Percentage depletion is a tax deduction that helps independent producers and royalty owners account for the reduction of a nonrenewable mineral resource, such as oil, gold, and iron, and to recover the associated cost. Another option for calculating depletion is the cost depletion method. This deduction is very similar to depreciation but is specific to the natural resource industry.
Who Qualifies for the Percentage Depletion Deduction
Depletion can be claimed by individuals, corporations, estates, and trusts with an economic interest in an income-generating natural resource (except timber). If you possess any of the following types of economic interests, you may be eligible to take advantage of this extremely valuable tax saving tool.
- Royalty interest: A property interest that entitles the owner to receive a share in the production from the natural resource deposit
- Working interest: An investment interest where the investor is liable for the cost of production
- Net profit interest: A nonoperating interest where the investor shares in the gross income
How To Calculate Percentage Depletion
To figure out the percentage depletion deduction, you need to multiply the assigned depletion rate by your gross income from the property. In any year that you use percentage depletion, the total sum of the deduction cannot exceed 50% (100% for the oil and gas industry) of your taxable income. While the deduction has this limitation, it still leads to a huge tax savings.
Let’s review a few percentage depletion rates and learn which rate may apply to you.
Percentage Depletion Rates
| Item | Rate |
|---|---|
| 22% |
| 15% |
| 14% |
All other minerals, including, but not limited to:
| 14% ***The percentage is 5% for other minerals (other than slate tine 7.5% depletion category when used, or sold for use, by the mine owner or operator as rip rap, ballast, road material, rubble, concrete aggregates, or for similar purposes.*** |
| 10% |
| 7.5% |
| 5% |
Example: Dan Conner owns a brick and tile clay mine. In 2022, the mine earned $100,000. In addition to his allowable business expenses and without regard for qualified business income deduction (QBID), Conner can claim a depletion deduction of $5,000 ($100,000 x .05) for the year 2022.
Pros & Cons of Percentage Depletion
| PROS | CONS |
|---|---|
| Supports the development of US oil, natural gas, and mineral resources | Has a deduction that’s limited to 65% of the taxable income on return for oil and gas properties |
| Allows operators to retain their earnings and reinvest back into American energy development | Has a deduction limited to 50% of taxable income from the property (100% for oil and gas properties) |
| Has no dollar limit to the deduction from income from qualified nonrenewable resources | Cannot be used to create a net operating loss |
Reporting the Depletion
If you’re ready to file your return and wondering where to report the depletion deduction, let’s take a look at the ways the deduction is reported and learn which one applies to you.
| Entity Type | Schedule/Tax Form |
|---|---|
| Partnership | Form 1065, Schedule K |
| S corporation (S-corp) | Form 1120S, Schedule K |
| Estate or trust | Form 1041, Schedule K |
| C corporation (C-corp) | Form 1120, Page 1, Line 21 |
| Sole proprietorship | Schedule C, Line 12 |
Alternative To Percentage Depletion
Cost depletion is another method used to figure out the depletion deduction. It allocates the cost of extracting natural resources and records the cost as an expense to lower your pretax income. If you mine timber, then you must use this method. All other natural resource producers and owners (including oil and gas) must use whichever method leads to the largest depletion deduction.
Bottom Line
If you’re a natural resource independent producer or royalty owner, you don’t want to miss out on this tax deduction. Percentage depletion can create huge tax savings and can provide an opportunity to increase your business cash flow.
