Legal Definitions - percentage depletion

Percentage Depletion is a specific tax deduction primarily available to owners of natural resource properties, most commonly in the oil and gas industry. It allows a taxpayer who holds an economic interest in a producing natural resource property to deduct a fixed percentage of the gross income generated from that property each year for tax purposes.

This method is an alternative to deducting the actual cost of acquiring and developing the property (known as "cost depletion"). A key characteristic of percentage depletion is that the total deductions can sometimes exceed the taxpayer's original investment in the property, as long as the resource continues to produce income.

Here are a few examples to illustrate how percentage depletion works:

• Example 1: Independent Oil Producer

  Imagine "Desert Bloom Energy," a small independent company, discovers a new oil field and invests significant capital in drilling and setting up production. Once the wells are operational and generating revenue from selling crude oil, Desert Bloom Energy can choose to use percentage depletion. Instead of meticulously calculating how much of their initial investment is used up with each barrel extracted (which would be "cost depletion"), they can simply deduct a specified percentage (e.g., 15% for oil and gas) of their annual gross income from that field. This reduces their taxable income, providing a consistent tax benefit as long as the wells are producing.

  This illustrates how a company with an economic interest in a producing well can use a straightforward percentage of its gross income as a tax deduction, simplifying the accounting compared to tracking the original investment's depletion.

• Example 2: Family Trust with Mineral Rights

  Consider the "Riverbend Family Trust," which owns the mineral rights beneath a large farm. A major energy company leases these rights and successfully drills several natural gas wells, paying royalties to the Riverbend Family Trust based on the volume of gas extracted. Even though the Trust didn't incur the drilling costs, they have an "economic interest" through their royalty income. For tax purposes, the Riverbend Family Trust can claim percentage depletion on a portion of the royalty income they receive from the natural gas sales. This allows them to reduce the taxable income generated from these natural resources, even without direct operational involvement.

  This demonstrates that percentage depletion is not limited to the direct operators of a well but can also benefit those who hold an economic interest through royalty payments from natural resource production.

• Example 3: Long-Producing Mine

  "Mountain Ore Mining Co." operates a copper mine that has been in continuous production for several decades. Over the years, Mountain Ore Mining Co. has already fully recovered its original investment in the mine through various tax deductions, including prior cost depletion. However, because the mine is still actively producing copper and generating gross income from sales, Mountain Ore Mining Co. can continue to claim percentage depletion each year. This allows them to deduct a portion of their ongoing income from the mine, providing a sustained tax benefit even though their initial capital outlay has long been fully accounted for.

  This highlights a key advantage of percentage depletion: it can continue to provide tax deductions even after the taxpayer's initial investment (their "actual basis") in the property has been fully recovered, which is not possible with cost depletion.