A working interest in oil and gas comes with an unusual tax and liability profile: the tax code lets you deduct most drilling costs immediately and use the resulting losses against your salary or business income, but only if you hold the interest in a way that leaves your personal assets exposed to well-site liabilities. Hold through an LLC or limited partnership and you protect your wealth but lose the non-passive loss treatment that makes the structure attractive in the first place. Every investor faces that choice, and the right answer depends on the size of the position and how much operational risk you can absorb.
What You’re Actually Taxed On
Your share of revenue is not the same as your working interest percentage. Gross sales are reduced by royalties owed to mineral owners who don’t share in costs, and what remains is divided among working interest owners by net revenue interest (NRI). A 25% working interest in a lease burdened by a 20% royalty yields a 20% NRI: 20 cents of every dollar the well earns.
Costs arrive in two waves. Drilling and completion capital is set out in an Authority for Expenditure (AFE), and working interest owners fund their share before work begins. After the well is producing, lifting costs cover labor, power, chemicals, maintenance, and compliance for as long as the well runs. The point where cumulative net revenue equals your capital contribution is called payout, and many joint operating agreements shift the revenue split once payout is reached.
Liability Exposure
Working interest holders face unlimited personal liability for obligations arising from exploration and production. Environmental contamination, injuries on the well site, and unpaid vendor invoices can all produce claims against the interest holders, and the liability is joint and several. If your co-owners can’t pay, a claimant can pursue you for the full amount.
The operator’s conduct binds you. If the operator causes a spill or violates a regulation, every non-operating working interest holder is potentially on the hook, which makes the choice of operator and the JOA’s liability provisions worth close attention before you fund an AFE.
Holding the interest through an LLC or similar entity shields personal assets from these operational liabilities. That shield has a tax cost, discussed below.
Intangible Drilling Cost Deductions
The largest single tax benefit is immediate expensing of intangible drilling costs (IDCs). These are the drilling expenses with no salvage value: labor, fuel, mud, chemicals, hauling, and similar items. IDCs typically run 60% to 80% of total drilling expenditure, and the full amount is deductible in the year paid, even if the well is not yet producing.
Tangible equipment does not qualify. Casing, wellhead, pumps, and other physical components are capitalized and recovered through MACRS depreciation over several years.
AMT Preference and the 60-Month Election
When your IDC deductions exceed 65% of your net income from oil and gas properties, the excess is a tax preference item added back for alternative minimum tax purposes.1Office of the Law Revision Counsel. 26 USC 57 – Items of Tax Preference Electing to amortize IDCs over 60 months under Section 59(e) removes them from AMT preference treatment entirely, at the cost of the front-loaded deduction. Starting in 2026, the AMT exemption phases out twice as fast as before, which makes the election more consequential for high-income investors.
Depletion Allowances
Depletion lets you recover the cost of the diminishing reservoir. Two methods are available each year, and you claim whichever produces the larger deduction.
Cost depletion divides your adjusted basis by total estimated recoverable reserves and multiplies by units sold. Once basis is recovered, the deduction stops.
Percentage depletion lets independent producers and royalty owners deduct 15% of gross income from the property, and it continues even after the original investment has been fully recovered.2Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells Over a well’s life it can return deductions well beyond original capital.
Two ceilings apply. The deduction from any single property cannot exceed 100% of taxable income from that property, computed before depletion.3Office of the Law Revision Counsel. 26 USC 613 – Percentage Depletion Total percentage depletion across all oil and gas properties cannot exceed 65% of your overall taxable income, with any disallowed amount carried forward. The 15% rate also applies only to average daily production up to 1,000 barrels of oil (with an equivalent gas limit); volume above that qualifies only for cost depletion.2Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
Non-Passive Losses and the Entity Trade-Off
This is the feature that distinguishes working interests from most private investments. Under Section 469, a working interest in an oil or gas property is specifically excluded from the definition of a passive activity, so losses can offset wages, business profits, and other ordinary income.4Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited A $200,000 IDC loss in year one can go straight against your day-job income.
The exception only applies when you hold the interest directly or through an entity that does not limit your liability.4Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited Hold through an LLC, limited partnership, or S-Corporation, and the working interest is treated as a passive activity. Your losses can then only offset other passive income.
So the choice comes down to this. Direct ownership gives you the full loss deduction against ordinary income and leaves your personal assets exposed. Entity ownership protects your assets and converts the losses to passive. There is no structure that gives you both.
One further wrinkle: if you take non-passive losses from a working interest in one year, net income from the same property in later years is also treated as non-passive.4Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited You cannot deduct losses against ordinary income while the well is losing money and then reclassify the income as passive once production ramps.
Self-Employment Tax on Direct Holdings
Direct ownership carries a cost that is easy to miss until the well turns profitable. Because the interest is treated as a trade or business, net income is subject to self-employment tax: 12.4% Social Security and 2.9% Medicare, totaling 15.3%. High earners pay an additional 0.9% Medicare surtax on self-employment income above $250,000 (joint) or $200,000 (single).5Office of the Law Revision Counsel. 26 USC 1401 – Rate of Tax
Over the 15 or 20 years a well may produce, the cumulative self-employment tax can be a large number. It’s the flip side of preserving non-passive treatment, and it should be modeled alongside the early-year loss benefit before deciding how to hold the interest.
At-Risk and Excess Business Loss Caps
Even with non-passive treatment, two more limits govern how much you can actually deduct in a given year.
Under Section 465, your deductible loss cannot exceed the amount you have at risk in the activity. At-risk includes cash and property contributed, plus borrowed amounts on which you are personally liable. It excludes money protected by nonrecourse financing, guarantees, or stop-loss arrangements.6Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk Losses beyond your at-risk amount carry forward until your at-risk basis grows large enough to absorb them. Your at-risk basis also decreases each year by the losses you deduct, so heavy IDC users need to watch what’s left.
Section 461(l) adds a second cap for non-corporate taxpayers. Aggregate business losses exceeding a threshold amount are disallowed for the current year and treated as a net operating loss carryforward.7Internal Revenue Service. 2025 Instructions for Form 461 For 2025 the threshold was $313,000 single and $626,000 joint; 2026 figures adjust for inflation under the same formula. The One Big Beautiful Bill Act signed in 2025 made this limitation permanent. For a large IDC year, this cap can push part of your deduction into future years as an NOL.
Recapture When You Sell
Selling a working interest triggers recapture under Section 1254. Any gain is treated as ordinary income, not capital gain, up to the total IDCs and depletion deductions previously claimed against the property. The recapture amount is the lesser of total IDCs and depletion taken or the gain on sale.8Office of the Law Revision Counsel. 26 USC 1254 – Gain From Disposition of Interest in Oil, Gas, Geothermal, or Other Mineral Properties It applies regardless of holding period and overrides provisions that would otherwise defer or avoid gain recognition. Only the portion of gain above the recaptured amount receives capital gains treatment.
Plugging and Abandonment
Every producing well eventually has to be plugged, and the working interest holder is legally responsible. State regulators require the wellbore to be cemented, surface equipment removed, and the site remediated. Average plugging costs reported by states in recent grant applications ranged from roughly $157,000 to $182,000 per well, though the number varies widely with depth, location, and condition.
Most states require a surety bond before issuing a drilling permit. Bonding ranges from a few thousand dollars for individual shallow wells to six-figure blanket bonds for multiple wells, and it rarely covers the actual cost of plugging. The rest comes out of the working interest holder’s pocket. That obligation should sit in your budget alongside drilling and lifting costs, because it becomes more certain with every barrel produced.