Income Program

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.

A sponsor will drill wells inside the boundaries of a field with known producing reserves, offsetting wells that are already flowing. The offering document calls the program exploratory. What is it in substance?

1. A.Exploratory, because any newly drilled bore may still fail to produceWrong. A chance of failure exists in all drilling and is not the dividing line between the two types.
2. B.An income program, because the surrounding wells in the field are already producingWrong. An income program acquires existing production; this one spends its capital drilling.
3. C.A royalty program, because the wells sit within a field that is already under leaseWrong. A royalty describes how revenue is shared, not what the program does with investor capital.
4. D.A development program, because it drills into reserves that have already been provenCorrect. Proven nearby production is exactly what moves drilling out of the exploratory category.

Why: The three drilling and production categories in the outline are separated by what the capital is exposed to. An exploratory program drills where the presence of hydrocarbons is unproven, an income program buys production that already exists, and a development program drills into reserves that have been proven by nearby production. Here the capital funds new bores into a known structure, which is development drilling and carries the outline's development profile: an up-front tax benefit, return potential from reserves, and fewer dry holes than exploratory. Had the sponsor been drilling a structure with no producing wells nearby, the exploratory label would fit.

A program acquires interests in wells that are already producing and will drill nothing. Which risk moves to the front of an investor's analysis compared with a drilling program?

1. A.The chance that the first wells the program drills turn out to be dry holesWrong. The program buys production that already exists, so there is no wildcat outcome pending.
2. B.The chance that intangible drilling costs are disallowed as deductions to the partnersWrong. This invents a disallowance and points at costs a non-drilling program barely incurs.
3. C.The chance that long-term financing cannot be arranged to fund the acquisitionWrong. Take-out financing risk belongs to real estate development in this outline, not here.
4. D.The chance that the reserves remaining in the acquired wells have been overestimatedCorrect. The engineering estimate is what the purchase price and the projected distributions both rest on.

Why: An income program has already resolved the question a drilling program exists to answer, because the hydrocarbons are demonstrably there and flowing. What remains uncertain is how much is left and what it will fetch, which is why the outline names overestimation of reserves and commodity pricing as the risks of an income program. A reserve estimate is an engineering opinion about rock that nobody can see, and an overstated one inflates both the price the program paid and the distributions investors were led to expect. Add a drilling component to the same program and dry holes return to the top of the list.

Crude prices fall by a third and stay there. Two programs from one sponsor are affected: an exploratory program still drilling its first wells, and an income program producing from acquired reserves. Which feels the decline first, and why?

1. A.The exploratory program, because a lower price makes a dry hole more likelyWrong. Price has no bearing on whether hydrocarbons are present at the bottom of the hole.
2. B.Neither, because oil and gas programs sell production forward at fixed prices as a matter of courseWrong. This assumes a hedging practice the facts do not state and the outline does not require.
3. C.The income program, because its whole return is current revenue from production already flowingCorrect. A program living on today's barrels sees a price cut in today's distribution.
4. D.The income program, because falling prices force an immediate write-off of its reservesWrong. The point is the cash the program collects, not a balance-sheet adjustment.

Why: Commodity pricing is listed as a risk of every oil and gas program type, but it does not reach them at the same speed. An income program is selling production this month, so a lower price cuts this month's distribution directly and proportionately. An exploratory program has no production to sell and is still spending; price reaches it later, through the value of anything it discovers and through whether a marginal discovery is worth completing at all. The ordering would look different for a discovery already made and awaiting completion, where price is precisely what decides whether the well gets finished.