Oil and Gas IRS Audits in Texas: Depletion, Working Interests, and the Issues That Trigger Exams

Oil and gas money runs through Texas tax returns like nowhere else in America: royalty checks from inherited minerals, working interests in a friend's drilling program, lease bonuses on family land. And oil and gas sits in its own strange corner of the tax code, with rules that exist for no other industry. The IRS audits this income knowing that many preparers outside energy country handle it badly.

If energy income shows up on your return, here is where the exams focus.

Depletion: The Deduction Everyone Gets Wrong

Mineral owners get to deduct depletion, the wasting of the asset as it produces, and most individuals use percentage depletion: 15 percent of gross income from the property, subject to limits. The audit traps are everywhere. Percentage depletion for oil and gas is limited to independent producers and royalty owners within daily production caps. It cannot exceed 100 percent of the taxable income from the property. Lease bonuses do not qualify for percentage depletion. And the deduction has to be computed property by property, not on a lump sum.

Sloppy depletion is low-hanging fruit for an examiner, and it recurs every year, so one bad method can mean three open years of adjustments at once.

Working Interests: Active Money, Active Risk

A working interest is a business stake in the drilling operation, and the code treats it with rare generosity: a working interest held outside a limited-liability wrapper is exempt from the passive loss rules, so drilling losses can offset wages and other income. Intangible drilling costs can be deducted immediately rather than capitalized. Those two provisions are why your dentist got pitched a drilling program.

The generosity draws scrutiny. Examiners check whether the interest was really held in a form that qualifies for the passive-loss exception, whether the IDC election was made and applied correctly, and whether self-employment tax was paid, because working interest income is generally self-employment income, a detail that surprises investors who thought they bought something like a dividend.

Royalties, 1099s, and the Matching Machine

Every operator issues 1099-MISC forms for royalties, and the IRS matches them. Inherited minerals scattered across counties produce small checks people genuinely forget, and the matching notice arrives two years later with penalties attached. Severance taxes and post-production costs deducted from your checks are deductible, but only if claimed; the gross on the 1099 is what the IRS sees.

Basis on inherited minerals is the other quiet issue: minerals get a stepped-up basis at death, which matters enormously when you sell, and almost nobody has the appraisal to prove it.

If the Exam Letter Arrives

An oil and gas audit is a documents game: division orders, JIBs, lease agreements, depletion schedules. Examiners respect organized records and well-supported positions, and these audits are very winnable when the underlying work was sound. They are also salvageable when it was not, through reconstruction and negotiation.

Either way, do not face a specialized exam with a generalist defense. I have been handling federal tax controversy for 32 years. Send me the letter before you respond to it.