Oil & gas tax shelters as an asset class

As investors become more sophisticated, a new asset class labeled "Alternative Investments" has become routine when diversifying portfolios. These include such assets as real estate, precious metals and oil and gas.

Let's look at oil and gas "tax shelters." These are usually marketed by stockbrokers or other financial advisors and structured as Limited Partnerships (LP) or Limited Liability Companies (LLC). Once funds are contributed, a net amount is expended to drill wells. The investor is now essentially "in the oil business" and, as the wells come on line and begin producing revenue, distributions are made.

This strategy has been useful for taxpayers in the top tax brackets or those with an unusual tax event that creates a large amount of income in one year. Benefits can include: reducing current income taxes, sheltering future income, reducing self-employment tax, offsetting earned income to protect loss of social security benefits, reducing estimated payments, qualifying for Roth IRA conversions or contributions, qualifying for college tuition credits and diversifying your portfolio.

The tax sheltering effect occurs in two ways. Most drilling costs are deductible in the first year. When deals are properly structured for tax purposes, tax deductions flow to investors and reduce their tax liabilities. Once wells begin producing, depletion and depreciation deductions result in investors paying tax on less income than they receive. These investments are often structured to reduce the investor's self-employment income.

Obviously, this can't be as good as it sounds, so what's the catch? Basically, the investor is still in the oil business. There are risks inherent in exploring for oil and gas, even when pursuing "low risk" prospects. Here is my list of things to consider, based on many years of experience with these investments.

1. Invest with someone with a good track record. Seek out former investors and ask if they were treated fairly.

2. Read the Risk Factors. Most public programs have a section in the offering materials that discloses various risks associated with an investment. Although these are often overstated due to liability concerns, they are real and you should be familiar with them.

3. More wells are better than less. The more wells to be drilled in the project, generally speaking, the less risk you assume.

4. Be aware that these investments are illiquid. There can be a secondary market, but deep discounts are common, so these investments should be viewed as long-term, illiquid investments.

5. If one of your primary reasons for investing is tax savings, ask your tax advisor to prepare a tax projection. Sometimes unexpected outcomes arise once you run the numbers. Beware of the Alternative Minimum Tax.

6. Inquire about liability insurance. Often, tax benefits depend upon taking additional risk during drilling. You should make sure that this risk is minimized by the organizer's insurance coverage.

7. Review the Historical Summary. Many times offerings to the general public are required to disclose the amounts invested and amounts returned to investors for previous programs. Review these so you have a realistic understanding of expected cash flows from the investment.

8. These investments will complicate your tax return and possibly delay filing. Tax information for oil and gas investments is often not available until the middle or end of March. Also, in some cases, you could be required to file a tax return in another state.

Investing in oil and gas can produce great rewards, so you can expect associated risks. However, if you do your homework and invest with your eyes wide open, you should be able to eliminate some of the surprises and improve your chances of success.

Mike Shaw is a CPA and tax partner with Dennis, Gartland & Niergarth, where he leads the firm's seven member Oil & Gas Industry Team. He is also a licensed financial advisor; mshaw@dgncpa.com.