IRC Section 613A: Percentage Depletion for Oil and Gas

Percentage depletion for oil and gas lets independent producers and royalty owners deduct 15% of the gross income from a qualifying property each year, without regard to how much they originally invested. The deduction is limited to production of 1,000 barrels per day (oil and gas combined, at 6,000 cubic feet of gas per barrel), capped at 65% of the taxpayer’s overall taxable income, and available only to those who stay under strict thresholds for retail sales and refining activity.¹ Large integrated companies do not qualify. The rules that follow live in Section 613A of the Internal Revenue Code.

Unlike cost depletion, which ends once you have recovered your basis in the property, percentage depletion can keep running year after year even after basis reaches zero. That is what makes it worth the trouble of qualifying.

Who Qualifies as an Independent Producer or Royalty Owner

Eligibility is defined by two things you cannot do above certain volumes. Cross either line and you lose percentage depletion for the entire tax year.

Retail Sales Threshold

You are disqualified if you (or a related person) sell oil, natural gas, or products made from them through retail outlets and combined gross receipts from those outlets exceed $5 million during the tax year. A “retail outlet” is any location where petroleum product sales are more than 5% of that location’s gross receipts. The test also catches indirect retailing through your trademark or through outlets you own or control. Bulk sales to commercial or industrial users and sales outside the United States are excluded from the calculation.¹

Refinery Threshold

You are also disqualified if you (or a related person) refine crude oil and combined average daily refinery runs exceed 75,000 barrels for the tax year.¹ The average is total annual runs divided by the number of days in the year. A modest refining operation under that daily average is still fine.

The 1,000-Barrel Daily Production Limit

Assuming you qualify, percentage depletion applies only to a limited volume of production. The statute sets a “tentative quantity” of 1,000 barrels of oil per day.¹ Anything above that must use cost depletion.

Your average daily production is your total domestic crude oil and natural gas output for the tax year, divided by the days in the year. Partial interests count only for your share. When production exceeds the cap, the percentage depletion allowance is prorated across your properties based on the ratio of your depletable quantity to total production.

The 1,000-barrel figure covers oil and gas together. You can elect to convert some or all of your depletable oil barrels into natural gas equivalents at 6,000 cubic feet of gas per barrel.¹ Each converted barrel reduces your oil quantity by one, so the total never exceeds 1,000 equivalent barrels per day.

The Standard 15% Rate and the Marginal Property Bump

For most qualifying production, the rate is 15% of gross income from the property. A higher rate applies to marginal properties when crude oil prices are low: one additional percentage point is added to the 15% base for each whole dollar by which $20 exceeds the reference price of crude oil for the prior calendar year, up to a maximum of 25%.² When the reference price is $20 or higher, no adjustment applies and the rate stays at 15%.

Gross income from the property, for this purpose, excludes lease bonuses and advance royalties. Those must be subtracted before running the percentage calculation.³

Taxable Income Caps

Two income-based limits stand between the raw calculation and the deduction you actually take. One works property by property, the other at the return level.

100% Property-Level Cap

For oil and gas, percentage depletion cannot exceed 100% of taxable income from the property, computed before the depletion deduction itself and before any Section 199A deduction.⁴ Oil and gas get a more generous ceiling than the 50% cap that applies to other minerals. A property that barely turns a profit can still generate a full deduction. If this limit does cut your depletion on a property, the excess is lost with no carryover.

65% Overall Cap with Carryover

Across all properties, your total percentage depletion deduction cannot exceed 65% of your taxable income from all sources.¹ The base for the 65% figure excludes the depletion deduction itself, any net operating loss carryback, and any capital loss carryback, so the math doesn’t feed on itself.

Anything cut by this cap carries forward indefinitely. It becomes an allowable percentage depletion deduction the next year, again subject to the 65% ceiling.⁵ A lean year followed by a stronger one can make the carryover meaningful.

Aggregation Across Related Parties

The 1,000-barrel quantity is meant for one economic unit, not for a corporate structure sliced into pieces. Section 613A pulls related parties together so the cap is applied once.

Members of a controlled group of corporations are treated as a single taxpayer, sharing one 1,000-barrel quantity that is allocated by each member’s share of domestic crude oil production.¹ “Controlled group” here follows Section 1563(a) but uses a more-than-50% ownership threshold rather than the usual 80%.

Outside formal corporate groups, aggregation still applies when 50% or more of the beneficial interest in two or more corporations, trusts, or estates is held by the same or related persons (counting only those with at least a 5% interest).¹ The single 1,000-barrel quantity is divided among them by production.

Family members share too. “Family” is narrow: the taxpayer, their spouse, and their minor children.⁶ Moving interests to a spouse or minor child does not create a second depletable quantity.

Partnerships and S Corporations

When the property is held through a partnership or S corporation, the entity does not claim depletion. Each partner or shareholder computes it individually.¹ The entity allocates each owner’s proportionate share of adjusted basis in each oil and gas property, and each owner tracks that basis separately, adjusting it each year for depletion taken.

The qualification tests, the 1,000-barrel quantity, and the 65% ceiling all apply at the owner level. A partnership with ten partners does not get ten depletable quantities; each partner’s share of production runs against their own limit.

Alternative Minimum Tax

Section 57(a)(1) generally treats percentage depletion above a property’s adjusted basis as a tax preference item for AMT. The statute carves out an exception for depletion computed under the Section 613A(c) independent producer exemption, which is not a preference item.⁷ For producers whose depletion routinely exceeds remaining basis, this is one of the most valuable features of qualifying.

How to Report It

Individuals claim percentage depletion on Schedule E of Form 1040, in the expenses section for supplemental income and loss.⁸ Interests held through a partnership or S corporation come through on Schedule K-1, with the basis and production figures you need to run the calculation on your own return.³ Keep separate adjusted basis records for each property. Cost depletion acts as a floor whenever it exceeds the percentage number, and gain or loss on any future sale depends on the running basis figure.

1
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
2
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells – Section: Oil and Natural Gas Produced From Marginal Properties
3
Internal Revenue Service. Publication 535 – Business Expenses
4
Office of the Law Revision Counsel. 26 USC 613 – Percentage Depletion
5
eCFR. 26 CFR 1.613A-4 – Limitations on Application of Percentage Depletion
6
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
7
Office of the Law Revision Counsel. 26 USC 57 – Items of Tax Preference
8
Internal Revenue Service. Tips on Reporting Natural Resource Income