I have an investment opportunity come my way and interested in this makes sense. Primarily for high net worth individuals in a high income bracket using IDC deductions.

As an example, if I invest 100K and a 37% tax bracket.
1. Invest 100K. 85% IDC tax deduction offset 1099 or W2 income.
2. If I did not invest, Uncle sam gets 37K
3. If I invest, 85% IDC tax deduction offsets my non O&G income so reduces my taxable income by 85K so I pay $5,550 on $15K.
4. So immediate $31,450 I pay less in taxes leaving $68,550 loss in the investment.
5. I do not pay taxes on the first $68,550 of distribution from O&G profits
6. After $68,550 distribution, I would be taxed as income from K1 profits.

From what I understand, this is how taxes on income should play out. Is this correct, or am I missing something? Any pitfalls other than drilling risks/oil prices?

Projection is payback of $68,550 in profit/distribution within the first 18 months due to larger % of oil production in first 2 yrs then slows after. Projection is distribution will be around 10% of investment until well runs dry or they sell which would be the last capital event/bite of apple.

There are some things in your list that show at least some misunderstanding of how this all works. Maybe it is just terminology, maybe something more. I'd suggest sitting down with a CPA and go over all this, and not rely on what the promoter/salesman is telling you.

One word that you use, understandably so, is "projected." Projections are just guesses and can be way off. I had a client that invested in six wells, four were dry holes, one was paying him very little, don't know how the last one turned out because I retired.

Anyone selling you stuff based on tax savings should be looked at with a wary eye. Yeah, if you invest $100,000 and are in the 37% tax bracket, and get to deduct the full $100,000 via IDC, depreciation, and other expenses against other income, then you started with $100,000 and wound up with $37,000. What a deal. They love to tell you about getting to deduct IDCs, but you paid for those IDCs. Deducting things is better than having to capitalize them, that's for sure, but they require an outlay of cash.

Unless the well or group of wells produces oil and/or gas, you are better off not investing a dime. Perhaps the well(s) will, perhaps not.

I work with the best in the business and I will tell you their projections and distributions are a little suspect.

If you are buying units in a prospect instead of directly owning a working interest in the well, run. I do invest in this personally, as a petroleum engineer but never invest in 'promoted deals'. There are several 'oil and gas' companies that do this and get carried on your dime. If it was that good of a deal or prospect, you would've never heard about it.

Yep

Anyone know how Hilcorp structures their offering for employees to buy into their wells? I can't imagine all of those employees are getting working interests.

Wouldn't the IDC drive your partnership tax basis down as well? I know some believe that IDC should be considered ordinary income property/unrealized receivables under 751, which would make this whole thing more complicated and just a TVM question.

Pinochet said:

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Wouldn't the IDC drive your partnership tax basis down as well? I know some believe that IDC should be considered ordinary income property/unrealized receivables under 751, which would make this whole thing more complicated and just a TVM question.

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IDCs, as a deduction, do reduce your partnership basis. If a well is sold and IDCs have been deducted, the gain up to the amount of the IDCs deducted is ordinary income.

I have never understood the fascination with IDCs and their deduction. IDCs are "paid for" as an amount of the cost of drilling a well. Admittedly, getting a deduction is better than having to capitalize them, but they don't appear out of thin air, you fund the cost of IDCs with your money. And, in turn, get a deduction like any other expense.

Percentage depletion, however, does appear out of thin air. You wrote no check for the percentage depletion deduction!

My fascination isn't with the IDC deduction, it's with getting your investment back in less than a year and then being on 'house money' for 5-10 years+.

Comeby! said:

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My fascination isn't with the IDC deduction, it's with getting your investment back in less than a year and then being on 'house money' for 5-10 years+.

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My fascination comment was more geared toward the promoters of oil and gas investments. I have a family member with interests in 57 or 58 wells, another with 7 wells, and had 30 or 35 clients with anywhere from 3 or 4 wells, to 30 to 35. Never really analyzed how quickly they had gotten their money back but was likely in the 3 years or longer time frame. I could be wrong though.

One of my classmate's parents asked me to start doing their return and his mom brought their stuff in and included was a 1099 for around $30,000 or so of royalty income. The second year it was in the $40,000 range. I asked her how many wells she had and she said, oh, just the one. I was thinking it had recently been drilled and asked her and she said it had been producing like that for close to 20 years. Lots of "house money" on that one. I suggested they adopt me but it didn't happen!

Promoters make the real operators look bad, honestly. It's a business in itself. In your friend's business, doubt it was a single well unless it was an absolute monster 20 years ago where they owned the entire royalty and it's pulled down over time. It's likely a water flood unit or other unitized group of wells that gets lumped into one entry.