HB 199 – Pennsylvania’s push for broader cost and percentage depletion deductions

The following article by Tia Churchfield and Glenn Thompson of Steptoe & Johnson PLLC appears in the March 2022 issue of The PIOGA Press.

At a regular session meeting in January, Pennsylvania House Majority Caucus Chairman George Dunbar reintroduced legislation to amend the Pennsylvania State Tax Reform Code of 1971. Included within the proposed legislation was House Bill 199, which would allow certain taxpayers that have an interest in extracted resources to account for the cost or percentage depletion of a mine, oil and gas well, or other natural resources when filing their personal income tax return.

This article explains how cost and percentage depletion deductions are used at the federal level, the current status of Pennsylvania tax law with regard to depletion deductions and how proposed legislation would expand access to depletion deductions, indirectly encouraging oil and gas development.[1]

What are cost and percentage depletion deductions and how are they applied at the federal level?

Depletion refers to the “using up” of natural resources as a result of operations and development.[2] Depletion in the context of tax deductions is a form of depreciation that allows for a deduction from taxable income to reflect the decreasing production of reserves over time. Currently, there are two accounting methods used at the federal tax level to calculate depletion on oil, gas and minerals: (1) cost depletion or (2) percentage depletion.

In order to qualify for a depletion deduction, several factors must be met by the taxpayer. First, the taxpayer must have an economic interest in the oil, gas or minerals for which the deduction is claimed. Taxpayers are considered to have an economic interest only if: (1) they have acquired by investment any interest in mineral deposits; and (2) they have a legal right to income from the extraction of the mineral. It is important to note that simply having a contractual relationship that affords a taxpayer some economic benefit from the oil, gas and minerals products is not enough to establish economic interest for the purpose of a depletion deduction.[3] Second, a depletion deduction is allowed only in instances where oil, gas or minerals are actually sold and income is reportable, meaning that the deduction is applicable only to royalty payments and not to bonus payments.[4]

Once economic interest has been established, a taxpayer must then make the decision as to which accounting method to choose. As a general rule, when deciding between using either the cost or percentage depletion method, the IRS requires that a taxpayer use the method that gives them the larger deduction.[5]

If using the cost depletion method, a taxpayer has to determine several factors, specifically (1) the property’s basis for depletion,[6] which is normally determined upon acquisition (i.e., purchase, inheritance, gift)[7] and includes the value of the land and its associated capital assets like timber, equipment, buildings and oil and gas; (2) the total recoverable units of minerals in the property’s natural deposit; and (3) the number of units of minerals sold during the tax year. Once these factors are determined, the property’s basis for depletion is divided by the total recoverable units in order to calculate the depletion unit. The depletion unit is then multiplied by the number of units sold during the tax year to arrive at the overall cost depletion deduction.[8] Note that the collective amount recovered using the cost depletion method can never exceed a taxpayer’s original capital investment.[9]

Because cost depletion applies only to taxpayers who have established a basis in their oil, gas and minerals, the use of the cost depletion method is somewhat unusual in Pennsylvania due to the fact that most taxpayers did not consider oil and gas under their property prior to the recent interest in Marcellus Shale and therefore did not allocate any oil, gas or mineral costs to their cost basis in the property. As a result, the majority of taxpayers automatically use the percentage depletion method. [10]

The percentage depletion deduction has been part of the U.S. Tax Code since 1926 and has had an important impact on the production of oil and gas in the United States since that time.[11] Unlike cost depletion, in order to claim a percentage depletion deduction, a taxpayer does not need to establish any type of basis.[12] In order to use the percentage depletion method for oil and gas well production, at least one of the following must apply: (1) the taxpayer must either be an independent producer (business with an average of 12 employees[13]) or a royalty owner; or (2) the well must produce one of the following: regulated natural gas, natural gas sold under a fixed contract or natural gas from a geopressured brine.[14] Of these two categories, most taxpayers who claim the percentage depletion deduction fall within the former group.

In order to calculate a depletion deduction using the percentage depletion method, the gross income from the property is multiplied by the specified percentage rate for that particular mineral. The allowable statutory depletion deduction is the lesser of net income or 15 percent of gross income from the income producing property. For oil and gas, the deduction is further limited to 65 percent of a taxpayer’s taxable income from all sources.[15] Additionally, percentage depletion deductions are assessed on a property-by property basis and may only be claimed on up to 1,000 barrels of oil or 6,000 mcf of natural gas per day.[16]

What is Pennsylvania’s current policy with regard to depletion deductions?

Currently, Pennsylvania law does allow for some form of depletion deduction, but only at the partnership or S corporation level.[17] A regulation adopted in February 2006, specifically 61 Pa. Code § 125.51, states:

Allowance of deduction for cost depletion.

(a) General rule. In the case of mines, oil and gas wells, other natural deposits, and timber, there shall be allowed as a deduction in computing income a reasonable allowance for depletion. In any case in which it is ascertained as a result of operations or development work that the recoverable units are greater or less than the prior estimate thereof, the prior estimate (but not the basis for depletion) shall be revised and the allowance under this section for subsequent taxable years shall be based on the revised estimate.[18]

Further, § 125.52 states that a deduction for percentage depletion shall be allowed only if four very specific circumstances are met:

(1) The deduction is allowable in computing Federal taxable income; (2) Insufficient information is available to estimate the amount of recoverable units in accordance with industry standards; (3) The cost of the recoverable units is fixed and certain; and (4) The cost of the recoverable units has not been fully recovered.[19]

Again, however, despite Pennsylvania’s allowance of depletion deductions, these deductions are not allowed at the personal income tax level.[20] Further, the documents required to be filed by the limited group that do qualify for these deductions are unworkable at best leading most taxpayers to forgo claiming it. HB 199 aims to streamline this existing regulation and make Pennsylvania’s depletion deduction similar to that of the Federal Internal Revenue Code.

Why are depletion deductions so important?

Overall, amending Pennsylvania’s tax code to make it more consistent with the Federal Internal Revenue Code and allowing depletion deductions at the personal income tax level would not only promote consistency, but would also give landowners and many small businesses a much-needed financial boost. There are currently 9,000 independent oil and natural gas producers in the United States that operate in 33 states, including Pennsylvania. Independent producers develop 91 percent of the wells in the United States and produce 83 percent of America’s oil and 90 percent of America’s natural gas.[21] According to proponents of HB 199, depletion deductions, specifically percentage depletion deductions, help smaller businesses offset the high costs associated with operating these oil and gas wells.

[1] Memorandum from the PA H.R. to All House Members (February 17, 2022, 10:56 a.m.),

www.legis.state.pa.us//cfdocs/Legis/CSM/showMemoPublic.cfm?chamber=H&SPick=20210&cosponId=34127

[2]Mineral Wise, Depletion Allowance (Feb. 17, 2022, 10:34 a.m.), mineralwise.com/owners-guide/leased-and-producing/royalty-taxes/depletion-allowance

[3] Publication 535 (2020), Business Expenses (Feb. 17, 2022, 10:13 a.m.), www.irs.gov/publications/p535#en_US_2020_publink1000209051

[4] Using the Depletion Deduction to Minimize Oil and Gas Tax Liability (Feb. 17, 2022, 10:21 a.m.), ohioline.osu.edu/factsheet/SOGD-TAX3

[5] Publication 535 (2020), Business Expenses (February 17, 2022, 10:40 a.m.), www.irs.gov/publications/p535; and Tax Treatment of Natural Gas (February 17, 2022, 10:38 a.m.), extension.psu.edu/tax-treatment-of-natural-gas

[6] Publication 535 (2020), Business Expenses (February 17, 2022, 10:40 a.m.), www.irs.gov/publications/p535#en_US_2020_publink 1000209037

[7] Using the Depletion Deduction to Minimize Oil and Gas Tax Liability (Feb. 17, 2022, 10:21 a.m.), ohioline.osu.edu/factsheet/SOGD-TAX3

[8] Publication 535 (2020), Business Expenses (February 17, 2022, 10:40 a.m.), www.irs.gov/publications/p535#en_US_2020_publink 1000209037

[9] Mineral Wise, Depletion Allowance (Feb. 17, 2022, 10:34 a.m.), mineralwise.com/owners-guide/leased-and-producing/royalty-taxes/depletion-allowance

[10] Tax Treatment of Natural Gas (February 17, 2022, 10:45 a.m.), extension.psu.edu/tax-treatment-of-natural-gas

[11] Percentage Depletion (February 17, 2022, 10:46 a.m.), www.ipaa.org/wp-content/uploads/2016/12/2009-04-PercentageDepletion.pdf; https://energytaxfacts.com/issues/percentage-depletion/

[12] Tax Treatment of Natural Gas (February 17, 2022, 10:45 a.m.), extension.psu.edu/tax-treatment-of-natural-gas

[13] Percentage Depletion (February 17, 2022, 10:46 a.m.), energytaxfacts.com/issues/percentage-depletion/

[14] Publication 535 (2020), Business Expenses (February 17, 2022, 10:40 a.m.), www.irs.gov/publications/p535#en_US_2020_publink 1000209037

[15] Using the Depletion Deduction to Minimize Oil and Gas Tax Liability (Feb. 17, 2022, 10:21 a.m.), ohioline.osu.edu/factsheet/SOGD-TAX3

[16] Percentage Depletion (February 17, 2022, 10:46 a.m.), www.ipaa.org/wp-content/uploads/2016/12/2009-04-PercentageDepletion.pdf; https://energytaxfacts.com/issues/percentage-depletion

[17] Natural Resources, Depletion (February 17, 2022, 10:52 a.m.), www.revenue.pa.gov/FormsandPublications/PAPersonalIncomeTaxGuide/Pages/Natural-Resources.aspx#:~:text=Pennsylvania%20personal%20income%20tax%20rules,must%20adjust%20the%20capital%20account

[18] Statements of Policy, Title 62 – Revenue, Department of Revenue (February 17, 2022, 10:53 a.m.), www.pacodeandbulletin.gov/Display/pabull?file=/secure/pabulletin/data/vol36/36-8/330.html

[19] Statements of Policy, Title 62 – Revenue, Department of Revenue (February 17, 2022, 10:53 a.m.), www.pacodeandbulletin.gov/Display/pabull?file=/secure/pabulletin/data/vol36/36-8/330.html

[20] Memorandum from the PA H.R. to All House Members (February 17, 2022, 10:56 a.m.), www.legis.state.pa.us//cfdocs/Legis/CSM/showMemoPublic.cfm?chamber=H&SPick=20210&cosponId=34127

[21] Who are America’s Independent Producers (February 17, 2022, 11:00 a.m.), www.ipaa.org/independent-producers