Depletion Allowance

A customer asks that his traditional IRA subscribe for units of an oil and gas income program, pointing to the depletion deductions the program passes through. What should the representative tell him?

1. A.Partnership interests sit on the list of investments an individual retirement account is barred from holding.Wrong. The barred categories are narrow and a program interest is not among them.
2. B.The interest is not itself off-limits to the account, but the depletion deductions have no value inside a tax-deferred vehicle.Correct. The holding is allowed; what fails is the reason he wants it.
3. C.The deductions flow through to him personally and can be claimed on his own return for the year.Wrong. Amounts allocated to the account belong to the account, not to the owner's personal return.
4. D.The account may hold the units only while the program's units remain listed on an exchange.Wrong. This invents a listing condition that no retirement account rule imposes.

Why: A retirement account may hold a wide range of assets, and the narrow categories it is barred from holding do not include an interest in a program. The obstacle here is not permissibility but purpose. The account already defers tax on what it earns, so a pass-through deduction offsets income that was not going to be taxed currently in any event, and the shelter is simply consumed with nothing to show for it. If the same customer bought the units in a taxable account that had other passive income, the deduction would actually do work.

Thaddeus Ruiz invests in an oil and gas INCOME program that acquires wells already in production. As the wells are pumped and the reserves are sold off, which deduction passes through to Thaddeus to reflect the exhaustion of the underground reserves?

1. A.Intangible drilling costsIDCs cover non salvageable costs of drilling such as labor and fuel. They are the hallmark of exploratory and developmental programs, not of a program buying producing wells.
2. B.The depletion allowanceCorrect. Depletion recognizes the exhaustion of the reserves and passes through to holders of an economic interest in production.
3. C.Recapture of prior deductionsRecapture is an income item that arises on disposition, converting part of the gain to ordinary income. It is not a deduction during operations.
4. D.Depreciation of the tangible equipmentDepreciation is a real deduction in these programs, but it covers pumps, casing, and tanks. It does not reflect the reserves being drawn down.

Why: The depletion allowance is the deduction that recognizes a natural resource being used up. Owners of an economic interest in producing reserves, including limited partners in an income program, take depletion as the oil or gas is extracted and sold. Intangible drilling costs are the large front loaded deductions found in exploratory and developmental programs, which is why income programs, buying wells that are already drilled, generate depletion rather than IDC write offs.

A representative recommends an oil and gas DPP marketed heavily around its ability to generate depreciation and depletion deductions that shelter income for investors. The customer has very little taxable income and virtually no passive income from any source. What suitability concern does this raise, independent of the program's other features?

1. A.None, since tax-oriented deductions benefit every investor equally regardless of their income level or tax bracketWrong. A deduction-driven benefit is worth far less to a customer with little income to shelter and little passive income to absorb it.
2. B.An accredited investor concern only, since her limited income and lack of passive income are exclusively relevant to whether she qualifies for the offering under securities registration exemptionsWrong. This misidentifies the issue as an accreditation question rather than a suitability question about the value of the product's central benefit to her.
3. C.A liquidity-needs concern only, since her limited income means she cannot afford to have any of her capital tied up in an illiquid investmentWrong. This introduces an unsupported liquidity conclusion not raised by the facts given.
4. D.A concern that the program's principal advertised benefit, sheltering income through passive losses, has limited value to this specific customer, since she has little income to shelter and little passive income to absorb passive losses in the first placeCorrect. The program's central tax benefit has limited value to a customer with little income and little passive income to absorb the resulting losses.

Why: A deduction-driven benefit is worth much less to a customer with little income to shelter and little passive income to absorb the resulting passive losses, which is exactly the customer's profile here.

An oil and gas program's operator computes both cost depletion and percentage depletion for a producing property each year and claims whichever produces the larger deduction that year. Is this approach correct, or must the program instead pick one depletion method at the start and use it for the life of the property?

1. A.Incorrect; once a depletion method is chosen for a property, it must be used for the life of the property, just as with a depreciation methodWrong. This applies the depreciation lock-in rule to depletion, which is instead recomputed under both methods annually.
2. B.Incorrect; percentage depletion may only be used once cost depletion has been fully exhausted, not compared to it annuallyWrong. There is no such sequencing rule; both methods are computed and compared every year regardless of whether cost depletion has been exhausted.
3. C.Incorrect; only cost depletion is permitted for partnerships, so a year-by-year comparison to percentage depletion is not a valid approachWrong. Percentage depletion is available to partnerships on qualifying properties; it is not barred at the partnership level.
4. D.Correct; depletion is computed under both methods each year, and the taxpayer claims whichever yields the larger deduction for that yearCorrect. Depletion is recomputed annually under both the cost and percentage methods, with the larger of the two allowed as the deduction.

Why: Unlike a depreciation method, which is generally locked in for an asset's life, depletion is computed under both the cost and percentage methods every year, and the taxpayer claims whichever is larger for that year.