IRS Allows Oil and Gas Company a Bulk Sale Exception

By Dale Lee Berg III, J.D., and Robert Swiech, J.D., MST, Houston, TX

Editor: Mary Van Leuven, J.D., LL.M.

Special Industries

Independent oil and gas producers should be pleased about the taxpayer-favorable position taken by the IRS in a recent private letter ruling. Although letter rulings cannot be used or cited as precedent, the position may provide helpful insights for oil and gas producers that contract for bulk sales to industrial, commercial, and governmental entities.

In a private letter ruling released January 14, 2011, the IRS allowed a bulk sale exception to the retailer exclusion, allowing an oil and gas company to claim percentage depletion. Letter Ruling 201102027 portrayed the taxpayer as an independent energy company primarily in the business of exploration, development, and production of crude oil, natural gas, and natural gas liquids. Beyond these activities, the taxpayer had no direct retail or refinery operations or activities, and it was not a related party to any entity or individual engaged in those activities.

The taxpayer had negotiated with three different buyers—a commercial entity, a school district, and a city government—separate, renewable, take-or-pay contracts for the sale of large quantities of compressed natural gas (CNG). In each contract, the CNG would be delivered to CNG distribution stations built, owned, and operated by the taxpayer. Except in the case of the contract with the commercial entity, which would allow sales of CNG to the taxpayer’s employees for personal use, the stations would be solely used to refuel fleet vehicles owned by each buyer. There would also be no public access to any of the CNG stations and no retail sales (other than those to the taxpayer’s employees as previously described) of CNG.

The taxpayer’s question to the IRS was whether under these facts, the taxpayer’s sale of CNG under each contract would qualify for the bulk sale exception to the retailer exclusion rule under Sec. 613A(c). As discussed below, qualification for the bulk sale exception directly affects the taxpayer’s ability to use the most advantageous method of calculation for cost depletion.

Cost and Percentage Depletion

Properties containing natural resources, including oil and gas, are treated as diminishing in value as the natural resources are produced, because following production there are fewer natural resources, which effectively lowers the value of the property. Due to the diminished value of the property, a taxpayer holding an economic interest in oil or gas property is eligible to receive a deduction for depletion—if the economic interest is acquired by investment in the minerals in place and secures, by any form of legal relationship, income derived from the extraction of minerals to which the taxpayer must look for a return of its capital (Regs. Sec. 1.611-1(b)(1)). When calculating depletion for oil or gas properties, the taxpayer must claim the higher of cost depletion or percentage depletion (if the property qualifies for percentage depletion) on each of its properties during the tax year (Regs. Sec. 1.611-1(a)).

Cost depletion works similarly to depreciation in that the taxpayer’s investment in the property is recovered on an annual basis using a determined formula (Regs. Sec. 1.611-2(a)). In no case can the total amount of cost depletion taken be greater than the adjusted basis of the property including capital additions (Regs. Sec. 1.611-2(b)(2)).

As between the two methods of depletion calculation, percentage depletion can produce a higher amount of depletion allowable on properties that are producing large amounts of oil or gas because, subject to certain limitations, it is based on a percentage of the amount of gross income from production and is not limited by the basis of the property (Sec. 613A(c)). However, percentage depletion has many limits, including being available only to independent producers and royalty owners. If the taxpayer is a retailer as described in Sec. 613A(d)(2) or a refiner under Sec. 613A(d)(4), the taxpayer cannot use percentage depletion and must instead use the limited cost depletion method. The taxpayer in the letter ruling was not a refiner, but engaged in the sale of CNG, so it ran the risk of being a retailer, unable to use the percentage depletion method.

Retailer Exclusion

A retailer, as described in the Code, is one who sells oil or natural gas or a product derived therefrom either directly or through a related person, to any person who is obligated under any agreement to use a trademark or name owned by the taxpayer or the related person in the distribution of the oil, gas, or product therefrom; or if that person is given authorization by the taxpayer or related person to occupy a retail outlet owned or controlled by the taxpayer or related person (Sec. 613A(d)(2)). The CNG that was being sold by the taxpayer to the various buyers was considered a product derived from natural gas under Regs. Sec. 1.613A-7(r)(3). The taxpayer intended to build and own the refueling stations where the CNG would be distributed to the various buyers’ employees who would come to refuel their fleet vehicles. The taxpayer’s employees would also be able to fuel their own personal use vehicles at the stations. The taxpayer would be considered a retailer in this instance since it would own the retail facilities where the CNG was being sold and would also be selling directly to its own employees for personal use.

As discussed below, even though the taxpayer was considered a retailer, exceptions to the retailer exclusion applied to it. The IRS looked to Sec. 613A(d)(2), which provides two exceptions to the retailer exclusion from percentage depletion, both of which applied to the taxpayer. First, the retailer exclusion does not apply in cases of bulk sales of oil or natural gas, which are defined as “sales in very large quantities,” to a commercial or industrial user (Regs. Secs. 1.613A-7(r)(1) and (3)). The users in this case were the commercial entity, school district, and city government, which would be considered commercial or industrial users. The CNG was also sold in large quantities that would then be distributed to the buyers’ employees to be used in the buyers’ fleet vehicles; it was not sold directly to the final consumers themselves as would be the case in a typical retail sale (see Whitco Chemical Corp., 742 F.2d 615 (Fed. Cir. 1984)). The second exception noted by the IRS referred to the taxpayer’s act of selling CNG to its employees in a retail-like manner for personal use under the contract with the commercial entity. The exception applies so long as the retail sales fall under a $5 million de minimis threshold. Although the taxpayer would allow its employees to purchase and use the CNG for personal use, these correctly classified retail sales of CNG would be tracked and kept under the $5 million threshold, thus not triggering the retailer exclusion.

The IRS finished the letter ruling by stating that, under the facts given, the proposed contracts between the taxpayer and each of the buyers fit within the bulk sale exception (and within the de minimis exception in the case of the contract with the commercial entity) to the retailer exclusion under Sec. 613A(c), allowing the taxpayer to take advantage of the more beneficial percentage depletion. This position will likely provide the taxpayer, and potentially other taxpayers that are similarly situated, a larger deduction than would have otherwise been allowed under cost depletion.

Because the contracts between the taxpayer and the buyers are renewable, this IRS ruling has additional implications since percentage depletion deductions allowable during the life of these contracts could potentially outlast deductions that would otherwise be allowable under cost depletion. Private letter rulings are taxpayer-specific rulings that can be relied upon only by the taxpayer to whom they are issued, and they cannot be used or cited as precedent. Nonetheless, the rulings can provide useful information about the IRS’s views of certain issues. Specifically, Letter Ruling 201102027 may provide helpful insights to independent producers of oil and gas that, by claiming allowable percentage depletion deductions, can lower their costs, while at the same time securing contracts for bulk sales of oil and gas with industrial, commercial, and government entities.


Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

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