Depletion Allowance-A Tax Benefit That May Be Overlooked

One benefit of mining operations is a federal tax deduction created by Section 611 of the Internal Revenue Code that is often referred to as a “depletion allowance”. The application of this deduction is common in the oil and gas industry, but it is occasionally overlooked in mining. It shouldn’t be. Landowners who lease their land for mining, as well as companies that operate mines, are both entitled to the deduction if they meet its requirements. The purpose of this Article is not to set out all of the details related to those requirements but simply make readers aware that the deduction exists.

The fact that extractive activities like mining exhaust valuable natural resources over time is the principle underlying the depletion allowance. To recognize this loss from a federal tax perspective, both the owners of lands that have mineral reserves, and mine operators extracting reserves, may claim an annual deduction in calculating the amount of their taxable income. The deduction can be calculated based on either of two methods, whichever results in the largest amount for the particular taxpayer. One method is based on the income that is produced by the reserve and the other is based on its cost.

Essentially, the income method permits a deduction equal to a specific percentage of the revenue that the taxpayer derived from the extraction and sale of the reserve, provided that the amount of the deduction for any year cannot exceed fifty percent of the total amount of income that was received by the taxpayer that year from the mining operation (computed without allowance for depletion). The percentage of income that results in the deduction varies with the type of mineral involved; for example, fourteen percent applies to limestone in certain circumstances, ten percent applies to coal reserves, and five percent applies to reserves of sand or gravel, and limestone in circumstances that do not qualify for the higher amount.

The cost method of calculating the deduction is slightly more complex. It begins with a basis that includes certain costs which are related to acquiring the reserve, amortizing that basis over the estimated amount of applicable reserves, and applying the resulting quotient to the reserves that were extracted and sold that year. Each year the cost method calculations must be repeated to recognize all depletion allowances which the taxpayer has previously taken with regard to the reserve, as well as the reduction that has occurred to the estimated amount of reserves which remain.

As noted, this brief article is intended only to make readers aware of the fact that an important federal income tax deduction exists for owners and lessors of lands that have mineral reserves, and mine operators. The rules and regulations relating to this deduction are more detailed than described, and may change from time to time. There may also be other tax consequences. AS A RESULT, THIS ARTICLE IS NOT INTENDED TO BE, AND SHOULD NOT BE RELIED UPON AS, A SUBSTITUTE FOR THE ADVICE OF AN APPROPRIATE TAX PROFESSIONAL.