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In an effort to stimulate domestic oil and natural gas production financed through private equity, Congress provided tax incentives in the 1990 Tax Act to significantly enhance the economics of investing in the oil and natural gas industry. This incentives have made investment in the oil and gas industry one of the most tax-advantaged investments available.

The new Tax Code specifically states that a working interest in an oil and gas well is not a “passive” activity. Therefore, deductions can be offset against any income. This includes active stock trades, salaries, and business income. (section 469 (c)(3) of the Tax Code)

The concepts of “Passive” and “Active” income was first introduced into the tax code in the 1986 Tax Reform Act. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. What this implies is that, a loss or expense in an investment in a mutual fund(passive investment – since he doesn’t actively manage the investment portfolio of the fund) by a doctor cannot be offset by earnings from his medical practice but should the investment be a working interest in the oil and gas industry(another passive investment – since he also doesn’t manage the business), he would be able to deduct such loss or expense from the tax returns of his medical practice.

The lure of petrol dollar with the ever high demand for petrol and petroleum-based commodities backed by tax incentives, offers a great investment opportunity for investors. The investment options available in the oil and natural gas industry for the likes of Dr. James Rodriguez from Iowa or Mrs. Camellia Sullivan of Georgetown, New Jersey are quite varied with each offering marginal returns on investment and some, tax breaks on their day jobs. It is worthy to note that not all investments in the oil and gas industry attracts such tax breaks and it is our intention to clarify those that offer such incentives and those that do not.

Investment in the oil and gas industry for individuals and small companies take different forms and risk/reward components. Investment portfolio in the oil and gas industry for small companies and individuals includes; mutual funds or ETFs, partnerships, royalty interest and working interest.

Mutual Funds or ETFs: This investment method poses the least amount of risk for the investor but it does not offer any of the tax benefits. Investors will pay tax on all dividends and capital gains, just as they would with other funds.

Partnerships: Partnerships in oil and gas investments can take several forms with limited partnership being the most common, this sort of partnership limits the liability of the entire producing project to the amount of the partner’s investment. They are sold as securities and must be registered with the Securities and Exchange Commission (SEC). Tax incentives are available on a pass-through basis. The partner will receive a Form K-1 each year detailing his or her share of the revenue and expenses. This sort of investment is direct and provides a stable base for investors looking at a minimal risk portfolio.

Royalty Interest: Refers to ownership of a portion of the resource or revenue that is produced. A company or person that owns a royalty interest does not bear any of the costs of the operations needed to produce the resource, yet the person or company still owns a portion of resource or revenue produced. Holders of royalty interest are not eligible for tax benefits enjoyed by holders of partnership and working interests.

 

Working Interests: This is the investment with the most risk and most involved way to participate in the oil and gas Industry. This sort of investment allow investors own a percentage ownership of the drilling operation, functioning as a form of lease, providing the investor a right to take part in drilling activities and a right to the resources produced from that activity. Along with deriving an income from the production of the resource, the investors are also responsible for a percentage of the expenses related to its acquisition. Investors with working interests are often eligible for certain tax deductions based on the operating costs associated with the business. This can include business expenses of a tangible or intangible nature, such as equipment costs or utility payments.

The oil and natural gas industry is quite volatile. When you become involved in these ventures, have a healthy respect for the potential risks and be honest with yourself about your own risk tolerance and investment horizons. Ask cogent questions such as; Are you a natural entrepreneur? Can you afford to lose substantially on any one venture? Is it worth the risk if there’s a chance at great reward?

You may be a candidate for limited partnerships, futures, working interest or shares in small exploration companies. If they strike it rich, so will you. But you could lose it all. Pay heed to liquidity. If there is any chance at all you will need to pull your money out in a hurry, the limited partnership route is not for you. These investments can be lucrative, but they work best for those who are able to lock up their funds for years at a stretch

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