After looking at depreciation and amortization, we'll now conclude the topic of cost recovery with depletion. Depletion is conceptually similar to depreciation and amortization, and that will be recovering the cost over a business used assets through deductions over time. With depletion, we're simply referring to cost recovery related to natural resources like oil, gas, and minerals, but not simply land itself. The general approach here is to calculate the annual depletion expense under two methods. The cost depletion method or the percentage depletion method, and then deduct the larger of the two. So let's take a look at each of these depletion methods. First, the cost depletion method. This is basically a straight-line method, except instead of using years as the denominator, we'll use units as the denominator. In particular, the depletion rate per unit is the basis in the natural resource divided by the estimated recoverable units of the natural resource. Units in this case can mean barrels of oil, ounces of gold, carats of diamonds and the like. Then the deduction is simply the depletion rate per unit times the number of units sold in the year. Notice that this is the number of units sold during the year, and not the number of units produced during the year. We'll continue deducting depletion only until all estimated units are sold. The second depletion method is known as the percentage depletion method. This is also rather straightforward and that it is computed using a statutory percentage rate for each resource type. I've included them here, but they're also available in the supplemental materials. For example, cobalt, lead, and nickel use a 22 percent rate; copper, gold, and oil, and gas use a 15 percent rate; granite and marble use a 14 percent rate; coal uses a 10 percent rate, and gravel and sand used a five percent rate. So what do we do with these rates? For the percentage depletion method, the eligible deduction here is the lesser of the percentage depletion rate from that exhibit, multiplied by the gross income from the resource, that is the sales revenue from selling the natural resource. Or 50 percent of the taxable income before considering the depletion deduction, or 100 percent of the taxable income before considering the depletion deduction if the natural resource is oil or gas. So just to put it all on one slide, the actual depletion deduction that's claimed on the tax return is the greater of the cost depletion method or the percentage depletion method. The cost depletion method is the depletion rate per unit times the number of units sold during the year. The percentage depletion method use the lesser of the percentage depletion rate times the gross income from the resource, or either half or all of the taxable income before the depletion deduction. So just to be aware that there's a greater of clause here for the actual depletion deduction, but an embedded lesser of clause within the percentage depletion method. Now, one major nuance in calculating depletion is for oil and gas producers. In particular, related to intangible drilling costs or IDCs. These IDCs are costs related to making the property ready for drilling, plus the cost of drilling for oil, gas, or geothermal wells. The Internal Revenue Code allows these taxpayers to elect to either deduct the IDC costs immediately, or capitalize them as an asset, and then recover the cost through depletion over time. That is, if the IDCs are capitalize, the amounts are added to the properties basis for determining cost depletion. The costs are expensed over time through cost depletion deductions. Usually, it's advantageous to simply elect an immediately expense IDCs rather than capitalize them, because it drives down taxable income in the current year. But a good tax department will actually go through the depletion deduction calculation shown on the earlier slide to make sure they're making the right decision for their tax profile. So where does this capitalization issue come into play exactly? Well, if we capitalize IDCs, we need to increase the basis when we calculate the cost depletion method. However, the capitalized IDCs won't affect the percentage depletion method calculation at the bottom. However, if the taxpayer decides to expense the IDCs, then the cost depletion method on the top half of the slide won't be affected because there won't be an increase in basis. But the calculation on the bottom half will be affected. In particular, the expense IDCs will reduce the taxable income under the percentage depletion method. This may be an issue because the percentage depletion method uses a lesser of calculation. So 50 percent or 100 percent of taxable income that has been reduced by expensing IDCs will be a smaller number than 50 percent or a 100 percent of taxable income that has not been reduced by expensing IDCs. So let's look at an example. In the current year, Carmen acquires for $400,000 an oil and gas property interests with 200,000 barrels of estimated recoverable oil. During the current year, 10,000 barrels of oil are sold for $250,000. IDCs amount to $100,000 and are expensed in the current year. Other deductible business expenses are $50,000. So what's the depletion deduction that Carmen can take for the current year? What is Carmen's taxable income after taking the depletion deduction? Again, here's the complete formula for figuring out the depletion deduction for the year as the greater of the cost depletion method or the percentage depletion method. First, let's look at the cost depletion method. Here, the cost depletion method is calculated as the cost basis divided by the number of estimated recoverable units times the number of units sold during the year. So we have a $400,000 basis divided by 200,000 estimated barrels of oil, times 10,000 barrels of oil sold, equaling $20,000. Next, we look at the percentage depletion method which uses this lesser of calculation. First, the percentage depletion rates. Because it's an oil and gas resource, firm exhibit so we can see that oil and gas has a 15 percent depletion rate. Now, what's the gross income from the resource? Well, Carmen sold her oil in the current year for a total of $250,000. The $250,000 is the gross income from the resource. Therefore, to figure out the first part of this calculation, we multiply 15 percent by $250,000. Once we multiply that out, we get $37,500. But we now need to compare that to the taxable income. Here, since we're talking about oil and gas, we'll use the 100 percent rate. Next, we need to figure out taxable income for the oil and gas property before considering the depletion deduction. To figure out taxable income, we basically take revenues minus expenses. Our revenues are the $250,000 gross income from the sale of the oil. We subtract out the expensed IDCs of a $100,000 as well as the other deductible business expenses of $50,000. This leaves us with taxable income of $100,000. So as you can see here, we take the 100 percent rate and multiply it by the $100,000 to obtain a $100,000 taxable income ceiling. Now, the percentage depletion method requires us to use the lesser of $37,500 or $100,000. In this case, $37,500. Finally, we compare the $37,500 under the percentage depletion method to the $20,000 under the cost depletion method, and we take the greater of the two. Therefore, the depletion deduction that Carmen can claim is $37,500. So what is Carmen's ending business taxable income after considering the $37,500 depletion deduction? Well, again, we take revenues minus expenses. But now, including the depletion deduction, to obtain a taxable income of $62,500. Now, what would be Carmen's depletion deduction and taxable income if she decided to capitalize instead of expense the IDCs? Well, we have to go back to our formula. But now, adjust the basis for the capitalized IDCs under the cost depletion method. So now, for the cost depletion method, we need to add in the $100,000 capitalized IDCs to the original basis. This will yield a slightly higher cost depletion method deduction than before when we expensed the IDCs and did not increase the basis. As you can see in this calculation, now, the depletion deduction under the cost depletion method is $25,000 instead of the $20,000 in the previous example when we expensed the IDCs. In particular, we added in the $100,000 of capitalized IDCs to the $400,000 of original basis. We divided it by the 200,000 estimated recoverable number of barrels of oil times the 10,000 barrels of oil sold. Now, we must compare the $25,000 to the percentage depletion method. For the first part of this calculation, there's actually no change from what we had before when IDCs were expensed. We still have a 15 percent oil and gas rate, and the total gross income from selling the oil and gas during the current year remains at $250,000. So we stay at $37,500. Now, what happens here with the second part of the calculation? Well, the IDCs are not being expensed, so our taxable income will be higher than before when IDCs were expensed. So again, we take the 100 percent rate and multiply it by the taxable income before depletion deduction. We still have a $250,000 in revenue, but now, no IDC deductions. We can still deduct the $50,000 and other business expenses. So now, we have a taxable income ceiling of $200,000. But of course, we can only take the lesser of $37,500 or $200,000. So the capitalization of IDCs here didn't really help us raise the amount we can actually deduct for depletion. So now, the depletion deduction is the greater of $25,000 or $37,500. So we're back at $37,500. In this case, the capitalization of IDCs did not change the depletion deduction at all. So why should we care about whether the IDCs are capitalized or immediately expensed? Well, we should care because not taking an immediate deduction, will by definition increase our bottom line taxable income. You can see it clearly here. The revenues, other expenses, and depletion deduction stays the same. But now, there are zero expensed IDCs. That is, by not deducting the $100,000 and IDCs immediately, Carmen's taxable income is now $100,000 higher. Now, at $162,500. Compare this number to the $62,500 we had before when she did expensed her IDCs. In this example, it's clear that Carmen cannot take advantage of capitalizing IDCs, and thus she should elect to expense her IDCs in the current year. In summary, in order to calculate the depletion deduction, we have to take the greater of the cost depletion method or the percentage depletion method. For oil and gas companies, they have the option of either expensing or capitalizing their intangible drilling costs or IDCs. If the cost depletion method is actually the method that the taxpayer chooses, because it's greater than the percentage depletion method, then capitalizing the IDCs might be advantageous because capitalization would increase the basis. However, many times it's more advantageous to immediately deduct IDCs to lower income significantly in the current year in order to pay less tax, rather than to spread out the depletion deduction over many years through an increase in basis.