Three provisions drive the tax return of an oil and gas client: the option to deduct intangible drilling costs, percentage depletion for small producers and royalty owners, and a passive activity exception for working interests. They interact with the book method (successful efforts or full cost), and the differences produce deferred taxes. The accounting side is in the oil and gas audit guide on full cost versus successful efforts.
Intangible drilling and development costs
Section 263(c) directs the Secretary to prescribe regulations granting the option to deduct as expenses intangible drilling and development costs (IDC) for oil and gas wells, and for geothermal wells on the same terms. The subsection does not apply to costs for which a deduction is allowed under section 59(e) or 291. Under Treas. Reg. 1.612-4, an operator, meaning one who holds a working or operating interest, may at its option charge IDC to capital or to expense. The option covers amounts paid for wages, fuel, repairs, hauling, supplies and similar items incident to and necessary for drilling and preparing wells for production, including clearing ground, draining, road making, surveying and geological work in preparation for drilling. The option reaches costs of drilling and development undertaken directly or through a contract. It does not reach tangible property ordinarily considered to have a salvage value: the regulation lists drilling tools, pipe, casing, tubing, tanks, engines, boilers and machines, which are capital items recovered through depreciation. Wages, fuel, repairs and supplies for operating the wells are ordinary expenses regardless of the option.
Practical points: under Treas. Reg. 1.612-4(d), the option is exercised by deducting IDC on the return for the first taxable year in which the costs are paid or incurred, and no formal statement is necessary. A taxpayer who does not deduct them on that return is deemed to have elected to recover them through depletion (to the extent not represented by physical property) and depreciation (to the extent represented by physical property).
Percentage depletion for independent producers and royalty owners
Section 613A(c) allows percentage depletion, at 15 percent of gross income from the property, for independent producers and royalty owners on average daily production up to the depletable quantity. The tentative depletable oil quantity is 1,000 barrels a day, reduced by average daily marginal production unless the taxpayer makes the election in section 613A(c)(6)(B). The depletable natural gas quantity is 6,000 cubic feet multiplied by the number of barrels of the depletable oil quantity the taxpayer elects to apply to gas. Average daily production is aggregate production divided by the days in the taxable year. Production above the depletable quantity does not qualify for the 15 percent rate.
Limits that matter:
- 65 percent limit. Under section 613A(d)(1), the deduction attributable to the percentage depletion exception cannot exceed 65 percent of the taxpayer's taxable income for the year, computed without regard to that depletion and certain other items such as the section 199A deduction and loss carrybacks.
- Carryforward. An amount disallowed by the 65 percent limit is treated as allowable in the following year, subject to the limit again.
- Retailers. Section 613A(d)(2) excludes a taxpayer who, directly or through a related person, sells oil or gas (other than bulk sales to commercial or industrial users) through a retail outlet operated by it or a related person. The exclusion does not apply when the combined gross receipts of the retail outlets for the year do not exceed $5,000,000.
- Refiners. Section 613A(d)(4) excludes a taxpayer that, with related persons, refines crude oil with average daily refinery runs above 75,000 barrels.
- Lease bonuses. Under section 613A(d)(5), gross income from the property does not include a lease bonus, advance royalty or other amount payable without regard to production.
- Property-by-property computation. Section 613(a) caps the allowance at 100 percent of taxable income from the oil or gas property (before depletion and any section 199A deduction), and in no case is the allowance less than cost depletion, so the larger amount is used.
The working interest exception to passive treatment
Section 469(c)(3)(A) provides that a passive activity does not include any working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest. If the entity limits the taxpayer's liability on the interest, the exception does not apply on its face and losses can be passive. Material participation is not required for the exception (section 469(c)(4)). Under section 469(c)(3)(B), once a loss from a working interest is treated as not passive, net income from that property in later years is also not passive.
Worked example
An investor holds a working interest through a sole proprietorship. In 2026 the well costs $900,000: $620,000 is IDC, $280,000 is equipment (tangible). The investor expenses the IDC. The first-year revenue from the well is $300,000, and lease operating expenses are $50,000.
- IDC deduction: $620,000.
- Equipment: depreciable over its recovery period, not expensed as IDC.
- Operating income before IDC and depreciation: $300,000 minus $50,000, or $250,000.
- Net loss before depreciation: $250,000 minus $620,000, or $370,000 loss.
Because the working interest is held without limited liability, the loss is not passive and offsets other income, subject to the basis, at-risk and other loss limits that apply to the client. In later producing years, income from the property is non-passive.
Second example: percentage depletion and the 65 percent limit
An independent producer owns a royalty interest in a property with $300,000 of gross income for the year and no rents or royalties paid. Cost depletion for the property is $30,000. Production is within the depletable quantity. The taxpayer's taxable income for the year, computed without percentage depletion, the section 199A deduction and loss carrybacks, is $60,000.
- Percentage depletion at 15 percent: $300,000 times 15 percent, or $45,000, which exceeds cost depletion of $30,000.
- Limit under section 613A(d)(1): 65 percent of $60,000, or $39,000.
- Deduction allowed: $39,000.
- Disallowed and carried to the next year: $45,000 minus $39,000, or $6,000.
The $6,000 is treated as allowable under subsection (c) in the following year, subject to that year's 65 percent limit.
Common errors
- Expensing casing, tubing and tanks as IDC. Tangible property with salvage value is depreciable.
- Applying percentage depletion to a retail or refining client without testing section 613A(d).
- Including a lease bonus or advance royalty in gross income from the property for percentage depletion.
- Ignoring the 65 percent limit and the carryforward of the disallowed amount.
Frequently asked questions
Can a taxpayer capitalize IDC instead of deducting it?
Yes. If the taxpayer charges the costs to capital, the amounts not represented by physical property are returned through depletion and the rest through depreciation (Treas. Reg. 1.612-4(b)).
File checklist
- Joint interest billing statements from the operator, split between IDC and equipment.
- Authority for expenditure documents and drilling contracts.
- Entity structure chart showing how the working interest is held.
- Daily production by property and the depletable quantity computation.
- Reconciliation of tax IDC and depletion to the book successful efforts or full cost balances.
Sources
- Legal Information Institute, 26 U.S.C. 263, Capital expenditures: https://www.law.cornell.edu/uscode/text/26/263
- Legal Information Institute, 26 U.S.C. 613, Percentage depletion (100 percent property limit, cost depletion floor): https://www.law.cornell.edu/uscode/text/26/613
- Legal Information Institute, 26 U.S.C. 613A, Limitations on percentage depletion in case of oil and gas wells: https://www.law.cornell.edu/uscode/text/26/613A
- Legal Information Institute, 26 CFR 1.612-4, Charges to capital and to expense in case of oil and gas wells: https://www.law.cornell.edu/cfr/text/26/1.612-4
- Legal Information Institute, 26 U.S.C. 469, Passive activity losses and credits limited: https://www.law.cornell.edu/uscode/text/26/469
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error