THE MOST FREQUENTLY ASKED QUESTION. . . AND ANSWERS REGARDING TAX BENEFITS OF OIL AND GAS DRILLING PROGRAMS

What type of information do you receive from John Henry Petroleum to show you how to claim your tax deductions from investing in our drilling programs?

A: Within a reasonable time after the close of each accounting year, the Managing Venturer (JHP) shall send to each venturer a report (in the form of Schedule K-1 to IRS Form 1065) indicating that person’s distributive share of all tax items. The income and deductions reflected on your K-1 is then used on your tax return.

What IRS tax code determines if your investment in our drilling programs is tax deductible?

A: Numerous code sections apply. Most importantly under, Section 469(c)(3) (the “working interest exception”) working interests in oil and gas properties are not treated as “passive activities” if the taxpayer owns the interest directly or through an entity that does not limit his liability with respect to the activity. Two elements must be met before a taxpayer qualifies for the working interest exception to the passive activity loss rules, so that losses will not be treated as losses from a passive activity. First, the property generating the losses must constitute a “working interest” as defined by the passive loss rules. Second, the interest must not be held through an entity that limits the liability of the taxpayer with regard to the activity.

Can individuals reduce their income from other sources with deductions generated by our ventures that own oil and gas working interests?

A: Generally, yes, because the deductions generated by our venturers’ oil and gas working interests are not treated as “passive losses.” The Tax Reform Act of 1986 provides that, in most cases, deductions generated after 1986 from investments in which an individual does not materially participate are treated as “passive losses” and can be deducted only against “passive income”. Deductions classified as “passive losses” cannot offset income such as wages, interest, or income from many businesses in which the individual materially participates. However, the law contains an exception, Section 469 (c)(3), under which, among other things, deductions generated by oil and gas working interests (as opposed to royalty interests) owned through general partnerships are not considered “passive losses,” so partners and joint venturers can deduct these losses against their income from other sources. Similarly, any income subsequently generated by such ventures will not be treated as “passive income.

What are some of the tax deductions from our oil and gas drilling programs?

A: Our oil and gas drilling programs are specifically designed to generate various tax deductions from drilling and operating oil and gas wells. These deductions include intangible drilling costs (IDC), depreciation, and operating costs. In addition, when production is achieved, our venturers claim a depletion deduction against their share of the venture’s income from oil and gas produced.

What other deductions are generated by our oil and gas drilling ventures?

A: Our ventures drill and operate oil and / or gas wells. We are defined as being engaged in a “trade or business” and therefore claim as a deduction, for federal income tax purposes, all ordinary and necessary expenses paid in carrying on our “trade or business,” such as costs of operating a well, general and administrative costs of the venture, and certain fees paid to the managing venturer.

What are Intangible Drilling Costs (IDC)?

A: These IDC costs include expenditures for wages, fuel, repairs, hauling, supplies and other items that have no salvage value and are necessary for the drilling of wells (i.e. hiring the drilling contractor) and the preparation of wells for the production of oil and gas. Intangible costs generally represent a majority of the total cost of drilling, testing, and completing an oil / or gas well.

How do Intangible Drilling Costs (IDC) produce tax benefits for our ventures?

A: The venture drilling a well may elect to deduct intangible drilling costs, so its venturers can get an immediate benefit from the expenditure. When the well drilled proves to be commercially productive, an election to deduct IDC’s will generally result in a tax benefit to venturers (in the form of tax deductions) in the year the well is drilled. However, if the oil and gas property or an interest in the venture is later sold at a gain, all or a portion of that gain may be classified as ordinary income because of the recapture of these deductions.

Can I deduct depreciation on tangible items purchased to equip an oil or gas well?

A: Yes. While it is true oil and gas drilling ventures cannot deduct the entire cost of items purchased to equip an oil or gas well in the year of purchase, those costs are capitalized and can be depreciated over a period of five to seven years (depending on when the particular property is place in service and on its depreciable “class life”). Consequently, a venturer could deduct his share of the depreciation on items such as casing, tubing, and pumping units. If such equipment is later sold for more than the depreciated value or if a venturer sells his venture interest, all or a portion of the gain may be classified as ordinary income because of the recapture of depreciation deductions.

What is “depletion” and how does it reduce or defer a venturer’s taxes?

A: Depletion allows the owner of a producing oil and / or gas well to recover his capitalized cost through tax deductions over the period in which the oil and / or gas is produced. Consequently, a venture generally cannot deduct in the first year the entire purchase price of an oil or gas leasehold interest or other oil or gas property interest. However, when a producing well is drilled, the venture can recover the cost of the oil and gas property through depletion deductions. A venturer’s depletion deduction is computed individually by the venturer rather than by the venture. A venturer makes this computation based on the portion of the property’s adjusted tax basis that the venture allocates to the venturer. If the property is later sold at a profit or a venturer sells his venture interest, all or a portion of the profit may be classified as ordinary income because of the recapture of deductions. If the venture drills a dry hole and the lease is worthless, the total capitalization of the oil or gas venture can be deducted in the year it is determined to be worthless.

What is the difference between cost depletion and percentage depletion?

A: Cost depletion allows a recovery each year of a portion of the capitalized costs, including the cost of the oil and gas lease, of a producing well over its life. The portion of those costs that can be recovered each year is based on the percentage of the estimated recoverable oil and gas reserves sold during each year. Percentage depletion, on the other hand, is computed on the basis of the income from the property rather than the cost of the property. Percentage depletion often results in a larger deduction than cost depletion because it may be taken over the entire productive life of the property, even though the total deduction claimed exceed the capitalized costs of the property. Percentage depletion, however, is generally only available to independent producers who received an interest in the property before the property was considered to be “proven property” for federal income tax purposes. Certain other restrictions also apply. This is only a brief explanation of a few of the most frequently asked tax questions concerning participation in our oil and gas drilling joint ventures. This analysis is not intended as a substitute for careful tax planning. Each prospective venturer should consult with his or her own personal tax advisor concerning the applicability to and affect on him or her of the United States income tax laws and their administration; and the applicability to and effect on him or her of state, local, and foreign tax laws and their administration.