7887 / What items of tax preference (for purposes of the alternative minimum tax) are unique to an oil and gas program?

Two items that are unique to oil or gas investments and that may give rise to tax preferences for purposes of the alternative minimum tax are the following: (1) intangible drilling and development costs; and (2) percentage depletion.

Intangible drilling costs. The amount (if any) by which “excess intangible drilling costs” exceeds 65 percent of the limited partner’s net income from oil and gas (determined without consideration of such “excess intangible drilling costs”) for the tax year is a tax preference item for purposes of calculating the limited partner’s alternative minimum tax for the year. “Excess intangible drilling costs” for a tax year is the amount by which the limited partner’s allowable deduction for intangible drilling and development costs in the tax year on productive wells exceeds the amount that would have been deducted had the costs been capitalized by the partnership and the limited partner’s allocated share amortized over a 120-month period or recovered through cost depletion (i.e., through a straight-line recovery method).¹

However, only those intangible drilling and development costs (IDCs) that both the partnership and limited partner elect to expense (and deduct) may give rise to a tax preference amount. IDCs that the partnership elects to capitalize and IDCs that the limited partner elects to amortize over 60 months (see Q 7869) will not create tax preferences for purposes of calculating the limited partner’s alternative minimum tax.²

Intangible drilling costs on nonproductive wells are never tax preference items.³ A well is nonproductive if it was plugged and abandoned without ever having produced oil or natural gas in commercial quantities for any substantial period of time.⁴ A well that is temporarily shut down is not “nonproductive” for this purpose.⁵

This preference does not apply in the case of taxpayers who are not “retailers” or “refiners” of crude oil or natural gas (see Q 7874). However, this exception is not available to the extent that it reduces the taxpayer’s alternative minimum taxable income by more than 40 percent of the amount of the taxpayer’s alternative minimum taxable income calculated without regard to the exception and the alternative tax net operating loss deduction.⁶

For treatment of electing large partnerships, see below.

Percentage Depletion. If a limited partner’s deduction for depletion with respect to a specific oil or gas property is greater than his or her share of the adjusted tax basis of that property (determined at the end of the year and without regard to the depletion deduction for that year), the amount of the difference is a tax preference item for purposes of the partner’s alternative minimum tax. This preference does not apply in the case of “independent producers and royalty owners” (see Q 7874).⁷ For this purpose, adjusted basis includes intangible drilling and development costs but not unrecovered tangible (depreciable) drilling costs.⁸ Thus, once a limited partner’s adjusted tax basis in a property has been reduced to zero (on account of previous depletion deductions, etc.), any percentage depletion deductions with respect to the property will generally create a tax preference item.

Of course, as cost depletion may not be taken once a limited partner’s adjusted tax basis in a property is reduced to zero, deductions for cost depletion can never result in a tax preference amount (see Q 7877).

Electing Large Partnerships

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

An electing large partnership generally calculates alternative minimum tax preferences (including those regarding excess IDCs and percentage depletion) at the partnership level. In the case of a limited partnership interest, these preferences are generally aggregated with other items of tax preference from passive loss limitation activities of the partnership and are considered one passive activity.⁹ In the case of a general partnership interest, tax preferences allocable to passive loss limitation activities are generally taken into account separately to the extent necessary to comply with the passive loss rules.¹⁰ However, in the case of a partner who is a disqualified person, items of tax preference 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 any other person whose average daily production of domestic crude oil and natural gas exceeds 500 barrels.¹¹ See Q 7733 regarding electing large partnerships; see Q 8010 regarding the passive loss rules.

For an explanation of the alternative minimum tax, see Q 777.