How does percentage depletion work?

What it is

Percentage depletion is an alternative to cost depletion. Instead of recovering basis, it allows a fixed percentage of gross income from the property. Because it is not limited to basis, it can continue for as long as the property produces income.

For oil and gas, percentage depletion has been limited since 1975 to independent producers and royalty owners, and it is subject to production and income limits that must be computed every year.

Gross income from the property is generally the amount received for oil or gas sold at or near the wellhead, less royalties and similar payments to others. For royalty owners, it is generally the royalty income received.

What the law says

IRC §613A(c)(1) allows independent producers and royalty owners to compute depletion under §613 at the rate in §613A(c)(5), which is 15%, on their depletable oil quantity and depletable natural gas quantity. Under §613A(c)(3), the tentative depletable oil quantity is 1,000 barrels a day, which can be allocated between oil and gas using 6,000 cubic feet of gas per barrel. Under §613A(c)(6), a higher rate may apply to marginal production when oil prices are low; the rate is set from a reference price the IRS publishes each year.

Section 613A(d)(1) limits the deduction to 65% of the taxpayer's taxable income, computed without certain items, with any excess carried forward. Section 613A(d)(2) excludes taxpayers who sell oil or gas through retail outlets above a threshold, and §613A(d)(4) excludes taxpayers whose refinery runs average more than 75,000 barrels a day. Under §613(a), the deduction for oil and gas properties also cannot exceed 100% of the taxable income from the property.

Requirements and tests

To claim percentage depletion:

Percentage depletion is not allowed on lease bonuses, advance royalties, or amounts received regardless of production, under §613A(d)(5).

• You must hold an economic interest and qualify as an independent producer or royalty owner.
• You must not be excluded as a retailer or large refiner under §613A(d).
• Production counted must fit within your depletable quantity; related parties share it.
• Gross income from the property excludes rents and royalties you pay out.
• The deduction for each property cannot exceed that property's taxable income before depletion.
• The total deduction cannot exceed 65% of your overall taxable income, computed as required; the excess carries forward.
• For partnerships and S corporations, depletion is computed by each partner or shareholder.

How it works

Each year, for each property, compute 15% of gross income from the property on qualifying production, limit it to the property's taxable income, and compare it with cost depletion. Take the larger. Then apply the 65%-of-taxable-income limit to the total percentage depletion. Amounts disallowed by the 65% limit carry forward.

Basis is reduced by the depletion allowed, but not below zero. Once basis is zero, cost depletion is $0, but percentage depletion can continue within the limits. For individuals, percentage depletion in excess of basis generally is not an alternative minimum tax preference for independent producers and royalty owners.

If you own several properties, compute the property-level limit separately for each, then total the results before applying the 65% limit. Keep records of production by property and of any related parties whose production must be counted with yours.

When a partnership owns the properties, the partnership allocates the adjusted basis of each property among the partners, and each partner computes depletion separately and tracks his or her own basis.

Risks and IRS scrutiny

The IRS Oil and Gas Handbook directs examiners to verify independent producer status, related-party sharing of the depletable quantity, the property-by-property income limit, and the 65% limit. Common problems include computing gross income without subtracting royalties paid, ignoring retailer or refiner status of related parties, and using an unsupported marginal production rate.

Because the 65% limit uses taxable income computed with specific adjustments, errors in that computation can change the allowed deduction and the carryforward for several years.

A depletion allowance is not limited to the percentage method. Compute cost depletion from the property's adjusted basis and supported reserve estimate, compute percentage depletion when §613A applies, and use the larger allowable amount under the applicable rules. See the separate cost-depletion explanation for the unit-of-production formula and basis records.

Who it is not for

Percentage depletion is not available to integrated oil companies, retailers, or large refiners, or for production above the depletable quantity. It gives little benefit if the property has little taxable income or if your overall taxable income is low.

How ebotCPA helps

We confirm your status, compute cost and percentage depletion property by property, apply both income limits, and track carryforwards.

Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.

Primary sources

1. 26 U.S.C. §613A(c). Independent producers and royalty owners.

   “For purposes of subparagraph (A), the tentative quantity is 1,000 barrels.”

   Allows 15% percentage depletion on the depletable oil and gas quantity.

2. 26 U.S.C. §613A(d)(1). 65% taxable income limit.

   “shall not exceed 65 percent of the taxpayer's taxable income”

   Limits percentage depletion to 65% of taxable income, with a carryforward.

3. 26 U.S.C. §613A(d)(4). Refiners excluded.

   “the average daily refinery runs of the taxpayer and such persons for the taxable year exceed 75,000 barrels.”

   Excludes large refiners; §613A(d)(2) excludes certain retailers.

4. 26 U.S.C. §613(a). Percentage depletion.

   Sets the property taxable income limit and requires the larger of cost or percentage depletion.

5. Treas. Reg. §1.613A-3. Exemption for independent producers and royalty owners.

   Explains the independent producer and royalty owner exemption and the depletable quantity.

6. IRM 4.41.1. Oil and Gas Handbook.

   The examiner handbook for oil and gas issues, including intangible drilling costs, depletable basis, reserves, and depletion for independent producers and royalty owners.

Frequently asked questions