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The Tax Cuts and Jobs Act passed by Congress and signed into law by President Donald Trump last year has a significant impact on taxpayers in the oil and gas industry.
Taxpayers in the oil and gas industry are affected because they hold their assets and investments in a variety of entity types, including C corporations, partnerships, S corporations and directly by individuals.
The act also eliminates or limits many tax breaks, and much of the tax relief is only temporary. The key changes that affect taxpayers in the oil and gas industry are outlined below.
Reduced Corporate Income Tax Rate: The corporate income tax rate was reduced to a flat 21 percent from 35 percent starting in 2018. With oil prices up substantially in 2018, many companies are generating profit again and are also looking to monetize certain oil and gas properties. If companies are in a taxable income position or plan to sell properties at a gain, the corporate rate reduction could be favorable.
New Deduction from Pass-Through Entities: The act provides taxpayers that are operating businesses through pass-through entities such as partnerships and S corporations a special deduction under new Section 199A. A significant number of oil and gas businesses are structured through partnerships owned primarily by large private equity groups, private investors and family groups.
The deduction is equal to the lesser of:
• The combined qualified business income amount
• 20 percent of the excess of the taxpayer’s taxable income determined before the Section 199A deduction over the taxpayer’s adjusted net capital gain
Combined Qualified Business Income : Subject to certain limitations discussed below, the combined QBI amount for a taxable year generally equals the aggregate of 20 percent of the taxpayer’s QBI with respect to each qualified trade or business.
Qualified and Specified Service Trade or Business : A qualified trade or business is any trade or business other than a specified service trade or business; or a trade or business involving the performance of services as an employee
A specified service trade or business: Involves the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more employees or owners; Performing services involving investing and investment management, trading, or dealing in securities, partnership interests, or commodities.
The definition of specified service trade or business specifically excludes engineering and architecture businesses
Limitations : Although a taxpayer’s combined QBI amount will generally equal 20 percent of the aggregate amount of QBI from each qualified trade or business, the calculation is subject to limitations.
Specifically, the QBI for each qualified trade or business is limited to the greater of:
• 50 percent of the W-2 wages with respect to the qualified trade or business
• The sum of 25 percent of the W-2 wages and 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property
On August 8, 2018, the treasury and the IRS issued new proposed regulations addressing several key issues including guidance on defining a “trade or business,” aggregation rules, and W-2 wages. The proposed rules allow aggregating businesses when the businesses are related in ownership and have similar characteristics. Also, regarding the W-2 wage limitation, the proposed rules permit taxpayers to include wages from workers who receive W-2 wages from third-party payers, including professional employer organizations.
Full Expensing of Tangible Property : This provision could be a significant benefit because the oil and gas industry is very capital intensive.
Tangible drilling costs, lease and well equipment, pipelines and all other tangible personal property can be fully deducted when acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023. The full deduction is phased down by 20 percent each year beginning in 2023 and is eliminated by 2027.
The new tax law also permits used property to be eligible for the full expensing provision. This change may impact merger and acquisition transactions by motivating buyers to structure deals as actual or deemed asset acquisitions rather than stock acquisitions. This is accomplished by enabling the buyer to immediately deduct a significant portion of the purchase price and generate Net Operating Losses in the year of purchase to offset future taxable income.
Limitation on Deduction of Net Interest Expense : For companies with high leverage, the limitation on deduction of net interest expense could offset some benefit of the lower tax rates.
The new tax law limits the deductibility of net interest expense to 30 percent of taxable income before interest, the Net Operating Loss deduction, the pass-through deduction, and, for years before 2022, depreciation, amortization, and depletion. Businesses with average annual gross receipts of $25 million or less are exempted from the limit.
Next Steps : The new provisions are complex, and there are still some unanswered questions. The IRS is expected to issue more guidance as companies and tax professionals grapple with these changes in the tax regime. Work closely with your tax professional to understand how these provisions will affect you and your business.
Moss Adams has 2,900 professionals in more than 25 locations in the West and elsewhere, specializing in accounting, consulting, and wealth management services. Through a combination with Hein & Associates, the firm has expanded its capacity to serve energy sector clients.