Typical end-of-year tax planning will be on everyone’s minds before you know it.

For years, investors and their accountants have been reducing taxes by using the generous tax benefits available through oil and gas drilling programs. To encourage domestic drilling, Congress and the Tax Code allow high tax write-offs for direct investments into drilling. These offerings are most often sold as DPPs, or direct participation programs, securities.

Investors could expect 65 to 95 percent write-offs, dollar for dollar against active taxable income, depending on the structure of the drilling program. Anyone who owes more than $12,000 in taxes could benefit, and certainly high-net-worth individuals often owe much higher than that.

A hypothetical tax illustration follows: An investor learns he has taxable income of $100,000 (line 36 of the tax return), after meeting with his accountant. In the 28 percent tax bracket, his tax liability is $28,000. He decides to invest $60,000 in a drilling partnership giving 65 percent write-offs, or a $39,000 write-off. His taxable income of $100,000 has now been reduced to $61,000, and his tax liability (now down to the 25 percent tax bracket) is reduced to $15,250. The savings in taxes in this example is $12,750. So again, instead of paying a $28,000 tax bill to the IRS, he will instead pay $15,250 and invest $60,000 (a total expenditure of $75,250) for which he will receive potential future income. He created an asset, potential future cash flow, and he is building his net worth, while diversifying his overall holdings.

In another example, a couple in a high tax bracket have high salary compensation and business income. Their taxable income is $360,000 (line 36 of the tax return). This couple decides to invest $100,000 in a drilling program that is structured to allow a 95 percent immediate write-off, or a $95,000 write-off against their active income. The taxable income of $360,000 has now been reduced to $265,000. Had they not invested, their tax would have been $126,000 (35 percent tax bracket). By reducing the taxable income to $265,000, their tax liability will now be $87,450 (down to the 33 percent tax bracket) and they are paying $38,550 less in taxes.

The investor will not normally receive any cash flow from the drilling investment for about six months to a year. The investment funds are used to drill the wells and bring them online. As the wells are brought online and the oil or gas is sold, the investor will then experience monthly cash flow from the sales. After the first year, an annual 15 percent depletion tax allowance is given against the income derived from oil and gas. Another more complicated calculation can be used, but most investors choose the straight 15 percent depletion.

For investors who may have an alternative minimum tax issue, drilling programs’ intangible drilling costs are included among AMT preference items and can help reduce the overall tax liability. In addition, since oil and gas working interests are considered “active” income rather than “passive” income, write-downs can be used against business income, salaries, stock trades, etc.

These tax benefits may go away in 2010 or 2011. This is unknown at the moment, but has been proposed by the Obama administration as one of the revenue raisers to reduce the federal deficit. Hence, 2009 may be one of the last years to benefit from this type of investment in the way we know it today.

Kathy Heshelow covers this and the many facts and issues a prospective investor must understand in her new book “Investing in Oil & Gas: the ABCs of DPPs (Direct Participation Programs).” For more information, visit www.oilgasbook.com. Kathy is not a CPA or tax attorney. These are commonly known tax benefits in the Tax Code today and are intended to be informational. Every investor will have a specific and personal situation to review with their CPA.

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