A tax deduction authorized by federal law for the exhaustion of oil and gas wells, mines, timber, mineral deposits or reserves, and other natural deposits.
Frequently, the ownership of such resources is split so that the depletion deduction is allotted among the various owners. Rights to royalty payments, leases, and subleases are not the same as ownership but the holders of such rights may be entitled to depletion deductions under the theory of "economic interest" formulated by the courts to ascertain the right to depletion allowances. Such economic interest, which signifies an investment interest in the minerals that furnish the sole resource for recouping the investment, is usually determined by the parties according to the provisions of their contract.
The cost method and the percentage, or statutory, method represent the two ways of calculating the Depletion Allowance.
Cost depletion, like depreciation, bases the allowance on the original cost of the income-generating property. For example, a taxpayer who purchases rights to extricate oil for $2 million should be permitted to regain the capital tax-free when he or she extracts and markets the oil. The earnings from the depletable property should be viewed as encompassing a return of the taxpayer's capital investment. A proportionate segment of such receipts each year should be exempt from taxation as income. When oil is viewed as a "wasting asset," cost depletion permits yearly deductions for the receipt of $2 million tax-free over the duration of the pumping operations. The tax law permits the taxpayer to divide the cost of the investment by the estimated total of recoverable units in the natural deposit. This cost per unit is subsequently multiplied by the number of units sold annually, which results in the depletion deduction permitted for that year.
The percentage, or statutory, method does not employ recovery of cost in the computation of the deduction. A percentage of annual income, rather than cost, is deductible each year, even if the owner has recovered all cost or discovery value of the depletable asset. The federal tax laws vary from year to year in regard to the percentage depletion allowable for oil and some other deposits, and the categories of producers entitled to such allowances.
Percentage depletion, which applies to other mineral deposits or energy sources such as geothermal steam, provides an extremely profitable allowance as an alternative to cost depletion. The taxpayer calculates a fixed percentage of his or her gross income and deducts that amount from gross income annually for as long as the property generates income, even after he or she has completely recovered the actual cost. Some taxpayers employ cost depletion at the outset of operations, when a large number of units of the deposit are extracted and sold, and then convert to percentage depletion upon recoupment of cost in other circumstances—when percentage depletion yields a more sizable deduction.
Percentage depletion furnishes an additional tax subsidy to detection, development, and dissipation of qualified reserves. The subsidy approach began during World War I to induce exploration for minerals. Cost depletion had been expanded to permit discovery value rather than cost to serve as the gauge of tax-exempt recovery. A problem in estimating the quantity of depletable units prior to extraction existed, however, and percentage depletion was enacted in 1924 as the solution. This method was subsequently extended to include additional minerals and other deposits and to raise rates of depletion in some instances. It was eventually diminished due to excessive profits and tax benefits obtained by some companies. Only depletion, rather than percentage depletion, may be used for gas, water, soil, timber, and oil.
For percentage depletion, gross income must be restricted to income from extracting and selling the deposit, not from refining, processing, or manufacturing it.
The option to deduct present exploration and development expenditures rather than capitalizing them represents an additional tax advantage for the industries entitled to depletion allowances. A more substantial tax benefit ensues if such expenses are deducted immediately, since they would never be recovered through the application of percentage depletion, which is based on gross income and not the cost of the capital invested in the enterprise.