What is Depletion Allowance?

Jim B.

Depletion allowance is a tax deduction permitted in the United States by federal tax laws to businesses that extract, produce, or sell natural deposits such as oil, gas, minerals, or timber. The idea behind this allowance is that the owners of such companies should be given tax incentives to atone for the depletion of the resources that occurs in the operation of the business.

Congress used the 16th Amendment to create the depletion allowance.
Congress used the 16th Amendment to create the depletion allowance.

In the first half of the 20th century, the U.S. Congress passed laws that allow for depletion allowance as a way to stimulate investment in high-risk endeavors. This deduction may be calculated by either the cost depletion method or the percentage method, depending on the type of industry and the choice of the business owners.

A depletion allowance deduction can be taken for timber.
A depletion allowance deduction can be taken for timber.

Using the 16th Amendment to the U.S. Constitution, which does not allow the government to tax capital, as a basis, the U.S. Congress created the depletion allowance in the Revenue Act of 1913. In 1926, percentage deductions were added to the law to further stimulate ownership in such commodities as oil, gas, and minerals. What started as a way to boost those risky industries soon became a lucrative tax boon to those in these industries.

Since these industries often require multiple owners of a single business, the depletion allowance deduction may be split. Those who don't solely own natural deposit businesses but can stake some claim to an economic interest in the business, whether by holding a lease or through royalty rights, may be eligible for the depletion deduction. Such stipulations are usually found within the pertinent contracts.

One of the two methods of calculating a depletion allowance is the cost depletion method. In this method, also known as depreciation, whatever money an owner sinks into the investment is the amount that is eligible to be deducted. For example, a payment of $5 million U.S. dollars (USD) for a contract to withdraw oil would result in a $5 million USD tax deduction. The cost depletion method is especially helpful to new businesses.

In the percentage method, also called the statutory method, owners are entitled to a percentage of the gross income earned by the business. This method of depletion allowance can be especially profitable for established businesses, since they may continue to collect on the deduction even after they have recovered all of the initial costs. The rate of percentage and the availability of the percentage method are dependent upon the type of industry and the laws which govern them.

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