7879 / How is percentage depletion calculated on oil or gas properties for independent producers and royalty owners?

An individual’s “average daily production” of crude oil or natural gas is determined by dividing the aggregate production from all oil or gas interests, as the case may be, during the tax year by the number of days in that year. A limited partner’s annual production of oil or natural gas from specific properties is determined by multiplying the total production of each property by the limited partner’s percentage participation in the revenues from that property.⁶ A taxpayer holding a “net profits interest” determines the taxpayer’s annual production by multiplying the total production of the property by the taxpayer’s percentage participation in the revenues from the property.⁷

If an individual’s average daily production of crude oil exceeds the individual’s maximum daily depletable quantity, the amount of percentage depletion allowable with respect to each domestic property is determined using the following formula:

		maximum daily
Percentage	=	depletable quantity	× 15% ×	gross income from
Depletion		average daily production		property in tax year
		(all properties)

This formula may also be used to determine allowable percentage depletion on natural gas production when an individual’s average daily production of natural gas exceeds the maximum daily depletable quantity.⁸

Special rules apply to the percentage depletion rate for marginal properties held by small producers. During any year in which the reference price for crude oil for the preceding calendar year drops below $20, the percentage depletion rate of 15 percent is increased by one percentage point for each whole dollar by which such reference price falls below the $20 level. However, the percentage depletion rate cannot exceed 25 percent.⁹ The applicable percentage for 2001 and thereafter is 15 percent.¹⁰ For tax years beginning after 1997 (except 2008) and before 2012 the limit of percentage depletion to 100 percent of the taxable income from the property (computed without allowance for depletion) did not apply to marginal properties.¹¹ “Marginal properties” for this purpose refers only to stripper wells or wells that produce heavy oil.¹²

Certain tertiary recovery projects begun or expanded after 1990 may qualify for a special tax credit; see Q 7885.

An additional limitation applies to percentage depletion for small producers. The aggregate deduction for percentage depletion of a small producer’s oil and gas properties (i.e., not including percentage depletion on domestic regulated natural gas, etc. – see Q 7880) may not exceed 65 percent of the individual’s taxable income; however, for this purpose, taxable income is calculated without regard to (1) certain depletion deductions, (2) any net operating loss carryback, and (3) any capital loss carryback. If this 65 percent limitation acts to disallow a portion of the percentage depletion deduction, the disallowed amount is allocated among the producing properties in proportion to the percentage depletion otherwise allowable (but for the 65 percent limitation), and the reduced percentage depletion deduction is compared to the cost depletion allowance on a property-by-property basis to finally determine whether cost or percentage depletion is greater (for each property). Any amount disallowed by reason of the 65 percent limitation may be carried forward to the following year in which it again will be subject to the 65 percent limitation.¹³ An electing large partnership (see Q 7733) calculates its percentage depletion without regard to the 65 percent of taxable income limitation.¹⁴