A depletion deduction is permitted by the Code because the natural resource (e.g., mine, oil or gas well, timber) has limited usefulness and is being gradually exhausted (or "depleted"). A depletion deduction is allowed to anyone with an economic interest in the oil, minerals, or timber in place.15 In the normal situation this would include both the operator (lessee) and the landowner (lessor), since each has a capital investment in the venture. The concept of an "economic interest" has been somewhat clarified by the Supreme Court, as noted below.
Two related ideas, first enunciated by the U.S. Supreme Court in Palmer v Bender, (1933), 287 U.S. 511, 11 AFTR 1106, fully cited at 6115.01(3), give taxpayers a depletion deduction if they have both: (1) acquired, by investment, any interest in mineral in place, and (2) secured, by legal relationship, income from mineral extraction to which they must look for a return of capital. Reg Sec 1.611-1(b). This rule also applies to standing timber. Legal title to mineral in place doesn't control; nor does State law or form of conveyance. The tests of Palmer have been developed in subsequent cases. Mere "economic advantage" from production was distinguished from "economic interest" in cases at (5), (10) and (30) of 6115.01 of the RIA Annotations. Return of capital must be solely from production.
The amount subject to the depletion allowance (the "economic interest") depends on whether the taxpayer is the lessor or the lessee. Typically, the person who owns the land also owns the mineral deposits. The owner usually leases the land to a producer (operator). The operator's depletable cost will be the total amount paid to the lessor (the lease bonus) and other costs not currently deducted (e.g., exploration, development, and intangible drilling costs). For the owner-lessor, the lease bonus would be subject to depletion, as well as any royalty payments received.
The depletion deduction differs significantly from depreciation deductions. Each year a taxpayer computes the potential depletion deductions under two methods, the cost method and the percentage (statutory) method, and the taxpayer deducts the larger of the two amounts.16 However, any natural resources that are not "minerals" do not qualify for percentage depletion. These include timber, soil, sod, dirt, turf, water, mosses, or any mineral from inexhaustible sources (such as sea water or air).17
The cost method of depletion is essentially a units of production method. An estimated cost per unit of the natural resource is computed each year by dividing the unrecoverable depletable cost at the end of the year by the estimated remaining units at the beginning of the year. This cost per unit is then multiplied by the number of units sold (not produced) during the year.18
The "estimated recoverable units" is not necessarily a fixed number, and may be revised periodically by geological or engineering studies. Finally, it should be noted that Sec. 613(a) provides that cost depletion, like depreciation, can never exceed the historical cost of the investment.
Schmidt Company, an oil and gas operator, paid $210,000 to acquire all oil rights to Blackacre. This was their only depletable cost. It is estimated that the deposit contains 700,000 barrels of usable crude oil.
During the current year, 180,000 barrels of oil were produced and 150,000 barrels of oil were sold. Schmidt's cost depletion deduction for the current year is $45,000, computed as shown above:
Quiz Question 8
The percentage method of depletion is determined by multiplying a statutory percentage times the gross income from the property. However, Sec. 613(a) limits the deduction to 50% of the taxable income from the property (100% for oil and gas properties). In addition, the percentage deduction for oil and gas properties is limited to 65% of the taxpayer's total taxable income.
The gross income from the property is defined in Sec. 613A(a) as the total value of the natural resource when extracted. For an operator (lessee), this is the total value of the mineral or metal less any royalty interest paid to the lessor, since this represents depletable gross income to the lessor. The net income from the property is the gross income less all other operating costs, including general overhead and any development costs.
The "statutory percentage" is specified in Sec. 613, and varies from 5% to 22%, depending on the natural resource. Representative percentages include gravel, peat, sand, and stone (5%), clay and shale (7.5%), coal, lignite, and perlite (10%), rock and asphalt (14%), gold, silver, oil shale, and geothermal deposits (15%), and sulphur and uranium (22%).
Zane Company leases land from Harold Edwards, who is given a one-eighth royalty interest. Zane extracts uranium from the mine, which qualifies for the 22% statutory rate. During the current year, Zane realized a total of $400,000 sales proceeds from the mining operation (of which 1/8, or $50,000, was paid to Edwards as a royalty) and incurred $220,000 of operating expenses. Zane's depletion deduction for the current year would be $65,000, determined as follows:
|Gross receipts from property||$400,000|
|Less royalty paid to Edwards||( 50,000)|
|Statutory percentage for uranium||x .22|
|Tentative percentage depletion||$ 77,000|
|Limited to 50% of taxable income from the property [($350,000 - $220,000) x .50]||$ 65,000|
Additionally, Edwards, the lessor, would be entitled to a percentage depletion of $11,000 ($50,000 x .22), assuming that he had no related expenses.
In comparing cost and percentage depletion procedures, it is important to note that percentage depletion can be deducted as long as the property produces a gross income. Unlike cost depletion calculations, the total cost recovery deduction over the life of the natural resource is not limited to the adjusted basis of the property. The percentage depletion deduction is available as long as the property generates gross income. However, this may create an alternative minimum tax problem, since any recovery beyond the adjusted basis is a tax preference item under Sec. 57(a)(1). This possibility is discussed in greater detail in Module 16.
Secs. 614(b) and (c) specifically allow a taxpayer to combine several working interests (e.g., properties) as one for purposes of computing depletion. The U.S. Tax Court has ruled that this may be done even if the sole purpose is to save taxes by avoiding the taxable income limitations on the percentage depletion deduction. See Day Mines, Inc., 42 TC 337 (1964). As illustrated in the following example, this election may prove advantageous to the taxpayer when aggregating low expense and high expense operating interests.
How aggregating or dividing mineral interests can save taxes. Aggregation to increase percentage depletion deduction: The percentage depletion allowable on interests S and T (not oil or gas properties) is only $280 ($50 + $230) if they are treated as separate properties but $400 if treated as a single property.
|Operating Mineral Interest
|Operating Mineral Interest
|Aggregation of S and T
|Taxable income before depletion||
|22% of gross income||220||220||440|
|50% of net income||25||375||400|
|Cost depletion (assumed)||50||200||250|
The tax treatment of expenditures associated with natural resources has in many ways been designed to subsidize such ventures. Special deductions have been provided to offset some of the high risk inherent in such ventures. For example, Sec. 617 permits mine operators to expense all exploration costs when they are incurred, and Sec. 616(a) permits a mining operator to deduct all development costs in the year paid or incurred. Additionally, Sec. 263(c) provides an oil or gas operator the option of immediately expensing or capitalizing (and depleting) certain intangible drilling costs. And finally, a depletion deduction is available as a means of cost recovery for investments in natural resources.