Cutting Your Tax Bill by Thinking Outside the Box

By Marshall H. Dean J.D., MBA, Tuesday, February 28th, 2012

This year’s tax free date will be May 7, and despite personal needs we at Alliance Affiliated Equities Corp. work every day until then just to cover federal income taxes. Because I believe our government has become overgrown and wasteful, it is my goal to give you ideas to help you reduce the number of days worked each year for Uncle Sam.

Most people know and use basic tax planning tools, such as maximizing your 401(k)/IRA contributions and deducting the interest on your mortgage. However, most investors are not aware of the significant tax planning tool provided by the tax code from investing in domestic oil and gas drilling programs.

Under Tax Code Section 469(c)(3)(B) investors in a domestic oil and gas drilling program can deduct intangible drilling costs (IDCs), which are often 80% to 90% of the invested amount in the first year. A diversified oil and gas program will have a multitude of wells in it to spread out risk, much like a mutual fund having many stocks.

With the development of horizontal shale drilling and oil prices over $100 per barrel, many diversified developmental drilling programs are providing very attractive returns. Properly structured drilling programs can provide solid investment returns from tax savings and monthly or quarterly cash flow distributions. In addition, these types of investments can be used to shelter IRA/401(k) withdrawals from income tax and provide a long-term partially tax-sheltered monthly or quarterly revenue stream from reinvestment of the funds withdrawn from a retirement account.

In today’s environment my recommendation is to invest in oil and “gas liquids” drilling programs for the following reasons:

— Hydraulic fracing, horizontal drilling and other technological advances have made drilling more attractive than ever. In addition to the front-end tax savings, a successful program should generate monthly cash flow from the sale of oil for years to come. Approximately 25% of your monthly cash flow is sheltered from income tax by the energy depletion allowance.
— The demand side for oil and gas liquids is likely to stay steady for years to come. As BP Chief Executive Bob Dudley said “Oil will remain the dominant transport fuel and we expect 87 percent of transport fuel in 2030 will still be petroleum based,”

When making this type of investment there are five things to look for in the programs you evaluate.

1. Invest in a program that pools your capital with other investors so that the program can drill a number of developmental oil wells. Developmental oil wells are wells drilled in an existing oil and gas field and are not exploratory wells. A multi-well developmental drilling program makes your investment less dependent on the outcome of a single well.

2. Make sure the company you are investing with is invested in the program too. This insures the company has hard assets tied up in the outcome of your drilling program.

3. Look for drilling programs where at least 80% of your investment is allocated to intangible drilling cost. Intangibles are 100% deductible in the year of the investment, while tangible drilling costs are amortized over seven years. In this example you would receive a first year deduction of 80% of your investment against taxable income.

4. Compare the drilling cost and monthly operating fees between programs and the long-term track record for delivering cash flow to the investors on a monthly basis.

5. I would avoid “dry gas” drilling programs due to the current (and foreseeable future) low price for dry natural gas. Look for oil or “gas liquids” programs to invest in.

People who have invested in oil drilling programs with reputable companies over the past few years have, in many cases, significantly outperformed the stock and bond markets. Many oil drilling programs we have reviewed have returned 30% to 50% of the investor’s gross investment in cash over the past 24 months — this equates to a 60% to 100% cash return on the investor’s after-tax investment.

Those of you who make this investment now will benefit once again if oil prices remain steady over the next five years. In addition, you will be helping the U.S. reduce our dependence on foreign oil by increasing the domestic supply of oil and gas.

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Marshall H. Dean J.D., MBA, is a registered representative at Alliance Affiliated Equities Corporation, a FINRA-registered broker/dealer specializing in the evaluation and acquisition of alternative investments. He invites questions and comments at (913) 428-8278 or marsh@aaeconline.com.