Depletion- What Is It and When Is It Available?

Overview

Depreciation is a familiar concept to a farmer or rancher.  It’s an allowance for the wear-and-tear over the life of an asset that is used (for a farmer) in the business of farming.  But what is depletion?  It’s conceptually similar to depreciation.  In tax “lingo” it’s a deductible allowance for the exhaustion of mineral deposits, timber and other natural resources.  If a taxpayer has an economic interest in the resource, the cost of the diminishing resource can be recovered through the depletion allowance.

Depletion – it’s the topic of today’s blog post.

In General

The depletion allowance is claimed either on a cost-per-unit basis or as a percentage of gross income from the disposal of the resource.  I.R.C. §611.  Cost depletion allocates to each unit of production a pro rata portion of the original cost or investment in the resource. In general, the total projected number of units in the deposit or timber tract (tons, barrels, boardfeet, etc.) is divided into the cost of the resource to obtain the amount of cost which should be deducted for each unit of production sold.  I.R.C. §612.  Cost depletion is required for timber.  See IRS Pub. 535.

Percentage depletion is applicable to all minerals.  With percentage depletion, a flat percentage of the gross income from the property each year is treated as the depletion deduction to allow the taxpayer to recover the cost of the minerals/resources.  The percentage depletion rates are set forth in the statute. I.R.C. §613(b).  The percentage figures range from a top of 22 percent for deposits in the United States of sulphur and uranium (and other specified elements such as bauxite and nickel), to 5 percent for clay that is used or sold for use in the manufacture of drainage and roofing tile, flower pots, and kindred products.  Id. 

The taxpayer has the choice of using the higher of cost depletion or percentage depletion and may make the choice each year.  However, special rules apply when the predominant property (by value) is hydrocarbon gas.   Another point to remember is that the depletion deduction under the percentage depletion method cannot exceed 100 percent of the taxable income from the property computed without the deduction for depletion.  

As noted above, percentage depletion is allowed to one who has an “economic interest” in the minerals in place.  That generally means that it is available to an owner or lessee.  But what if the lessor can terminate the lease on short notice?  In that situation does the lessee still have an economic interest entitling the lessee to a deduction for percentage depletion?  That question was answered in United States v. Swank, 451 U.S. 571 (1981).  In that case, the lessor owned a coal mine and leased the unmined coal (e.g., mineral interest) to lessees in exchange for a fixed royalty per ton based on the sale of the mined coal at prices the lessee would determine.  The lessee mined the coal over an uninterrupted period of several years and the proceeds of the sale of the coal were the only revenue from which the lessees recovered royalties that were paid to the lessors.  The lessor had the right to terminate these leases with 30 days' notice.  But, that termination right was never exercised.  The lessee sought to claim a percentage depletion deduction for the cost of the mined coal. The IRS claimed that the lessee should not have been allowed to take a percentage depletion allowance because the lessor had the right to terminate the lease on short notice.  That termination right, the IRS asserted, deprived the lessee of an economic interest.  The trial court disagreed with the IRS and the U.S. Supreme court affirmed.   The mere existence of the unexercised right to terminate leases did not destroy the lessee’s economic interest in the leased mineral deposits.  A deduction based on percentage depletion of the coal deposit was proper.  See also Rev. Rul. 83-160, 1983-2 C.B. 99; and FSA 1999-927 (date redacted).  

The impact of the U.S. Supreme Court opinion in Swank, is that a when a farmer leases a mineral deposit to a lessee to extract the minerals, the farmer should have little trouble in being able to claim a deduction for depletion based on an application of a percentage to the gross royalties received.  The tax issues get more complex, however, if the farmer become the operator of the mineral deposit. 

Depletion of Soil

Soil, sod, dirt, turf, water and mosses are not included within the terms “all other minerals” for purposes of claiming 14 percent percentage depletion.  I.R.C. §613(b)(7)(A)-(C).   However, soil in place can be subject to depletion under the cost method.  Rev. Rul. 78, 1953-1 C.B. 18.  While no depletion allowance is generally allowed for sod, a federal district court in Florida has held that sod was a natural deposit and that the removal of the grass resulted in a loss of the soil for which a depletion allowance could be claimed.  Flona Corp. v. United States, 218 F. Supp. 354 (S.D. Fla. 1963).  Likewise, cost depletion of topsoil is allowed to a taxpayer upon the sale of sod and balled nursery where the taxpayer can establish that each cutting removed some part of the natural deposit.  Rev. Rul. 77-12, 1977-1 C.B. 161, revoking Rev. Rul 54-241, 1954-1 C.B. 63.

Other points on soil.  Soil presents some interesting depletion questions.  Here are a few of the more common ones:

• If a mineral or natural resource deposit is continuously replenished by the decomposition of other plants, no depletion is available. See, e.g., Rul. 79-267, 1979-2 C.B. 243.
• Loam is a natural deposit subject to depletion, but not percentage depletion. Rul. 79-411, 1979-2 C.B. 246.
• “Peat” is eligible for percentage depletion at a 5 percent rate, but various types of “moss” are not. See, e.g., I.R.C. §613(b)(7)(A).   
• Peat moss is subject to a percentage depletion allowance of 5%. The question, then, is the point at which moss becomes peat moss. 
• Peat moss must actually be extracted rather than merely subside. See, e.g., A. Duda & Sons, Inc. v. United States, 560 F.2d 669 (5th Cir. 1977), rev’g., 383 F. Supp. 1303 (M.D. Fla. 1974).

Depletion of Timber

The sale of standing timber typically triggers capital gain for a farmer-seller.  The tax basis in the timber can be recovered either through depletion or by an offset against the selling price.  But, if the income from a timber sales is reported as “Other income…” on Schedule F, timber depletion should be claimed in order to preserve the basis.  Alternatively, if the income from timber sales is reported as an item purchased for resale, depletion on the timber should be listed as the cost (or other) basis.  There is no line on Schedule F for depletion.  That means that the taxpayer will have to indicate how the depletion was computed.  The taxpayer should complete Form T to show the depletion computation.

Depletion of Groundwater

In some parts of the country, the IRS permits a depletion allowance for water deposits in an aquifer beneath the surface.  In portions of the Ogallala formation which runs through Western Nebraska and Kansas, Eastern Colorado, part of New Mexico and the panhandles of Oklahoma and Texas, taxpayers are permitted to claim a depletion deduction for water.  In these areas, the water is being pumped at a level exceeding the recharge rate for the underlying aquifer.  The IRS permits a depletion allowance on water in these areas where it can be shown that the rate of recharge in the underlying aquifer is extremely low.  In 1965, the Fifth Circuit Court of Appeals held that groundwater in the Ogallala formation in the Southern High Plains of Texas and New Mexico was a depletable mineral and natural deposit. United States v. Shurbet, 347 F.2d 103 (5th Cir. 1965).

The IRS stated that it would follow this case, but that it would limit the application of the rule to situations similar to those in the Southern High Plains of Texas and New Mexico where water is extracted from the Ogallala formation.  Rev. Rul. 65-296, 1965-2 C.B. 181.     

In late 1982, IRS announced a broadening of the rule in Shurbet to areas where it could be demonstrated that the groundwater is being depleted and that the rate of recharge is so low that, once extracted, the “groundwater would be lost to the taxpayer and immediately succeeding generations.”  Rev. Rul. 82-214, 1982-2 C.B. 115.

Depletable Property Held by an Estate or Trust

 For mineral or timber property held in trust, the allowable deduction for depletion is to be apportioned between the income beneficiaries and the trustee on the basis of trust income from the property allowable to each unless the governing instrument allows the trustee to maintain a reserve for depletion.   If the trust instrument or local law requires or permits the trustee to maintain a reserve for depletion, however, the allowance may be allocated first to the trustee to the degree that income is placed in the depletion reserve. Any excess amount is apportioned between the income beneficiaries and the trustee on the basis of the trust income allocable to each. Rev. Rul. 60-47, 1960-1 C.B. 250; Regs. § 1.611-1(c)(4).  Rev. Rul. 61-211, 1961-2 C.B. 124, modified by Rev. Rul. 74-71, 1974-1 CB 158, governs the situation if the trust or estate is entitled to a portion of a depletion deduction from a partnership or another estate or trust.  See also Rev. Rul. 66-278, 1966-2 C.B. 243.

Conclusion

While depreciation is a commonly understood concept, depletion is less understood in its application.  But, the point remains that a tax deduction may be available for the exhaustion of mineral deposits, timber and other natural resources.

Note:  There won't be any postings next week in light of the Christmas holiday.  To all of the blog post readers, may you and your family have a very Merry Christmas!  Postings will resume on Dec. 31.