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The Energy Policy Act of 1992 changes the effect of the AMT on most oil and gas producers.

Congress's restructuring of the alternative minimum tax (AMT) in 1986 produced many unhappy taxpayers. Perhaps most unhappy were independent oil and gas producers. They quickly discovered that the new AMT effectively denied them the special tax benefits the Code afforded for depletion and intangible drilling costs (IDCs).

Oil and gas groups pressed their case with Congress, arguing that the AMT provisions were inconsistent with a national energy policy intended to reduce U.S. dependence on imported oil. Congress granted some relief in the Revenue Reconciliation Act of 1990 (RRA): It enacted Sec. 56(h), which provided a special AMT adjustment based on energy preferences. This adjustment, which was effective for tax years beginning after Dec. 31, 1990, mitigated the AMT's impact by allowing taxpayers to reduce their alternative minimum taxable income (AMTI) by an alternative tax energy preference deduction. This deduction equaled 75 % of the taxpayer's IDC preference attributable to "qualified exploratory costs" plus 15% of the taxpayer's IDC preference attributable to other costs plus 50% of the taxpayer's "marginal production depletion preference."(1)

The benefits of Sec. 56(h) were subject to a number of limitations: The deduction could not exceed 40% of the taxpayer's AMTI computed without regard to Sec. 56(h); the deduction was subject to phase-out rules that applied if the average price of crude oil exceeded $28 per barrel (adjusted for inflation) and Sec. 56(h) was not available to integrated oil companies.

Despite the RRA changes, the AMT remained a thorn in the side of most oil and gas taxpayers, who, therefore, felt compelled to continue their lobbying efforts until Congress passed the Energy Policy Act of 1992 (EPA).(2) The EPA's AMT provisions are generally effective for tax years beginning after 1992.

The EPA did not totally repeal the depletion and IDC preferences. But for most oil and gas taxpayers, the preferences' teeth have been pulled. Perhaps the best evidence of this is that the government has estimated that these AMT changes will cost it $456 million.

Overview of the AMT

The AMT is generally viewed as a separate tax system based on AMTI, rather than "regular" taxable income. The taxpayer determines AMTI by starting with regular taxable income, and then modifying it for a variety of AMT adjustments and preferences.(3) The result is AMTI. The taxpayer uses this to determine the tentative minimum tax (TMT), which is calculated using a flat 24% rate for individuals, or a flat 20% for corporations. If the taxpayer's TMT exceeds the applicable regular tax, the excess is the AMT, which the taxpayer must pay.(4)

Most taxpayers do not pay any AMT because the AMT rate is generally lower than the regular tax rate and their AMT adjustments and preferences are not significant. Other taxpayers have such large adjustments and preferences that, despite the lower AMT rate, their TMT exceeds their regular tax and they must pay AMT.

Most AMT adjustments apply to both corporate and noncorporate taxpayers. However, there are a number of exceptions, the most significant of which is the adjusted current earnings (ACE) adjustment under Sec. 56(g), applicable only to corporations. While the rationale behind the ACE adjustment is not absolutely clear, it appears to reflect Congress's desire that economically profitable corporations pay some tax, even if they have little or no regular taxable income.

This adjustment relies on a separate tax base (ACE) that uses AMTI before the ACE adjustment (preadjustment AMTI) as its starting point. To compute ACE, the corporation modifies preadjustment AMTI for a number of different items including accelerated depreciation, certain earnings and profits (E&P) items, and several miscellaneous adjustments. Suffice it to say, the computation of ACE is breathtakingly complex, even by AMT standards.

On the brighter side, corporations are entitled to a minimum tax credit (MTC) for all AMT they pay after 1989.(5) Noncorporate taxpayers are entitled to an MTC for AMT attributable to certain AMT adjustments and preferences (these adjustments and preferences are referred to as "deferral preferences"), but not for AMT attributable to others (referred to as "exclusion preferences"). The taxpayer (corporate or noncorporate) can use this credit to offset a subsequent year's regular tax liability. The subsequent year's regular tax, however, cannot be reduced below the taxpayer's TMT for that year.(6)

The Depletion Preference Under Pre-EPA Law

Before the EPA was enacted, the depletion preference under Sec. 57(a)(1) applied to corporate and noncorporate taxpayers and could arise with respect to any natural resource that afforded a depletion deduction. The preference was determined on a property-by-property basis and equaled the excess of the taxpayer's depletion deduction for the year over the taxpayer's adjusted basis in the property.(7) Because cost depletion does not allow a taxpayer to depreciate a property once its basis is zero, this preference typically resulted from percentage depletion.

Example 1: In 1991, A, a calendar-year individual, claims a $20,000 percentage depletion deduction for an oil property that has a year-end adjusted basis (disregarding this deduction) of $5,000.(8) His depletion preference for the property is $15,000 ($20,000 - $5,000). If A's AMTI was $200,000 before considering this preference, it would be $215,000 after considering it.

If A's depletion deduction resulted from so-called marginal production, he would be entitled to use the Sec. 56(h) adjustment based on energy preferences to reduce his $215,000 AMTI by $7,500 (i.e., 50% of his $15,000 depletion preference).(9)

For corporations, this was not the end of the story. Sec. 56(g)(4)(f) required corporations to determine their depletion for ACE purposes using cost depletion.(10) This generally did not create new problems for properties with a $0 adjusted basis (the damage was already done by the depletion preference in Sec. 57(a)(2)), but it could increase a corporation's ACE for properties with a positive adjusted basis.

Example 2: XYZ Corp., a calendar-year C corporation, is an independent oil producer that claims a $20,000 percentage depletion deduction for an oil property with a year-end adjusted basis (disregarding this deduction) of $50,000. This does not generate a depletion preference under Sec. 57(a)(1) because the deduction does not exceed the property's adjusted basis. If, however, cost depletion on the property was only $15,000, the corporation's ACE would have to be increased by $5,000 ($20,000 - $15,000). Thus, if XYZ's ACE was $500,000 before considering this preference, it would be $505,000 after considering it.

As in Example 1, if XYZ's depletion deduction resulted from marginal production, the corporation could use the Sec. 56(h) adjustment based on energy preferences to reduce its AMTI by a portion of the ACE depletion adjustment.

The depletion preference was a particular problem for noncorporate taxpayers. The preference was treated, for MTC purposes, as an exclusion preference. Thus, AMT paid on account of the depletion preference did not produce an MTC and, therefore, did not produce subsequent tax benefit.

The EPA's Impact on Depletion

The EPA amended Sec. 57(a)(1) by adding a sentence indicating that the depletion preference "shall not apply to any deduction for depletion computed in accordance with section 613A(c)."(11) Since Sec. 613A(c) provides special oil and gas depletion rules only for independent producers and royalty owners, Sec. 57(a)(1) continues to apply to integrated oil companies' oil and gas depletion, and to other depletable minerals (silver, coal, etc.).

For corporations that are independent oil and gas producers and royalty owners, the EPA also rescinds the ACE depletion adjustment. That provision, Sec. 56(g)(4)(F)(ii), also states that Sec. 56(g)(4)(C)(i) does not apply to depletion deductions for these taxpayers. Sec. 56(g)(4)(C)(i) generally requires a corporation to increase its ACE by amounts deductible for tax purposes, but not for E&P purposes. By saying that Sec. 56(g)(4)(C)(i) does not apply to depletion deductions, the Code makes clear that the deductions do not increase ACE even if they would not be allowed for E&P purposes.(12)

As a result of these and other changes, the Sec. 56(h) adjustment based on energy preferences became unnecessary, and was repealed.(13)

The effective date provisions for the depletion changes are in amended Sec. 57(a)(1):(14)

Effective with respect to taxable years beginning after December 31, 1992, this paragraph shall not apply to any deduction for depletion computed in accordance with section 613A(c).

This means that the new, beneficial depletion rules can apply to a well drilled before 1993, as well as to those drilled after 1992.

Example 3: In 1987, A, a calendar-year individual, drills an oil well. A computes his depletion on the property using the percentage method. In 1992, A has an AMT depletion preference because his depletion deduction exceeds his adjusted basis in the property. In 1993, the well generates percentage depletion of $25,000. Even though the well was drilled before 1993, the EPA allows A to avoid the depletion preference in 1993.

The IDC Preference Under Pre-EPA Law

Before the EPA was enacted, the IDC preference under Sec. 57(a)(2) applied to corporate and noncorporate taxpayers and could arise with respect to IDCs from oil, gas and geothermal properties. The preference for oil and gas IDCs was computed separately from that for geothermal IDCs. For both IDC groups, the preference equaled the amount by which the taxpayer's "excess IDCs" exceeded 65% of net income from the activities giving rise to the IDCs.(15)

Example 4: In 1991, Y, a calendar-year individual, had $100,000 of net oil and gas income (disregarding excess IDCs) and $80,000 of excess oil and gas IDCs. Her IDC preference is $15,000, calculated as follows:
Excess oil and gas IDCs $80,000
Less: 65% of net oil and
gas income ($100,000 X 65%) (65,000)
IDC oil and gas preference $15,000


Example 5: Assume the same facts as in Example 4, except that Y also has net income of $100,000 from geothermal deposits. Her excess geothermal IDCs are $40,000. Y must compute the IDC preference resulting from her geothermal properties separately from the IDC preference resulting from her oil and gas properties. The geothermal properties do not give rise to an IDC preference because the following calculation results in a negative value.
Excess geothermal IDCs $ 40,000
Less: 65% of net geothermal
income ($100,OOO X 65%) (65,000)
 $(25,000)


Because negative preferences are not taken into account, and the geothermal IDC preference is computed separately from the oil and gas IDC preference, Y cannot use this negative amount to offset her $15,000 oil and gas IDC preference. Her total IDC preference, therefore, remains at $15,000.

A taxpayer's "excess IDCs" generally equal the taxpayer's allowable oil, gas and geothermal IDCs, under Sec. 263(c) or 291(b), reduced by the IDCs the taxpayer would have been able to deduct if those costs were capitalized and recovered over a 120-month period.(16)

Y, in Examples 4 and 5, would be entitled to use the Sec. 56(h) adjustment based on energy preferences to reduce her AMTI. The exact extent of the deduction would depend on what amount, if any, related to so-called qualified exploratory costs.

As with depletion, this was not the end of the story for corporations. Sec. 56(g)(4)(D)(i) required corporations to determine their IDCs for ACE purposes by capitalizing them and deducting them ratably over a 60-month period, beginning with the month paid or incurred.(17) Thus, if a corporation's IDC deduction for AMT purposes--after considering the Sec. 57(a)(2) preference--exceeded the deduction that would be allowed using a 60-month write-off period, the difference would increase the corporation's ACE. The corporation would, however, be able to use the Sec. 56(h) adjustment based on energy preferences to reduce its AMTI by a portion of this IDC ACE adjustment.

Unlike the depletion preference, the IDC preference is a deferral preference that could give rise to an MTC for noncorporate taxpayers. Thus, AMT paid by an individual taxpayer on account of the IDC preference could produce a subsequent tax benefit, if the taxpayer was subject to the regular tax in a later year.

The EPA's Impact on IDCs

The EPA amended Sec. 57(a)(2) by adding a new subparagraph (E). Clause (i) of that subparagraph excepts "any taxpayer which is not an integrated oil company (as defined in section 291 (b)(4))" from the IDC preference for oil and gas wells. This relief, however, is subject to the following limitation:

The reduction in alternative minimum taxable income by reason of clause (i) for any taxable year shall not exceed 40 percent (30 percent in case of taxable years beginning in 1993) of the alternative minimum taxable income for such year determined without regard to clause (i) and the alternative tax net operating loss [NOL] deduction under section 56(a)(4).

This benefit limitation warrants particular attention for a number of reasons. First, the statute instructs the taxpayer to compute AMT income "determined without regard to clause (i) ...." This is not the same as directing the taxpayer to compute AMT income under the pre-1993 rules. For pre-1993 tax years, taxpayers with IDCs could use the Sec. 56(h) adjustment based on energy preferences to reduce AMT income. As noted earlier, the EPA repealed Sec. 56(h). The language of Sec. 57(a)(2)(E)(ii), with its explicit reference to clause (i) only, does not seem to resuscitate the Sec. 56(h) adjustment for purposes of computing this special limitation. This result is favorable to taxpayers, since it increases the AMTI base the taxpayer uses in computing the 30% or 40% limitation.(18)

For tax years beginning in 1993, this new rule cannot reduce the taxpayer's AMT IDC preference for oil and gas IDCs by more than 30% of the taxpayer's AMT income, computed before taking this deduction into account; see Example 6. The limitation is 40% of AMT income, rather than 30%, for subsequent tax years.

Example 6: In 1993, X, an independent oil producer and calendar-year taxpayer, would have an oil and gas IDC preference of $100,000, were it not for Sec. 57(a)(2)(E)(i). Without the IDC preference, X's AMT income is $125,000. With the preference, X's AMT income would, therefore, be $225,000. (He has no AMT NOL deduction for 1993.) The benefit afforded by Sec. 57(a)(2)(E)(i) cannot exceed $67,500 (30% X $225,000).

Thus, X's AMT income for 1993 will be $157,500, computed as follows: AMT income computed without application of Sec. 57(a)(2)(e)(i) $225,000 Benefit allowed after application of limitation described in
Sec. 57(a)(2)(E)(ii) (67,500)
AMT income $157,500


The 30% limitation means that X must include $32,500 of his $100,000 oil and gas IDC preference in AMT income ($100,000 - $67,500 = $32,500).

Another way to look at this is that, for 1993, a taxpayer can ignore the IDC preference if it does not exceed three-sevenths (i.e., 42.85714%) of his AMT income, computed without regard to the IDC preference.(19) In Example 6, X's IDC preference ($100,000) is 80% of his AMT income computed without regard to the preference ($125,000). Therefore, it is limited. If the IDC preference does exceed three-sevenths of AMTI, as in this case, the taxpayer must perform the full-blown computation to determine the exact amount of the IDC preference.

In tax years beginning after 1993, the 30% limitation is replaced by a 40% limitation. Example 7 illustrates the effect of this change.

Example 7: Assume the same facts as in Example 6, except that it is 1994. The benefit afforded by Sec. 57(a)(2)(E)(i) cannot exceed $90,000 (40% x $225,000).

Thus, X's AMT income for 1993 will be $135,000, computed as follows: AMT income computed without application of Sec. 57(a)(2)(E)(i)

$225,000 Benefit allowed after application of limitation described in
Sec. 57(a)(2)(E)(ii) (90,000)
AMT income $135,000


The 40% limitation means that X must include $10,000 of his $100,000 oil and gas IDC preference in AMT income ($100,000 - $90,000 = $10,000).

Another way to look at this is that, for post-1993 tax years, a taxpayer can ignore the IDC preference if it does not exceed two-thirds (i.e., 66.66667%) of his AMT income, computed without regard to the IDC preference. In Example 7, X's IDC preference ($100,000) is 80% of his AMT income computed without regard to the preference ($125,000). Therefore, it is limited.(20) If the IDC preference does exceed two-thirds of AMTI, as in this case, the taxpayer must perform the full-blown computation to determine the exact amount of the IDC preference.

For obvious reasons, these percentage limitations will generally present problems only for those independent producers with unusually large IDCs.

For corporations that are independent producers, the EPA also rescinds the ACE IDC adjustment for their oil and gas IDCs.(21) This repeal is complete; no percentage limitation applies to this change.

As with the depletion changes, reformation of the IDC preference and its ACE counterpart is limited to oil and gas expenses. Thus, a geothermal well can generate an IDC preference and, in the case of a corporate taxpayer, an ACE IDC adjustment as well. Moreover, integrated oil companies continue to be subject to these AMT items.

The effective date provisions for the IDC changes are similar to those for the depletion changes. But, because Sec. 57(a)(2)(A) applies to IDCs "arising in the taxable year," the relief the EPA provides is limited to IDCs "arising" in tax years beginning after 1992. Prior IDCs will not benefit from the new rule.

Planning Considerations

The frequent tax law changes over the last decade have sensitized many taxpayers and their advisers to the idea that these changes often offer planning opportunities. The changes discussed above, however, are AMT changes, and these typically create special planning problems.

As with all AMT planning, the first question is: Is the taxpayer subject to the AMT this year? The fact that a corporate taxpayer's TMT is $400,000 is generally irrelevant for AMT planning if its regular tax liability is $750,000. It is usually unnecessary to expend effort to reduce AMTI in this circumstance, since it generally will not affect the taxpayer's tax bill.22

Even assuming that the taxpayer is subject to the AMT, little planning is now available for the AMT depletion changes. The situation, however, is different for IDCs. Although this preference gives rise to an MTC for noncorporate and corporate taxpayers, both types of taxpayers may benefit from deferring some IDCs from 1993 to 1994 if they expect to be subject to the AMT for the foreseeable future (and, therefore, cannot use their MTC in the short term). For 1994, the IDC preference is rolled back to the extent it does not exceed 40% of the AMTI base. For 1993, the percentage is only 30%. Thus, deferring IDCs may reduce the client's total AMT for the two-year period. Since the MTC will not provide any short-term tax benefit, there is some advantage to reducing AMT.

The rules are different if the taxpayer will be subject to the regular tax in the near future: AMT paid by a corporate or noncorporate taxpayer will give rise to an MTC. This will be available to reduce a subsequent regular tax liability. Thus, the advantage to deferring the IDCs is rather limited.

Conclusion

The Energy Policy Act of 1992 goes a long way to mitigate the problems that independent oil and gas producers had with the AMT. Some remnants of the old system remain, however--particularly regarding IDCs. The best that independent producers and royalty owners can do is keep a wary eye on the AMT, as they brace for the next round of tax legislation.
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Author:Rook, Lance W.
Publication:The Tax Adviser
Date:Aug 1, 1993
Words:3354
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