7869 / If the limited partnership elects to expense intangible drilling costs, how does a limited partner treat allocated shares of such costs?

Election to Amortize Costs

If the limited partner makes this election, the limited partner may deduct each year on his or her income tax return a ratable portion of the allocated share of intangible drilling costs over the 60-month period beginning with the month in which such amounts were expended by the partnership.²

If a limited partner elects to amortize intangible drilling costs over the 60-month period, any amount of intangible drilling and development costs covered by the election will not be treated as an item of tax preference for purposes of the alternative minimum tax.³ See Q 7887.

In the case of a disposition of a limited partner’s interest in an oil and gas limited partnership, deductions taken under the amortization method may, like expensed intangible drilling costs, be required to be recaptured as ordinary income.⁴

Deduction of Expensed Costs

If a limited partner does not elect to amortize the allocated share of intangible drilling costs, the limited partner will deduct (within the limits described in Q 7862) the amount on his or her federal income tax return.⁵

Assuming the limited partnership has elected cash basis tax accounting (as is usually the case), the limited partner will deduct the allocated share of intangible drilling and development costs with respect to a particular well in the year they are paid by the partnership if
(1) the cash basis partnership (or more specifically, the general partner) drills the well and incurs the intangible drilling costs itself, or (2) the drilling is performed by a drilling contractor and the well is drilled in the same (or previous) calendar year that the drilling fees are paid by the partnership.⁶ However, where the drilling contractor is paid by the partnership in a year prior to the year in which the drilling services are performed under the contract (i.e., where the intangible drilling costs are “prepaid”), the IRC and the courts have limited the ability to take the deduction in the earlier year.

If intangible drilling costs with respect to a particular well are prepaid and the drilling of that well commences within ninety days after the close of the calendar tax year (including where the drilling commenced but had not been completed during the earlier year), the limited partner may deduct the entire allocated share of the intangible drilling costs with respect to that well in the earlier year if (1) the expenditure (i.e., the payment of fees under the drilling contract) is a payment rather than a refundable deposit, (2) there is an adequate business purpose for prepaying the drilling fees, and (3) the deduction of such costs in the year of prepayment does not result in a material distortion of income. However, in such case, the portion of the intangible drilling costs attributable to drilling commencing within ninety days after the close of the earlier year is deductible only to the extent of the limited partner’s cash basis in the partnership.⁷ (A limited partner’s “cash basis” in the partnership is his or her adjusted basis in the partnership determined without regard to (1) any liabilities of the partnership, (2) any borrowings of the partner that were arranged by the partnership or an organizer or promoter of the partnership, and (3) any borrowings of the partner that were secured by any assets of the partnership.⁸ See Q 7737.)

Example 1. A limited partner purchases an interest in an oil and gas partnership in December 2026. The partnership hires a drilling contractor to drill the well under a contract that requires payment in December. Drilling is commenced on February 1, 2027. Assuming that the requirements with respect to adequate business purpose, payment rather than deposit, and non-distortion of income are met, the limited partner’s entire share of prepaid IDC is deductible for the 2026 taxable year, but only to the extent of his or her cash basis in the partnership.

Example 2. Assume the same facts as in Example 1, except that drilling begins in December 2026 and continues until February 1, 2027. The limited partner’s entire share of prepaid IDC is deductible for the 2026 taxable year; however, the limited partner’s share of the portion of intangible drilling costs that are attributable to drilling prior to the end of 2026 is not subject to the “cash basis” limitation discussed in the text above. (The limited partner’s share of intangible drilling costs attributable to drilling after 2026 is, however, subject to this “cash basis” limitation.)

If the drilling of the well does not commence within ninety days after the close of the calendar tax year in which the intangible drilling costs were prepaid, then the deduction of amounts that constitute intangible drilling costs can be taken only as economic performance occurs with respect to such costs (i.e., only as the drilling services are actually provided to the partnership).⁹

For purposes of determining if an expenditure is a payment rather than a deposit and whether a business purpose exists for a prepayment, the following principles and holdings should be considered: To the extent amounts prepaid pursuant to a footage or daywork contract may be recovered by way of a refund under a work stoppage provision in the contract, the amounts are deposits rather than payments.¹⁰ Turnkey contracts fulfill a substantial business purpose and therefore do not distort income.¹¹ Where a turnkey drilling contract required payments on completion of each well, the Tax Court found that a valid business purpose existed for payments made after substantial drilling services had been performed but before any wells had been completed.¹² Where prepayments of intangible drilling costs were made to a general contractor who was the parent company of the general partner, the Service ruled that the deductions could not be taken for any year before such contractor actually contracted with and paid a drilling contractor.¹³ However, where prepayments were made under a turnkey-type contract to a corporation related to the general partner, the Tax Court held that limited partners could deduct their shares of intangible drilling costs in the year the fees were prepaid, even though the related corporation would contract for, rather than perform, the drilling services.¹⁴ In Revenue Ruling 73-211,¹⁵ the Service allowed a deduction for prepaid intangible drilling costs under a turnkey drilling contract with a drilling contractor controlled by the operator, but only to the extent such costs would have been incurred in an arm’s length transaction. Where the drilling contract provided that drilling fees were payable when the well reached a predetermined depth, the Service ruled that a voluntary partial prepayment made in a year prior to the year in which the wells were drilled could not be deducted in the year paid; instead, the prepayment was deductible in the year the well reached the predetermined depth.¹⁶

When an interest in an oil or natural gas property (including a limited interest therein) is disposed of, all or part of the intangible drilling costs that were expensed rather than capitalized by the operator must be recaptured as ordinary income.¹⁷

Electing Large Partnership

Editor’s Note: The electing large partnership rules were repealed for tax years beginning after 2017.

An electing large partnership generally calculates intangible drilling and development costs at the partnership level. In the case of a limited partnership interest, these deductions are generally aggregated with other items of income or loss from passive loss limitation activities of the partnership and are considered one passive activity.¹⁸ In the case of a general partnership interest, deductions allocable to passive loss limitation activities are generally taken into account separately to the extent necessary to comply with the passive loss rules.¹⁹ However, in the case of a partner who is a disqualified person, items of income, gain, loss, deduction, or credit from oil and gas property are treated under the regular partnership rules discussed above. A disqualified person is a “retailer” or “refiner” of crude oil or natural gas (see Q 7874), or a person whose average daily production of domestic crude oil and natural gas exceeds 500 barrels.²⁰ See Q 7733 regarding electing large partnerships; see Q 8010 regarding the passive loss rules.