Oil & Gas IRS Audit Issues for Texas Taxpayers

Texas is the heart of American oil and gas production, and the tax rules governing this industry are among the most complex in the Internal Revenue Code. Depletion deductions, intangible drilling costs, working interest passive activity rules — these are all fertile ground for IRS scrutiny.

Depletion Deductions

The depletion deduction allows oil and gas producers to recover the cost of depleting a natural resource. There are two types: cost depletion (based on actual costs) and percentage depletion (a fixed percentage of gross income from the property). Independent producers and royalty owners can use percentage depletion even after costs are fully recovered — a significant tax benefit that the IRS watches closely for abuse.

Intangible Drilling Costs

Intangible drilling costs (IDCs) — labor, fuel, and supplies used in drilling — can generally be deducted in the year incurred rather than capitalized. This is one of the most valuable deductions in the oil patch. The IRS scrutinizes whether costs are properly classified as intangible versus tangible, and whether the deductions are taken in the correct year.

Working Interest vs. Royalty Interest

Working interest owners bear the costs of production and are generally not subject to passive activity loss rules — meaning losses can offset other income. Royalty interest owners are passive investors and are subject to the passive loss rules. The IRS examines whether taxpayers are correctly classifying their interests and whether the material participation rules are being properly applied.

What to Do If You Are Audited

Oil and gas audits are document-intensive. You need complete records of all well costs, production records, royalty statements, and the legal documents establishing your interest in each property. Do not respond to an IRS audit notice without representation. The issues are too complex and the stakes too high.

Our office has experience with IRS oil and gas audits. We understand the industry and we know how to present the documentation to defend legitimate deductions.

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