Successful oil and gas explorations can be lucrative, with minerals extracted from newly found reserves generating a steady stream of revenues for years, which can pay for the exploration and development costs of that site many times over. But many explorations don't pan out. The IRS encourages investment in exploration and development in several ways, by making allowances in the tax code specific to oil and gas development and similar industries. The specific manner in which you claim a deduction, however, depends on your situation, such as whether you are an investor in a partnership, a shareholder in a corporation or actually managing a company.
Many energy exploration companies take the form of limited partnerships. In these cases, profits and losses from energy exploration flow through the company and get taxed on the partner's individual income tax return. The same is true for sole proprietors, but this situation would be extremely rare. In these cases, you file an IRS Form 1040 Individual Income Tax Return, together with a Schedule C, Profit (Or Loss) From Business. Schedule C will list any investments you made into the project, effectively deducting them from your earnings for the year. The same procedure applies for limited liability company members, if the LLC has not elected to be treated as a corporation for income tax purposes.
The base document that the owner of a C corporation uses to account for oil and gas exploration expenses is Form 1120, which is the income tax return for corporations. However, the supporting documents that go with a Form 1120 can be complex and are not necessarily standard IRS forms.
When you pump oil or natural gas out of a piece of property, you are also gradually depleting the value of the property over time. The IRS allows the property owner to deduct an approximation of the reduced value of the land through a depletion allowance. Chapter 9 of IRS Publication 535, Business Expenses, gives detailed information on the different methods of claiming depletion. Non-corporations will generally file a Schedule E, Supplemental Income (And Loss) forms, along with IRS Form 4562, Depreciation and Amortization, to account for depletion.
Net Operating Loss
When you have a large capital investment in the expectation of a payoff in future years, you will likely incur an operating loss in the early stages of the exploration. You can keep track of these losses and use them to offset profits in future years, using the IRS's net operating loss carry-forward rules. Corporations file a Form 1139, while non-corporations file a Form 1045 with the IRS to claim refunds or adjustments to income due to net operating losses.
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