The Tax Cuts and Jobs Act (TCJA) outlines many changes for taxpayers in the oil and gas industry.

The TCJA generally lowers income tax rates for individual taxpayers, significantly reduces the income tax rate for corporations, and eliminates the corporate alternative minimum tax (AMT). It also provides a large new tax deduction for most owners of pass-through entities and significantly increases individual AMT and estate tax exemptions.

Taxpayers in the oil and gas industry are affected because they hold their assets and investments in a variety of entity types, including C corporations, partnerships, S corporations, and directly by individuals. 

The TCJA also eliminates or limits many tax breaks, and much of the tax relief is only temporary. The key changes that affect taxpayers in the oil and gas industry are outlined below. 

Reduced Corporate Income Tax Rate

The corporate income tax rate was reduced to a flat 21% from 35% starting in 2018.

Oil prices declined sharply from above $100 per barrel in late 2014 to below $30 per barrel in early 2016. Prices have slowly risen since early 2016 and are slightly above $60 per barrel at the beginning of 2018.

With this dip in prices, many exploration and production companies generated net operating losses (NOLs) during the past few years. However, with prices rising, some companies are generating profit again and are also looking to monetize certain oil and gas properties. If companies are in a taxable income position or plan to sell properties at a gain, the corporate rate reduction could be favorable.

New Deduction from Pass-Through Entities

The TCJA provides taxpayers that are operating businesses through pass-through entities such as partnerships and S corporations a special deduction under new Section 199A. This new deduction will impact a large amount of taxpayers in the oil and gas industry because a significant number of businesses are structured through partnerships owned primarily by large private equity groups (PEGs), private investors, and family groups.

The deduction is equal to the lesser of:

• The combined qualified business income amount
• 20% of the excess of the taxpayer’s taxable income determined before the Section 199A deduction over the taxpayer’s adjusted net capital gain

Combined Qualified Business Income

Subject to certain limitations discussed below, the combined qualified business income amount for a taxable year generally equals the aggregate of 20% of the taxpayer’s qualified business income with respect to each qualified trade or business.

Qualified and Specified Service Trade or Business

A qualified trade or business is any trade or business other than:

• A specified service trade or business
• A trade or business involving the performance of services as an employee

A specified service trade or business :

• Involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such a trade or business is the reputation or skill of one or more employees or owners
• Performing services involving investing and investment management, trading, or dealing in securities, partnership interests, or commodities

The definition of specified service trade or business specifically excludes engineering and architecture businesses. 

Limitations

Although a taxpayer’s combined qualified business income amount will generally equal 20% of the aggregate amount of qualified business income from each qualified trade or business, the calculation is subject to limitations. 

Specifically, the qualified business income for each qualified trade or business is limited to the greater of:

• 50% of the W-2 wages with respect to the qualified trade or business
• The sum of 25% of the W-2 wages with respect to such trade or business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property

While the statute doesn’t provide any guidance on the phrase unadjusted basis immediately after acquisition of all qualified property, it presumably refers to the initial cost basis of the qualified property.  

In general, qualified property is tangible property subject to the allowance for depreciation and satisfies three additional requirements:

• The property must be held by, and available for use in, the qualified trade or business at the close of the taxable year.
• It must be used at any point during the taxable year in the production of qualified business income.
• The depreciable period of the property must not end before the close of the taxable year.

It’s important to note that these limitations are determined separately for each qualified trade or business of the taxpayer. A taxpayer can’t use excess W-2 wages or qualified property from one qualified trade or business to increase the limitation with respect to a second qualified trade or business.

The W-2 wages and qualified property limitations don’t apply to certain small taxpayers. Specifically, the limitations don’t apply if a taxpayer’s taxable income before the Section 199A deduction doesn’t exceed $315,000 for joint return filers or $157,500 for other filers.

Complexity for Partners, Shareholders

The deduction is calculated at the partner or shareholder level. This provides additional complexity for partners or shareholders of oil and gas partnerships or S corporations, respectively. 

Separately stated items and calculations determined at the partner or shareholder level, such as intangible drilling costs and depletion, will impact the determination of the deduction. The deduction will also impact each partner’s and shareholder’s outside tax basis in their capital account and stock, respectively.

Full Expensing of Tangible Property

This provision could be a significant benefit because the oil and gas industry is very capital intensive.

Tangible drilling costs, lease and well equipment, pipelines, and all other tangible personal property can be fully deducted when acquired and placed in service after September 27, 2017, and before January 1, 2023. The full deduction is phased down by 20% each year in taxable years beginning on or after January 1, 2023:

• 2023—80%
• 2024—60%
• 2025—40%
• 2026—20%
• 2027—0%

The new tax law also permits used property to be eligible for the full expensing provision. This change may impact merger and acquisition transactions by motivating buyers to structure deals as actual or deemed asset acquisitions rather than stock acquisitions. This is accomplished by enabling the buyer to immediately deduct a significant portion of the purchase price and generate NOLs in the year of purchase to offset future taxable income.

Limitation on Deduction of Net Interest Expense

For companies with high leverage, the limitation on deduction of net interest expense could offset some benefit of the lower tax rates.

The new tax law limits the deductibility of net interest expense to 30% of taxable income before interest, the NOL deduction (discussed below), the pass-through deduction, and, for years before 2022, depreciation, amortization, and depletion. Businesses with average annual gross receipts of $25 million or less are exempted from the limit.

Repeal of Domestic Production Activities Deduction

The repeal of Section 199 could offset some benefit of the lower tax rates for oil and gas companies that are generating qualified production activity income.   

Repeal of Corporate AMT

The repeal of AMT for corporations is favorable for the oil and gas industry. In addition to taxpayers being able to fully deduct tangible drilling costs as explained above, corporate taxpayers will now be able to fully deduct intangible drilling costs without a potential preference for AMT purposes. Integrated oil and gas corporations would still be required to capitalize 30%of those costs ratably over a 60-month period beginning in the month in which they were incurred.

For mining companies, taxpayers were generally limited to only cost depletion for AMT purposes even though for regular tax purpose they were allowed the higher of cost or percentage depletion. Historically, a lot of mining companies have been in an AMT position due to the preference for percentage depletion.

Limitation on Net Operating Losses

As mentioned above, many oil and gas companies generated NOL carryforwards because of low commodity prices in recent years.

The new tax law eliminates the ability to carryback NOL to prior years for NOLs generated in tax years ending after December 31, 2017, and limits NOL carryforwards generated in tax years beginning after December 31, 2017, to 80% of taxable income. NOL carryforwards generated in tax years ending on or before December 31, 2017, won’t have this 80% limitation and continue to have a carryforward period of 20 years. However, NOL carryforwards generated in tax years beginning after December 31, 2017, won’t expire.

This could impact a taxpayer’s ability to carryback NOL to receive cash refunds of taxes paid in a prior year. It may also trigger a tax liability from taxable income generated in a future year due to the inability to fully offset the taxable income with NOL carryforwards.

We’re Here to Help

If you’d like to learn more about how your business is affected by this historical change in tax law, contact your Moss Adams professional. You can also visit our dedicated tax reform webpage for more insight, or subscribe to have articles and event notifications sent to your email.