Capitalization of Prepaid IDCs: The Government Position on
Audit
By Professor Richard A.
Westin
University of Kentucky Law School, Lexington, KY
The tax law allows cash method taxpayers to prepay intangible
drilling costs (IDCs). At the same time, the IRS audit position
restricting that right is somewhat aggressive. The position appears in
the Audit Manual at I.R.M 4.41.1.2.4.5.1 (7/31/02). The question
presented here is how defensible the IRS audit position is,
considering the situation in the context of an actual audit.
The Internal Revenue Manual takes the position that a cash method
taxpayer can deduct prepaid IDCs if, and only if: (1) the prepayment
is made for a bona fide business purpose; (2) the prepayment does not
substantially distort income; (3) the drilling contract compels a
prepayment of the agreed amount, not just a deposit; (4) the
prepayment covers 100% of the operating interest; (5) the actual
drilling of the well began in the first part of the following year;
and, (6) some well site work was done before the end of the taxable
year. The IRM then cites Rev. Rul. 71-252, 1971-1 C.B. 146, and the
well known Keller decision to support the six part test, but it
does so in a hesitating way: “The Tax Court sustained parts
of the IRS position in Keller v. Commissioner, 79 T.C. 7
(1982).” (Emphasis added.) Revenue Agents' attention should be
drawn to this equivocation.
Requirement “(3)” is completely correct. Deposits are
not payments.
Items “(1)” and “(2)” are supported by
judicial authority. However, rule “(2)” against material
distortion of income is not a requirement of the tax law, but instead
is based on the IRS's administrative authority under §446(b) to
compel adjustments to taxpayers' returns in the discretion of the IRS.
However, once an audit has begun, the Revenue Agent is free to
exercise the §446(b) power and should be expected to do so, given
the position in the IRM.
Items “(4),” “(5)”and “(6)” are
pure inventions on the part of the IRS. The Keller decision,
which Revenue Agents are expected to rely on, depended on the first
three standards only. Item “(4)” is unclear, but seems to
mean that if some holders of working interests do not prepay, then the
test is not met. This seems unreasonable, and is unsupported. There
may be good reasons, especially lack of money, why some participants
would not prepay. Item “(5)” is a reasonable exercise of
discretion, but is not well supported in the sense that on given facts
there may be good reasons, such as geophysical issues or necessary
delays because the contractor has mired in problems with other wells,
for putting off drilling. The same considerations apply to
“(5).”
Finally, as to “(2)” and “(3)”, there is
authority to the effect that one should consider business purposes and
distortion together; for example, a major distortion may be offset by
the existence of compelling business standards. What the audit
guidelines fail to observe is that there is judicial authority for the
position that prepaid IDCs must generally be reasonable in amount.
To summarize this area, it is useful to know how the government
will deal with prepaid IDCs in an audit when arranging for prepaid
IDCs by cash method taxpayers, but the issue is more complex than
Agents may be aware. Bona fide prepayment arrangements that meet the
first two tests, using a balancing approach, and that call for
payments as opposed to deposits should feel reasonably confident of
coming out of the audit successfully, although it may not be until the
Appeals Conference, where the government's decision-making becomes
objective, that the taxpayer will succeed. In the interim, the
taxpayer is free to assert that the application of tests
“(4)”-“(6)” is unreasonable and may justify
recovery of costs.
For more information, in the Tax Management Portfolios, see
Baer, 605 T.M., Oil and Gas Transactions, and White, 570
T.M., Accounting Methods--General Principles, and in Tax
Practice Series, see ¶2620, Intangible Drilling and Development
Costs, and ¶3530, Methods of Accounting.
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