Oil and gas is a business of large commitments made ahead of uncertain returns. A well is paid for long before it produces, prices change from month to month, and the applicable tax rules are among the most specialized in the code. We work with operators, oilfield service companies and individual interest owners to make the numbers clear enough to plan around with confidence.
Why do oil and gas companies need project-level accounting?
Because the business is, in effect, a collection of projects. Each lease, well or service contract carries its own costs and its own return, and a single consolidated profit and loss statement obscures which of them are carrying the company.
The oil and gas company in our case study had grown without that visibility. We built a chart of accounts and project costing designed around its operations, segmented the data so each division head received the figures relevant to their area, and consolidated the results for the leadership team. Rolling financial and cash flow projections kept management ahead of both short-term needs and long-term investment. That structure is what made faster, better-informed decisions possible.
How are drilling costs deducted?
Drilling costs fall into two groups. Tangible costs, such as casing, pumps and tanks, are treated as equipment and depreciated. Intangible drilling costs, such as labor, fuel, site preparation and drilling services, have no salvage value, and Section 263(c) of the tax code allows an election to deduct them as current expenses, as described in the IRS oil and gas audit technique guide.
For example, an investor who commits $200,000 to drilling a well through a working interest, of which $140,000 is intangible drilling cost, may be able to deduct that $140,000 in the year the well is drilled. The remaining $60,000 of equipment is depreciated. Most of the value lies in classifying invoices correctly between the two categories, and that begins with how costs are coded in the books.
What is depletion, and which method applies?
Depletion is the deduction for using up a mineral reserve, and it can be calculated in two ways. Cost depletion recovers your investment as reserves are produced, while percentage depletion is a set percentage of gross income from the property. According to the IRS fact sheet on reporting natural resource income, only independent producers and royalty owners can use percentage depletion for oil and gas, and you must use whichever method yields the greater deduction.
For oil and gas, the percentage depletion rate is 15 percent, subject to limits on daily production and on taxable income. Because percentage depletion is not limited to your cost, it can continue after your investment has been fully recovered, which is why careful tracking by property is worthwhile.
How are working interests and royalties taxed differently?
A working interest bears a share of the costs of operating a well, whereas a royalty interest receives a share of production without bearing those costs. The distinction has real tax consequences. Under IRS Publication 925, a working interest held directly or through an entity that does not limit your liability is not a passive activity, so its losses can offset wages and other income whether or not you materially participate, meaning take part in operations on a regular, continuous and substantial basis. Working interest income is generally subject to self-employment tax, while royalty income is usually reported on Schedule E and is not.
Colorado adds its own layer of obligation. The Department of Revenue’s severance tax page states that anyone who receives income from oil and gas production must file a return, and that tax may be due even without a net profit on the investment.
How SBA CPA works with oil and gas businesses
We keep books by project and division, produce rolling cash flow forecasts, classify drilling costs, calculate depletion by property and prepare federal, Colorado and severance tax filings. For owners and investors, we also review how each interest is held and how that affects the return. An introductory call is the simplest way to begin.