PLR 200851017: drilling costs buried in a leases account became a deemed election, and the accountant's error undid it

Plain-English summary

A publicly owned oil and gas company spent its first three years buying producing properties. Buying an existing well is a purchase, so there were no intangible drilling costs to worry about. In the fourth year the business changed. The company began buying raw property without wells on it and drilling those properties itself, which generates intangible drilling and development costs, the non-salvageable spending on labor, fuel, supplies and site work that goes into getting a well down.

The bookkeeping did not change with the business. Development costs went onto the balance sheet in an account called "Oil and Gas Leases," the same account that had held purchases of producing properties. The company's tax professional looked at that account, read it as more of what it had always been, and left the costs capitalized. Two years of drilling costs sat there undeducted. The error surfaced only while the sixth year's return was being prepared, when the same professional noticed the leases account had jumped and traced the increase back through three years of drilling costs.

The trap is that doing nothing is itself a choice. Section 263(c) lets a taxpayer elect to deduct intangible drilling costs, and the regulation at section 1.612-4(d) makes the election by the simple act of claiming the deduction on the return for the first year such costs are paid or incurred. No form, no statement, no signature. The flip side is stated in the same place: a taxpayer who fails to deduct the costs is deemed to have elected to recover them through depletion instead. Silence locks in the opposite answer. By the time anyone noticed, the company had made a binding election it never knew it was making, by not filling in a line.

Relief came through the professional reliance safe harbor. Section 301.9100-3(a) grants an extension where the taxpayer acted reasonably and in good faith and the government is not prejudiced, and section 301.9100-3(b) deems a taxpayer to have acted reasonably and in good faith if they reasonably relied on a qualified tax professional, including one the taxpayer employs, and that professional failed to make the election or to advise the taxpayer to make it. The facts were built to fit: the company did not know an election was required and relied on its professional for tax elections. The Service found the requirements of sections 301.9100-1 through 301.9100-3 satisfied and granted 60 days from the date of the letter to make the election on an amended return, with a copy of the letter attached.

The reservation is unusually pointed. The Service expressly declined to say whether the taxpayer satisfies the requirements of section 263(c) at all. So the company received permission to make a late election without any assurance the election is one it is entitled to make. Whether these costs are intangible drilling costs, and whether this taxpayer holds the operating interest that the deduction requires, are left for examination.

One defect in the released document is left as issued. The header block was never filled in. It reads "[Third Party Communication:" with the following line "Date of Communication: Month DD, YYYY]," leaving the template's own placeholder text and its square brackets in the published release, where other letters in this series carry either an actual date or the words "None" and "Not Applicable."

Ruling snapshot

• Question: May an oil and gas developer get an extension of time to elect under section 263(c) to deduct intangible drilling costs, where its tax professional mistook the costs for purchases of existing properties, left them capitalized in a leases account, and thereby triggered the deemed election to recover them through depletion?
• Outcome: Approved. The requirements of sections 301.9100-1 through 301.9100-3 were satisfied, including the safe harbor for reasonable reliance on a qualified tax professional who failed to make or advise the election. An extension of 60 days from the date of the letter was granted to make the election on an amended return. No opinion was expressed on whether the taxpayer satisfies the requirements of section 263(c).
• Key authorities: IRC section 263(c); Treas. Reg. sections 1.612-4 and 1.612-4(d), 301.9100-1(a) and (c), 301.9100-2, and 301.9100-3(a), (b) and (d).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200851017 [Third Party Communication:
Release Date: 12/19/2008 Date of Communication: Month DD, YYYY] Person To Contact: Index Number: 263.16-00, 9100.00-00 ------------------- , ID No.------------- Telephone Number:
--------------------
------------------ Refer Reply To:
----------- CC:PSI:B06
------------------------------------------------- PLR-125585-08
--------------------------------------- Date:
------------------------------------------- September 10, 2008

LEGEND

Taxpayer = -------------------------------------------------
------------------------
State = ------------
Date = -------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Year 6 = -------
Year 7 = -------

Dear ----------:

This responds to a letter dated -----------------------, from Taxpayer’s representative requesting permission, under § 301.9100-1(a) of the Procedure and Administration Regulations for an extension of time to make an election under § 263(c) of the Internal Revenue Code.

According to the submission, Taxpayer is a publicly owned corporation incorporated in State on Date. Taxpayer develops and sells oil and gas properties. During the years Year 1 through Year 3, Taxpayer was buying existing oil and gas properties and did not incur any intangible drilling costs (IDC). In Year 4, Taxpayer started purchasing property without existing wells and developing these properties. All these development costs were shown on the balance sheet under the account “Oil and Gas Leases” for Year 4 and Year 5. Believing the “Leases” account to be expenditures for existing oil and gas wells as in previous years, Taxpayer’s qualified tax professional did not deduct any IDC capitalized into the Leases account for Year 4 and Year 5. While preparing the Year 6 return in Year 7, Taxpayer’s qualified tax professional noticed a substantial increase in the “Leases” account for Year 6 and discovered that the “Leases” account included IDC from Year 4, Year 5, and Year 6. Taxpayer was not aware that an election was required in order to deduct the IDC and relied on its qualified tax professional to make any elections relating to tax matters.

Section 263(c) provides an election, under regulations prescribed by the Secretary, to deduct intangible drilling and development costs. The regulations appear under § 1.612-4. Section 1.612-4(d) states that the election may be exercised by claiming IDC as a deduction on the taxpayer’s return for the first taxable year in which the taxpayer pays or incurs such costs. No formal statement is necessary, but if the taxpayer fails to deduct the IDC, it is deemed to have elected to recover such costs through depletion.

Under § 301.9100-1(c), the Commissioner in exercising the Commissioner’s discretion may grant a reasonable extension of time under the rules set forth in
§§ 301.9100-2 and 301.9100-3 to make a regulatory election, or a statutory election (but no more than six months except in the case of a taxpayer who is abroad), under all subtitles of the Code, except subtitles E, G, H, and I.

Sections 301.9100-2 and 301.9100-3 provide the standards the Commissioner will use to determine whether to grant an extension of time to make a regulatory election. Section 301.9100-1(a).

Section 301.9100-2 provides automatic extensions of time for making certain elections. Section 301.9100-3 provides extensions of time for making elections that do not meet the requirements of § 301.9100-2.

Requests for relief under § 301.9100-3 will be granted when the taxpayer provides the evidence (including affidavits described in § 301.9100-3(d)) to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. Section 301.9100-3(a). Section 301.9100-3(b) provides, in relevant part, that a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.

Based solely on the information submitted and the representations made, we conclude that the requirements of §§ 301.9100-1 through 301.9100-3 have been satisfied. Accordingly, Taxpayer is granted an extension of time of 60 days from the date of this letter to make the election on an amended return to deduct IDC with the appropriate service center. A copy of this letter should be attached to the amended return. A copy is enclosed for that purpose.

Except as specifically set forth above, no opinion is expressed concerning the federal tax consequences of the facts described above under any other provision of the Code and the Regulations thereunder. Specifically, no opinion is expressed concerning whether Taxpayer satisfies the requirements of § 263(c).

This letter ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this ruling letter is being sent to your authorized representative.

Sincerely,

Curt G. Wilson
Deputy Associate Chief Counsel
(Passthroughs and Special Industries)

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