Oil and gas companies who want to calculate their tax burden accurately can't afford to misunderstand depletion. Over time, the natural resources extracted by oil and gas companies will be used up, meaning the land that contains those assets becomes less valuable. When an organization prepares to file taxes, it must take this value loss into account.
By working with a CPA who has experience in the oil and gas industry, companies can ensure they are paying taxes that reflect their actual income.
How depletion impacts basis
Basis is a tax term that refers to the capital investment a company has put toward a property. In many cases, the value of a piece of property will increase as a company builds new structures on the property or otherwise develops it. Oil and gas present a different situation, however, because accessing the resources that gave the land value inherently lessens the property's overall worth.
Depletion is used to account for the value lost through mineral production. While there are limitations on how much depletion can be taken, companies that ignore depletion will overpay on their taxes.
Two methods for calculation
Because there are several different factors within the oil and gas industry that can impact depletion, there are several ways for businesses to account for the lost value.
Businesses can either calculate based on cost or use a flat percentage. With cost depletion, the level of depletion is based on the actual units of production from a piece of property each year. That amount is subtracted from the property's initial worth. Percentage depletion functions as a percent of gross revenue regardless of the unit production from a piece of property during that year.
No matter what method a company uses, there are limits to depletion's effects. Cost depletion cannot exceed the property's basis, while the use of percentage depletion is limited to the revenue from production of 1,000 barrels a day. The percentage method also cannot exceed either 65 percent of taxable income before depletion without NOL carryovers, or 100 percent of income from the property before depletion – whichever is less. In every case, depletion can't reduce the property's basis to less than zero.
Depletion has a huge impact on how much tax a company needs to pay each year, and can affect the tax burden created by the sale or purchase of a property that has already undergone some level of depletion. To ensure your business is properly accounting for depletion, it's important to work with a CPA who is well-versed in oil and gas companies. LaPorte's large portfolio of oil and gas clients makes it a perfect partner to accurately assess depletion of your assets.