Like depreciation, depletion is an accounting item that is the allocation of costs associated with utilizing assets to generate revenue. Where the two differ is that unlike depreciation, which allots an expense associated with a physical asset such as equipment, depletion allots an expense associated with the extraction of natural resources. The process of mining natural resources entails bringing machinery to the extraction site, drilling into the ground and extracting it to the surface for sale or use.
With depreciation, it is easier to ascertain the useful life of the asset at hand and match it with the revenue that will be generated from the asset. Depletion, on the other hand, requires a less precise estimate. The Internal Revenue Code (IRC) Sections 611 and 613 provide two different methods one can allocate depletion: cost depletion or percentage depletion.
Cost depletion is determined using the adjusted cost basis of the asset. When a taxpayer purchases the rights to a site, which he believes holds valuable natural resources, he estimates the amount of resources under on site. He would then take his adjusted basis (purchase price) and divide it by the estimated amount of resources to be recovered. This calculates the cost per unit that can be deducted when each unit is ultimately sold to another party.
Unlike cost depletion, percentage depletion ignores the adjusted basis of the site in calculating depletion. Rather, this method uses specified percentages provided by the Internal Revenue Code. These percentages dictate the amount of expense allocated to a sale. The percentages range from 5 to 22 percent based on the types of resources being extracted. The 5 percent category includes, but is not limited to: gravel, sand, and stone.
These percentages are multiplied by gross income on the sale of the resource. One important provision of percentage depletion is that in no event may the deduction exceed 50 percent of the taxable income from the property before the depletion. Even given this limitation, percentage depletion has one major advantage over cost depletion: it is possible to claim aggregate depletion deductions that exceed the original purchase price of the site. That means we get a deduction even after we have expensed the entire basis.
For example, if a taxpayer purchases the rights to a mineral interest for $1,000,000, he cannot only deduct the full purchase price, but additional deductions provided by the percentage depletion method. Thus, as long as the taxpayer is generating income from the site, he gets a percentage of that income as a deduction from income even after the full $1,000,000 cost basis is expensed to $0. This gives pit owners a “free” deduction every year. Under cost depletion, the taxpayer may in no circumstance write off more than his $1,000,000 purchase price.
Congress enacted the percentage depletion method to incentivize taxpayers to invest in the development of natural resources. Unfortunately for taxpayers, the introduction of the Alternative Minimum Tax (AMT) effectively took back this benefit to raise taxes.
In accordance with IRC Section 57(a)(1), the depletion deduction taken, over the adjusted basis of the site, is added back as a preference item to AMT. In instances where percentage depletion is utilized, a taxpayer would have a smaller regular tax liability compared to use of cost depletion. However, the AMT addback would result in an additional tax liability due to AMT being higher than their regular tax liability. This renders percentage depletion less effective.
Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act is the biggest change to the Internal Revenue Code since 1986, with most provisions effective January 1, 2018. Included in the provisions are significant changes to AMT. For C-Corporations, AMT has been entirely eliminated. This means that companies will not be negatively affected by taking percentage depletion over cost depletion due to AMT.
For pass-through entities (S-Corporations and Partnerships), the percentage depletion addback is still applicable as Individual AMT. However, the phaseout thresholds have been increased significantly. Pass-through shareholders will be less likely to be subject to AMT, which is why percentage depletion will bring them regular tax benefits without diminishing them through AMT addbacks.
The new tax law has given pit owners tremendous benefits; please do not miss the tax savings available.
For over 40 years, Dannible & McKee, LLP has worked with clients engaged in mining activities whether it be for construction material, gravel, or stone. Throughout that time, we have utilized percentage depletion to minimize our client’s regular tax liability while minimizing AMT. This synopsis highlights only one of the important initiatives taxpayers must take in order to minimize their Corporate and personal tax liabilities. With the newly enacted Tax Cuts and Jobs Act, it is more important than ever to understand the tax implications that effect anyone involved with extracting natural resources.
Joseph A. Hardick, CPA, CCIFP is a Tax Partner with Dannible & McKee, LLP, a Syracuse, NY based public accounting firm with more than 90 professionals has been providing services to the construction industry since its inception in 1978. You may contact him at (315) 472-9127 or visit the firm online at www.dmcpas.com.