Recently, the tax court found that an accrual basis partnership could not fully deduct intangible drilling costs (IDC) on its 1999 return, the year it entered into a turnkey contract, since the actual drilling had not occurred. The payment for the IDC’s consisted of both cash and notes payable, and the turnkey contract stipulated drilling was to begin no later than March 2000. However, no drilling occurred in 1999 or 2000.
A turnkey contract is defined as a drilling contract that calls for a stipulated amount payable to the drilling contractor in exchange for completion of a well. The judgment highlighted two exceptions of when an accrual basis partnership can deduct intangible drilling costs before the drilling has occurred:
- The 90 day rule which allows a taxpayer to deduct IDC costs prior to economic performance if the bit penetrates the ground within 90 days after the close of the tax year in which the taxpayer prepaid and deducted the IDCs.
- The 3 ½ month rule that allows a taxpayer to treat a liability as having been economically performed at the time of payment if the taxpayer reasonably expected the service provider to provide all services within 3 ½ months after the date of a cash payment.
The court did not allow the taxpayer to deduct the prepaid IDCs due to the fact pattern not falling within these two exceptions listed above as drilling did not commence within 90 days, and all services were not performed within 3 ½ months. Additionally, the use of notes further restricted the deduction of the IDCs, even if the 3 ½ month rule had applied, as the definition of payment refers to cash or cash equivalent payments.