I’m going to post this now, because I have another post that will need to link back to it several times. This is a bit of economics, a subject I have never studied, but when did that ever stop me from writing about something?
Students probably get this stuff the first year studying economics, but the subject is not taught so much in the public school system, and some of the concepts are hazy to most of us. This is apparent from conversations I have observed and also from many postings on Facebook and elsewhere. Here it is:
In the United States, suppose you are a wage earner, and let’s say you make $100,000 a year. Good for you. You have to pay the federal government taxes on all of that on a percentage basis. Not quite. They government will allow you to whack off a piece of that before you apply the percentage factor. How much you get to whack off depends. Depends on whether you have dependents. And medical expenses. And non-refunded employee expenses. Then you apply the percentage, and pay that amount.
Now suppose you are not a human being, but you are instead a company doing business. You, the company, take in $500,000 in a year. You do not have to apply the percentage to the full amount. You only apply the percentage to the business profit. How do you compute business profit? Glad you asked:
- $500,000 gross revenues
- – salaries and other employee expenses
- – the electric bill for the entire year
- – cost of goods used in the business
- – all other costs of doing business
If all the minuses are equal to the gross revenues, you pay nothing. If you were a human being your breakdown would be something like this:
- $100,000 gross income
- – food
- – clothing
- – rent
- – cash dropped at the strip club
If your minuses equal your gross income (less the allowed deductions) you still owe the government money. There’s a benefit in operating like a business. In its wisdom the government does allow individuals to operate as businesses.
In its magnificent spirit of fairness, the government gives companies some slack. Some years their balance sheet will show red. They get to apply business losses in bad years against profits in other years.
So, you want to go into business. You need a store. You build a store. It costs money. You tell the government you didn’t make a profit, because you spent all your revenues building the store.
The government responds with a nice letter reminding you that you spent all that money (a minus) to build a store, but you now have the store (a plus) that offsets your minus for building it. You cannot deduct the cost of the building in the first year of business.
What the government will do is allow you to amortize the cost of the store over a period of years. You know about this if you are a home owner who has a house to rent out. You can amortize the cost of the house over 30 years and deduct 1/30 the cost of the house each year you have it rented. There’s more to this story, but this is all that’s important.
Let’s take the curious case of the depletion allowance used by oil companies:
Percentage depletion To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. The rates to be used and other conditions and qualifications for oil and gas wells are discussed later under Independent Producers and Royalty Owners and under Natural Gas Wells. Rates and other rules for percentage depletion of other specific minerals are found later in Mines and Geothermal Deposits.
Cost depletion Cost depletion is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset. Cost depletion is computed by (1) estimating the total quantity of mineral or other resources acquired and (2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period. For example, Big Texas Oil, Co. discovers a large reserve of oil. The company has estimated the oil well will produce 200,000 barrels of oil. The company invests $100,000 to extract the oil, and they extract 10,000 barrels the first year. Therefore, the depletion deduction is $5,000 ($100,000 X 10,000/200,000).
Cost depletions sounds reasonable enough. A company invests $100,000 to set up a business (oil extraction from a field). It gets to amortize the costs over several years, as it recoups the cost by extracting and selling oil. Of course, the company also gets to deduct all other costs, such as operation of the wells, royalties paid to owners of the mineral rights, local taxes paid and also the cost of exploring barren fields, which have ended up producing no oil.
Percentage depletion is another matter. Here is additional clarification:
The percentage, or statutory, method does not employ recovery of cost in the computation of the deduction. A percentage of annual income, rather than cost, is deductible each year, even if the owner has recovered all cost or discovery value of the depletable asset. The federal tax laws vary from year to year in regard to the percentage depletion allowable for oil and some other deposits, and the categories of producers entitled to such allowances.
This is the curious part. Even after an oil company has recouped all it’s development cost, it can continue to take a tax deduction for every barrel of oil it extracts. That is so neat. How wonderful it would be if I had cancer, and I had to pay $100,000 out of pocket expenses for the cure, and I got to deduct all the $100,000 from my earnings when filing my income tax return. Then if I were still not feeling so good, I would be able to deduct money year after year, because the cure was not complete. That does not make much sense, and neither does the oil depletion deduction described above.
This is from a story a few years back on CNN:
The percentage depletion allowance: This lets oil companies deduct about 15% of the money generated from a well from its taxes. Eliminating it would save about $1 billion a year.
The deduction essentially lets oil companies treat oil in the ground as capital equipment. For any industry, the value of that equipment can be written down each year.
But critics say oil in the ground is not capital equipment, but a national resource that the oil companies are simply using for their own profit.
The foreign tax credit: This provision gives companies a credit for any taxes they pay to other countries. Altering this tax credit would save about $850 million a year.
Foreign governments can collect money from oil companies through royalties — fees for depleting their national resources — and income taxes.
A royalty would be deducted as a cost of doing business, and would likely shave about 30% off a company’s tax bill. Categorized as income tax, it is 100% deductible.
Foreign governments long ago grew wise to the U.S. tax code. To reduce costs for everyone involved and attract business, they agreed to call some royalties income taxes, allowing oil companies to take the 100% deduction on a bigger slice of their bill.
Intangible drilling costs: This lets the industry write off about $780 million a year for things like wages, fuel, repairs and hauling costs.
All industries get to write off the costs of doing business, but they must take it over the life of an investment. The oil industry gets to take the drilling credit in the first year.
And that’s the story. Make sure you understand all of this, because I’m going to link back to it when I post a recent interview with my favorite congresswoman, Michele Bachmann of Minnesota.