After looking at depreciation and amortization,

we will now conclude the topic of cost recovery with depletion.

Depletion is conceptually similar to depreciation and amortization,

and it will be recovering the cost of our business

used assets through deductions over time.

With depletion, we're simply referring to

cost recovery related to natural resources like oil,

gas, and minerals, but not simply land itself.

The general approach here, is to calculate

the annual depletion expense under two methods:

the cost depletion method or

the percentage depletion method and then deduct the larger of the two.

So, let's take a look at each of these depletion methods.

First, the cost depletion method.

This is basically a straight line method,

except instead of using years as the denominator,

we'll use units as the denominator.

In particular, the depletion rate per unit is the basis in the natural resource,

divided by the estimated recoverable units of the natural resource.

Units in this case can mean barrels of oil,

ounces of gold, carats of diamonds, and the like.

Then the deduction is simply the depletion rate per unit,

times the number of units sold in the year.

Notice, that this is the number of units sold during

the year and not the number of units produced during the year.

We'll continue deducting depletion,

only until all estimated units are sold.

The second depletion method is known as the percentage depletion method.

This is also rather straightforward,

in that it is computed using a statutory percentage rate for each resource type.

I've included them here,

but there are also available in the supplemental materials.

For example, cobalt, lead,

and nickel use a 22 percent rate, copper, gold,

and oil and gas use a 15 percent rate,

granite and marble use a 14 percent rate,

coal uses a 10 percent rate,

and gravel and sand use a five percent rate.

So, what do we do with these rates?

For the percentage depletion method,

the eligible deduction here is the lesser

of the percentage depletion rate from that exhibit,

multiplied by the gross income from the resource.

That is, the sales revenue from selling the natural resource,

or 50 percent of the taxable income before considering the depletion deduction,

or 100 percent of the taxable income before considering the depletion deduction,

if the natural resource is oil or gas.

So, just to put it all on one slide,

the actual depletion deduction that's claimed on the tax return,

is the greater of the cost depletion method or the percentage depletion method.

The cost depletion method is the depletion rate

per unit times the number of units sold during the year.

The percentage depletion method use the lesser

of the percentage depletion rate times the gross income from the resource,

or either half or all of the taxable income before the depletion deduction.

So, just to be aware that there's a greater

of clause here for the actual depletion deduction,

but an impeded lesser of clause within the percentage depletion method.

Now, one major nuance in calculating depletion,

is for oil and gas producers.

In particular, related to intangible drilling costs or IDCs.

These IDCs are costs related to making the property ready for drilling,

plus the cost of drilling for oil gas or geothermal wells.

The Internal Revenue Code allows these taxpayers

to either deduct the IDC costs immediately,

or capitalize them as an assets,

and then recover the cost through depletion over time.

That is, if the IDCs are capitalized,

the amounts were added to the properties basis for determining

cost depletion and the cost or expense over time through cost depletion deductions.

Usually, it's advantageous to simply elect immediately expense IDCs,

rather than capitalize them because it drives down taxable income in the current year.

But a good tax department will actually go through

the depletion deduction calculation shown on

the earlier slide to make sure they're making the right decision for their tax profile.

So, where does this capitalization issue come into play exactly?

Well, if we capitalize IDCs,

we need to increase the basis when we calculate the cost depletion method.

However, the capitalized IDCs won't affect

the percentage depletion method calculation at the bottom.

However, if the taxpayer decides to expense the IDCs,

then the cost depletion method on the top half of

the slide won't be affected because there won't be an increase in basis.

But, the calculation on the bottom half will be affected,

in particular the expense IDCs will reduce

the taxable income under the percentage depletion method.

This may be an issue because

the percentage depletion method uses a lesser of calculation.

So, 50 percent or a 100 percent of taxable income

that has been reduced by expensing IDCs,

will be a smaller number than 50 percent or a 100 percent of

taxable income that has not been reduced by expensing IDCs.

So, let's look at an example.

In the current year, Carmen acquires for $400,000 an oil and gas

property interests with 200,000 barrels of estimated recoverable oil.

During the current year, 10,000 barrels of oil are sold for $250,000.

IDCs amount to $100,000 and are expensed in the current year.

Other deductible business expenses are $50,000.

So, what's the depletion deduction that Carmen can take for the current year?

What is Carmen's taxable income after taking the depletion deduction?

Again, here's the complete formula for figuring out the depletion deduction for the year,

as the greater of the cost depletion method or the percentage depletion method.

First, let's look at the cost depletion method.

Here the cost depletion method is calculated as

the cost basis divided by the number of estimated recoverable units,

times the number of units sold during the year.

So, we have a $400,000 basis divided by 200,000 estimated barrels of oil,

times 10,000 barrels of oil sold, equaling $20,000.

Next, we look at the percentage depletion method,

which uses this lesser of calculation.

First, the percentage depletion rates.

Because it's an oil and gas resource,

from exhibit two we can see that oil and gas has a 15 percent depletion rate.

Now, what's the gross income from the resource?

Well, Carmen sold for oil in the current year for a total of $250,000.

The $250,000 is the gross income from the resource.

Therefore, to figure out the first part of this calculation,

we multiply 15 percent by $250,000.

Once we multiply that out, we get $37,500.

But, we now need to compare that to the taxable income.

Here, since we're talking about oil and gas,

we'll use the 100 percent rate.

Next, we need to figure out taxable income for the oil and gas property,

before considering the depletion deduction.

To figure out taxable income,

we basically take revenues minus expenses.

Our revenues are the $250,000 gross income from the sale of the oil,

we subtract out the expensed IDCs of a $100,000,

as well as the other deductible business expenses of $50,000.

This leaves us with taxable income of $100,000.

So, as you can see here,

we take the 100 percent rate and multiply it by the

$100,000 to obtain a $100,000 taxable income ceiling.

Now, the percentage depletion method requires us to use the lesser

of $37,500 or $100,000.

In this case, $37,500.

Finally, we compare the $37,500 under the percentage depletion method,

to the $20,000 under the cost depletion method,

and we take the greater of the two.

Therefore, the depletion deduction that Carmen can claim, is $37,500.