to the lessor or sublessor
as consideration for granting a lease.

MINERALS - The term commonly used to describe all hydrocarbons and other natural
resources. It also may refer to the rights to those minerals.
NET PROFITS INTEREST - Entitles the owner to a portion of the net profits from
operation of the property. The interest owner has no obligation to pay for
development or production costs if the share of production attributable to this interest
is not sufficient to pay those costs. If no net profit exists, the holder of the interest
receives no payment.

OVERRIDING ROYALTY INTEREST / OVERRIDE (ORI) or (ORRI) - A royalty
interest carved out of a working interest and is interest in oil and gas produced at the
wellhead free of expenses. Its duration is limited to the duration of the working
interest from which it was created.

PASSIVE ACTIVITY - The conduct of any trade or business in which the taxpayer does
not materially participate throughout the year on a regular and continuous basis.

PRODUCTION PAYMENT - Entitles the holder to a specified percentage of
production for a limited period of time, or until a defined amount of money has been
received, or until a certain number of production units has been received. At the time
it is created, this interest must have a projected life shorter than the life of the
operating interest from which it was created. The owner of a production payment has
no responsibility for the costs of development and production.

PRIMARY TERM The initial term of the lease. During this term the lease may be
held or kept from terminating either by drilling or, in the absence of drilling, by the
leasee making a yearly payment called a delay rental payment.

Page 71
PROJECT AREA - A general geographical area of exploration selected to yield data
that will afford a basis for identifying specific geological features.

ROYALTY INTEREST Created under a mineral lease and is the right to share in a
stated portion of the mineral production from the property, free of developing and
producing cost.

SALT WATER DISPOSAL WELLS Service wells drilled to dispose of salt water
that may be produced with hydrocarbons.

SECONDARY RECOVERY The process of injecting water, gas, etc., into a
producing formation as a means of increasing the drive mechanism in order to
produce oil that would otherwise be unobtainable.

SUPPLY WELL Service wells drilled to obtain water or carbon dioxide for use in a
secondary or tertiary recovery project.

TANGIBLE EQUIPMENT COSTS - Costs incurred to purchase equipment of a type
ordinarily considered to have a salvage value. Tools, surface and production casing,
wellhead equipment, tanks, pumps, separators and other machinery would be
classified as tangible equipment.

TERTIARY RECOVERY The use of sophisticated techniques such as flooding the
reservoir with steam to increase the production of oil or gas.

UNIFORM CAPITALIZATION RULES (UCR) - A single comprehensive set of rules
in the tax code governing the capitalization of costs for acquiring, developing,
producing, and holding properties.

WORKING OR OPERATING INTEREST - Held by the assignee of the lease and
represents an interest in the minerals burdened by the cost of exploration,
development and production.

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TRAINING & REFERENCE MATERIAL TR-41

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