Energy Taxation & Offering Structure

Developments

Brad Updike, Mick & Associates

Wally Kunzman, Kunzman & Bollinger

Jack Hollander, Atlas Energy

Brett Evans, Hull Evans & Kob

Energy Taxation & Offering Developments

• Tax Fundamentals• Tax Program/Investment Pitfalls• Tax Legislative Developments• Program Structure (Public vs. Private)• General Solicitation • 1031 Issues• Marketing Issues (Rule 2210, RN 13-18)• RIA Participation in DPPs• Issuer Exemption

Programs Having Varying Tax Consequences

Sources of Income- Active (Wages, Managed Businesses, SSI, Pensions)- Passive (Non-Managed Businesses, Most Rental Activities)

- Portfolio (Dividends, Bond Interest, Royalties)- Capital Gains (Portfolio or Passive)- Self Employment Income Presents Additional Planning Opportunities

Must Understand Client’s Income on Multiple Levels Because Tax Features Vary By Program

- Drilling Programs (Depletion, IDC Follow the GP/LP Election)- Royalties (Depletion, Portfolio Income, Not UBTI in RIA, No IDC)- Producing WI (Passive Income Generator for LP investor)- Hybrid Production/Lease Development (Some IDC, Cap Gains)- §1031 Direct Ownership Programs (Tax Deferral vs. Load Adjusted

IRR; Does the Economics Justify the Investment?)

Drilling Program Use of Capital Falls Into Four BucketsIntangible Drilling Costs (55% to 65% of Program Cap ExTangible Equipment (15% to 20% of Program Cap Ex)Offering Expenses (10% to 13% of Program Cap Ex)Leasehold Costs (5% to 15% of Program Cap Ex)Program Cap Ex = Investors + Sponsor Capital

Amount of General Partner Capital Varies by Sponsor And Sponsor Contribution Facilitates Functional Allocations

Extent/Timing of Deductions Follow Use of Funds

Why Deductions Can Vary From Program to Program

Functional Allocations Require Substantial Economic Effect

Intangible Drilling Cost Deductions

• Are Non-Salvageable Costs Incurred in Drilling Wells (e.g., Rig Time, Drilling Fluids, Operator Supervision)• Are Associated With Drilling, Completion, and Work Over Activities• Can Be Up To 100% of the Investor Capital• Investor Election To Expense OR Amortize Over 60 Months• Timing of Deduction is Tied to the Commencement of Drilling (Need Non-Refundable Payment to Operator by Dec. 31 of Investment Year and Commencement of Drilling Within First 90 Days of Following Year for the Up- Front Deduction)

GP/LP Election and Conversion

• You Must Pay Attention to the Client’s Income • GP Election Needed To Use IDC Against Active and Self Employment Income • Some Programs Will Let You Bifurcate the Election But Once A GP Always A GP For Tax Purposes• GP’s Are Liable for Partnership Liabilities Incurred Prior To Conversion To LP Status• Conversion Should Occur After All Development Activities Are Finished (See, Treas. Reg. 1.469-1T(e)(4)(iii) (e.g. 2) (if economic performance relative to the IDC is deemed to occur when interest is passive, you could have passive IDC deductions).• LP Election by a Closely Held C-Corporation

Tax Structure/Investment Pitfalls

• Must Match Income to the GP/LP Election Decision (Planning)

• Drilling Ahead of the Raise

• Taking Away the “At-Risk” Element (e.g., Premature Conversion of the GP Interest Falls Here)

• Paying IDC With Leverage (What Constitutes a Payment for Economic Performance Purposes, Structure)

90-Day Rule-What Constitutes Drilling?

Caltax Oil Venture, et. al., v. Commissioner of Internal Revenue U.S. Tax Court, Jan. 2012 Doc. No. 3793-08

• IDC Was Prepaid in 1999 on a Turnkey Contract by Cash and Notes • Some Permitting Activities Occurred Before March 31, 2000• The Drill Bit Did Not Land in the First 90 Days of Year Following the Investment Year• IRS Says You Have to Spud to Deduct in Year of Investment• Taxpayer Says “Commencement of Drilling” Can Include Pre- Drilling Activities (e.g., Permits, Surveys, Location Building)• A CCH Tax Manual Excerpt Points Out That the Word “Spudding” was not Used in the Primary Rule Language of IRC 461(i).

Caltax Oil Venture, et. al., v. Commissioner (Cont.)

• IRS Gets a Victory at the Tax Court Level • Tax Court Construes the “Commencement of Drilling” Term by its Plain Meaning in Webster’s 3rd Dictionary• You Could Have Different Results Across the Federal Circuits• Don’t Oversell the First Year IDC Deduction

Side Note: Notice the long and drawn out progression of the problem from 1999 when the deduction was taken until 2012 when the Tax Court’s ruling came out; 6-year SOL for material understatement of income per IRC 6501(a).

Case is on appeal to the 3rd Federal Circuit.

Be Careful About Making Energy Investments With Qualified Money

• Unrelated Business Taxable Income (“UBTI”) Could Apply

• Drilling Programs Typically Not Suited for IRAs and Other Qualified Plans (You Normally Want to Match IDC With Income of Taxpayers in Higher Tax Brackets)

• IRA Custodians Treat UBTI Exposure Differently

• Royalties Could Make Sense Depending on Investor’s Financial Circumstances

• Sect. 512(b) Lists Non-UBTI Income Sources

Recent Tax Developments

New Tax RatesMarried Filing Jointly• $0 to $8,925 = 10% rate• $8,926 to $36,250 = 15%• $36,251 to $87,850 = 25%• $87,851 to $183,250 = 28%• $183,251 to $398,350 = 33%• $398,351 to $400,000 = 35%• $400,001 and above = 39.6%

Single Filers• $0 to $8,925 = 10% rate• $8,926 to $36,250 = 15%• $36,251 to $87,850 = 25%• $87,851 to $183,250 = 28%• $183,251 to $398,350 = 33%• $398,351 to $400,000 = 35%• $400,001 and above = 39.6%

Bonus Depreciation

New Medicare Tax

IDC Discussions

Public vs. Private (NASAA Guidelines)

General Solicitation

Historically Engrained In Oil & Gas (Unfortunately) Requirements

Will It Affect Energy Program Quality?

Energy Programs Can Sometimes Cater to § 1031 Planning§1031 Going In and At Exit:

- Royalties- Mineral Interests

- Leasehold Interests- Working Interests in Producing Wells

- Direct Interest in Pipelines (state law applies)

§1031 at Exit: - Working Interests in To-Be Drilled Wells

No §1031 Treatment - Partnerships and LLC Interests- Most Production Payments

Like-Kind Exchange Treatment Not Applicable to Partnership Interests; but May Apply to One of the Above Held in a Single Member LLC

1031 Developments

Structure: Avoid P’ship Characteristics

Control: 1-Year Management Contracts & JOA Ability to Sell Manager Removal Title: Direct Title Preferable

Subscription/Participation Agreement: Elect out of P’ship Status

Tangible Equipment Cost Deductions

• Applies to Salvageable Equipment (e.g., Pipe, Separators, Tanks)

• Historically 7-Year Deduction With Higher Accelerated Deduction in First 2-3 Years (MACRS)

• Tangible Equipment is Typically 15-35% of the Total Drilling and Completion Costs

• 2010 Tax Act Allows For 50% Bonus Depreciation for Equipment Placed in Service in 2013

Depletion Allowance

• A Somewhat Similar in Concept to Depreciation for Real Estate

• Cumulative Depletion Can Exceed Client’s Basis

• Shelters 15% of Oil, Gas and Royalty Cash Flow from Taxation

• Not an AMT Preference Item

Alternative Minimum Tax Opportunities and Pitfalls

• AMT Review Pre-Investment Offers Planning Opportunities (i.e., High Real Estate and State Income Taxes) • Excess IDC = [IDC Deducted-IDC Amortized Over 10 Years] – 65% Net Income From Oil & Gas• IDC From Non-Productive Wells Excluded• Applies if Excess IDC Exceeds 40% of Alternative Minimum Taxable Income• Quick Test: Did You Reduce Alternative Minimum Taxable Income 40% or More?• Does not Apply if Investor Capitalizes and Deducts IDC’s Over 60 Months

Questions?