Percentage Depletion

Percentage depletion is a tax deduction that assigns a set percentage of depletion to the gross income derived from extracting fossil fuels, minerals, or other nonrenewable resources from the earth. Percentage depletion is provided as an incentive for drillers and investors to develop domestic mineral and energy production.

The rules of oil and gas accounting require that the costs incurred to find, develop, and obtain minerals and oil and gas producing properties must be capitalized. Depletion is a form of depreciation for mineral resources that allows for a deduction for these capitalized costs from taxable income to reflect the declining production of reserves over time. The percentage depletion is a measure of the amount of depletion associated with the extraction of nonrenewable resources. It is an allowance that independent producers and royalty owners can apply to the taxable gross income of a productive well’s property.

Oil and gas investments at the wellhead have become one of the most tax-advantaged investments available in America today due to the depletion allowance. Approximately 15% of gross income from oil and gas is tax-free for small investors and independent oil and gas producers. There is no dollar limit as to the total amount of depletion one can deduct from income from qualified nonrenewable resources. However, percentage depletion can only be taken from a property that has net income (or profits). If a property recognizes a net loss for any given tax year, percentage depletion cannot be deducted. Percentage depletion is limited to 50 percent of net income, less exploration costs.

The allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income. If net income is less than 15% of gross income, the deduction is limited to 100% of net income. Percentage depletion is a capital cost recovery method allowed for nearly all natural resources, except timber. The IRS sets different depletion rates for different resources. For instance, oil and gas has a 15% percent depletion; 5% for sand, gravel, and crushed stone; 14% for borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone and carbon dioxide produced from a well; 22% for sulfur and uranium; gold, silver, copper, iron ore and certain oil shale from U.S. deposits have their rates set at 15%; and so on. The percentage depletion formula requires that gross income be multiplied by the appropriate percentage.

The IRS provides another method of determining depletion – cost depletion. Cost depletion is easier to calculate and involves producers writing off the real cost of their investments based on the fraction of resources extracted. Since the percentage depletion deduction is a flat rate, the resulting tax break often exceeds the cost depletion deduction, thus, acting as a sizable subsidy to qualifying energy companies.