What expense category is Intangible Drilling Costs?

For businesses in the oil and gas industry, the costs associated with developing a well are substantial. The IRS categorizes these costs into two main types: tangible costs for equipment and intangible costs for labor and services required for drilling. These Intangible Drilling Costs (IDC) have a unique and favorable tax treatment.

While most costs of creating a long-term asset must be capitalized and recovered slowly, the IRS allows businesses to make a special election to deduct Intangible Drilling Costs immediately. This guide explains what qualifies as Intangible Drilling Costs, the tax choices available, and how to track these critical expenditures for compliance.

Intangible Drilling Costs (Intangible Drilling Costs) Expense Category

Ordinarily, the costs of developing an oil, gas, or geothermal well are capital expenditures. However, IRS Publication 535 gives businesses the option to elect to deduct Intangible Drilling Costs as a current business expense.

Intangible Drilling Costs are not a pre-defined line item on tax forms. If you elect to deduct them currently, they are reported under Other expenses on your business tax return (e.g., Schedule C for a sole proprietor). If you choose not to deduct them, they are capitalized and recovered through depletion or depreciation.

Important Considerations When Classifying Intangible Drilling Costs

The rules for Intangible Drilling Costs are highly specific to the oil and gas industry.

What Qualifies as an Intangible Drilling Cost?

The deduction for Intangible Drilling Costs applies only to costs for items that have no salvage value. As defined in Publication 535, this includes expenditures for:

• Wages, fuel, repairs, hauling, and supplies related to drilling wells and preparing them for production.
• The cost of any drilling or development work done by contractors.

This does not include the cost of tangible assets, such as pipes, pumps, or tanks, which must be capitalized and depreciated over time.

The Election is a One-Time Choice

You must make the election to deduct Intangible Drilling Costs as a current expense on your tax return for the first tax year you have eligible costs. Once you make this election, it is binding for that year and all future years. If you do not make the election in that first year, you must capitalize all your Intangible Drilling Costs.

Domestic vs. Foreign Intangible Drilling Costs

The option to deduct Intangible Drilling Costs currently applies primarily to wells located in the United States. Publication 535 states that you generally cannot deduct Intangible Drilling Costs for wells located outside the U.S. Instead, foreign Intangible Drilling Costs must be either:

• Included in the adjusted basis of the well for depletion purposes; or
• Deducted over a 10-year period.

Examples of Intangible Drilling Costs

Deductible as Intangible Drilling Costs:

• Wages are paid to the drilling crew.
• The cost of fuel and supplies consumed during the drilling process.
• Payments to a third-party contractor for drilling services.
• Costs for preparing the well site for drilling.

Not Intangible Drilling Costs (Must be Capitalized):

• The cost of the physical drilling rig.
• Casing, tubing, and pumps.
• Storage tanks and treatment equipment.

Tax Implications and Reporting

Businesses have two primary choices for the tax treatment of their domestic Intangible Drilling Costs.

1. Deduct as a Current Expense: You can elect to deduct all eligible Intangible Drilling Costs in the year they are paid or incurred. This is the most common choice as it provides an immediate tax benefit.
2. Capitalize and Recover: If you do not elect to deduct Intangible Drilling Costs, you must capitalize them. You can then recover these costs through annual depletion or depreciation deductions. Publication 535 also notes an option to amortize capitalized Intangible Drilling Costs over a 60-month period.

How to Report the Deduction

• Making the Election: You make the election simply by taking the deduction on your income tax return for the first year you have Intangible Drilling Costs. No special statement is required.
• Reporting on Schedule C: For a sole proprietor, the deducted Intangible Drilling Costs are reported under Part V, Line 27a, Other expenses.

How Fyle Can Automate Tracking for Drilling Costs

Fyle provides a robust platform to manage the high-value invoices and project costs associated with drilling a well, ensuring every expense is captured and documented for tax purposes.

• Track Well-Specific Costs: Use Fyle's project tracking to assign every Intangible Drilling Costs invoice and payment to a specific well or drilling project.
• Centralize Contractor Invoices: Have drilling contractors and suppliers email invoices directly to Fyle for automatic data capture and organization.
• Create a Clear Audit Trail: Fyle maintains a complete, unalterable record of all payments, contracts, and invoices for each well.
• Automate Your Accounting: Sync categorized Intangible Drilling Costs directly to the proper expense or capital asset account in QuickBooks, Xero, NetSuite, or Sage Intacct.