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Audits In the Oil and Gas Industry

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    In August 2020, the WESTLAW Energy and Environment Daily Briefing posted the following update:

    • A Pennsylvania man has been sentenced to prison and ordered to pay more than $10.2 million in restitution to multiple federal agencies for fraudulently obtaining renewable fuel credits for his businesses.

    This was the ruling from United States v. Dunham, et al. U.S. District Judge Jeffrey L. Schmehl for the Eastern District of Pennsylvania sentenced David M. Dunham Jr. on Aug. 6, saying his prison stint will be followed by three years of supervised release.

    Dunham, owner of Smarter Fuel LLC and co-owner of Greenworks Holdings LLC, was convicted in April 2019 on charges of wire fraud, obstruction of justice, filing false tax documents, and associated conspiracy counts.

    The criminal case stemmed from Dunham’s scheme to deceive the U.S. Environmental Protection Agency, other federal agencies, and his customers by obtaining renewable fuel credits for his biofuel business, the DOJ said. “David Dunham is a thief, dressed up in ‘green energy’ clothing,” U.S. Attorney William M. McSwain said in a statement from the Department of Justice.

    This article will tell you how you may be able to save yourself from becoming a similar headline. The oil and gas industry is one of the most regulated in the world, so it should come as no surprise to you that it is frequently a target of tax audits by the IRS and California taxing authorities. In order to ensure that your or your enterprise, or Oil and Gas Investment does not fall on the wrong side of the law, it is crucial that you are aware of all of the intricate issues involved in audits of the oil and gas industry.

    Oil and Gas Industry Overview

    Huge sums of money are needed to discover, develop, and produce crude oil and natural gas. Companies will occasionally collaborate and pool their resources to fund oil exploration. Partnerships are frequently created to allow outside investors to fund drilling projects. The investors can be unfamiliar with the oil and gas sector. They are prepared to put money into risky drilling projects since there are potential tax advantages and significant economic gains. Institutional investors make substantial investments to achieve returns without taking on excessive risk by purchasing royalty interests in producing oil and gas properties.

    The IRS and California Taxing Authorities, such as the California Franchise Tax Board (FTB), Employment Development Department (EDD), and California Department of Tax and Fee Administration (CDTFA are aware that the unique aspects of the oil and gas industry present opportunities to evade taxes in numerous ways. The IRS audits oil and gas companies so frequently that it has even developed an Oil and Gas Audit Technique Guide strictly for examinations within this industry. You should know that the IRS is extremely meticulous in its approach and has a deep understanding of all of the vulnerable areas. For example, in light of the fact that the oil and gas industry has expanded its activities into financial products, the agents are now trained to be on the lookout for vehicles that are being used to “hedge” and claim an ordinary loss versus a capital loss.

    Mr. Klasing is a dually licensed Tax Attorney and CPA who has decades of experience as a former auditor himself from working for various public accounting firms. As such, he can often anticipate the approach auditors will take and can craft a strategy to meet these challenges.

    Why Was I Audited?

    Why were you chosen? Well, the IRS selects returns to audit not “at random” but (often) according to a well-defined scoring system. Every tax return is “scored” using the IRS’s “Discriminant Function System” or DIF. There are an array of reasons why oil and gas entities get audited. Some of the most common issues that get audited include the following: the total amount of gross income reported; the trade or business deductions taken; bad debts; net operating losses; capital loss carryforwards; depreciation; and capital expenditures.

    You may have improperly included estimates that are overstated, nondeductible costs, or allowances for contingencies in the total estimated costs figure that reduced the percentage of completion. This may have resulted in the understatement of the corresponding income to be reported on the contract.

    Or youmay have improperly allocated costs from contracts that are still in progress to completed contracts that accelerated the expense recognition. An unusually low gross profit on a job could have indicated to the IRS existence ofan improper job allocation.

    Common Oil and Gas Industry Audit Issues

    Audit Techniques

    Please be aware that examiners will ascertain your overhead allocation during the initial interview. They will try to establish whether you had an economic interest in the property. Your properties will be inspected to check whether overhead is distributed between producing and nonproducing properties. Additionally, the properties will be closely examined to check whether all business activities, such as investing, manufacturing, refining, etc., are receiving their fair amount of overhead. Interest payments made on operating capital borrowings are an overhead expense that is recognized as an increasing production cost under the guidelines of IRC. Before allocating, you are advised to net interest expenses to the extent of interest income.

    The compliance requirements are undoubtedly complex and burdensome. In order to ensure all legal requirements are being met, The best course of action in such a  situation would be to consult the Tax Law Office of David Warren Klasing.


    It is important to determine if the taxpayer has a preference item for alternative minimum tax if they are claiming percentage depletion. Pursuant to IRC section 57(a)(1), a tax preference item is defined as the excess of percentage depletion over the adjusted basis of the depletable interest at the end of the tax year with respect to each property. Without considering the depletion deduction for the tax year, the property’s adjusted basis is calculated, and the amended basis of the depletable property at the start of the year must be supported by documentation from the taxpayer. The majority of taxpayers incorporate the property’s modified basis in their depletion schedule. All percentage depletion will be regarded as a tax preference item if the taxpayer is unable to produce this substantiation. Therefore, it is crucial to be as meticulous as possible and to seek professional assistance.


    The property concept is the basis for the use of the property unit as the tax entity for purposes of depletion, abandonment losses, recapture rules, etc. The property definitionemphasizes separateness, specifically, the separateness of different types of interests, geographic locations (surface), and oil and gas deposits (subsurface). The taxing authorities are aware that the taxpayer might manipulate the definition of property to attempt to take larger deductions for depletion, take a premature deduction for an abandonment, or reduce its recapture potential. They know that many taxpayers will account for their income and expenses on a well-by-well basis for their accounting records; others might segregate their income and expenses by prospect. Since records are set up this way, many taxpayers may not want to go through the inconvenience and cost of converting the records to reflect the property concept for tax purposes.

    Initial Information Documents Request

    Several records are required to start investigating oil and gas activity. You can expect to be served with the first Information Document Request (IDR) and Form 4564. Additionally, you may be invited to attend the audit from the very beginning. The list below covers oil and gas-related items, which will be requested on the initial IDR. The basic records that might be required of you are as follows:

    1. Charts of cost centers, lease names, and numbers.
    2. Detailed depletion schedules related to the tax return.
    3. Records show the lease’s expiration or release for leaseholds abandoned during this tax year.

    In order to establish which elements apply specifically to you, it is imperative to seek assistance from a qualified tax attorney to help in the identification of legal regulations and requirements.

    Requesting Assistance from Specialists

    It is common practice for examiners of an oil and gas company to seek assistance from subject matter experts (“SMEs”) or a specialist in the field. Doing this helps them identify planning and development issues. An examiner may sometimes require support from more than one specialty examiner (specialist). Specialists can include IRS engineers, computer and audit specialists, CBA representatives, financial products specialists, etc.

    State Regulation of Oil and Gas Production

    State agencies closely monitor and regulate oil and gas development and production. Each state’s authorities to carry out law enforcement differ. A variety of state permits must be secured before any form of drilling, exploration, deepening, plugging, abandoning, or examiners can use another activity to summarize the various acts taken on oil and gas assets. Different useful dates of notices of intention to drill a well, the type of well, the legal description of the property, the estimated total depth, etc., are included in the applications for the various permits and reports of work submitted to state agencies.

    Business Segments

    “Upstream” and “Downstream” are typically considered to be the only two fundamental parts of the oil and gas business. Companies in the upstream segment explore oil and gas fields and drill wells to produce crude oil and natural gas, along with harvesting those raw materials in the general area of its wells. Companies in the downstreamsegment execute the tasks such as gathering, processing, transportation, refining, marketing, distribution, and retailing. Although more than one person carries out some functions, the downstream segment has several recognized sectors. The conversion of these raw materials into completed ones must typically be carried out differently due to the physical and chemical differences between crude oil and natural gas.

    Royalty Interest

    This type of interest entitles its owner to a portion of the mineral deposit’s production, free of development and maintenance charges, and extends undiminished for the duration of the property’s productive life.

    Working Interest

    Entitles its owner to a share in the production. However, the owner is still responsible for paying a share of the development and operation costs. Owners of working and royalties interests may sell or otherwise dispose of all or a portion of their respective interests in the total production, subject to certain limitations. The overall production is then further divided into overriding royalties, oil and gas production payments, net profits interest, carried interest, and other income categories.

    Overhead Costs of Oil Company Departments

    The cost of acquiring oil and gas leasehold properties must be deducted from certain departmental overhead expenses.

    Leveraged Oil & Gas Drilling Partnerships

    Investors in specific drilling operations use partnerships to make claims for loss and current deduction for IDC in amounts that the Services claims exceed the partnerships’ real IDC and the investors’ economic expenditure. Even while not all oil and gas drilling partnerships participate in these unethical practices, agents looking into these partnerships are very conscious of this issue.

    Taxpayer Audit Steps

    The key steps that examiners follow in oil and gas audits are:

    • Identifying the operator of all drilling prospects associated with the partnership.
    • Determining if the partnership has a working interest.
    • Identifying if there are any wells or activities outside of the United States.
    • Comparing wells actually drilled to wells only listed in the document that transfers working interests, often identified as a prospect agreement, but not actually drilled.
    • Determining when the wells were actually drilled and whether any related invoices are dated prior to the stated or actual formation of the partnership.
    • Reviewing the dates of the invoices for the wells and noting any unusual lengths of time after the well was spudded.
    • Determining whether documents from third parties indicate whether the promoter, a promoter-controlled entity or its contractor, was the primary or sole contact with the actual well operators.
    • Determining whether the division order or joint interest billing statements were sent to the promoter, or a promoter-controlled entity, as the named working interest partner for payment.
    • Determining whether the promoter, promoter-controlled entity, or the partnership, signed the election letters for well operations.
    • For each associated partnership, requesting executed copies of agreements between the Turnkey Driller and any well-servicing companies for activities, i.e., logging, cementing, casing, perforating, fracturing, and maintenance.

    Why do You Need Us?  If any actions with your filing could be viewed as fraudulent!!!

    While representing you, our objectives in dealing with the examining agent are:

    1. to attempt to limit the scope of the inquiry;
    2. to limit the information provided to avoid both waiver of the Fifth Amendment and incrimination;
    3. to avoid tying you to an explanation you cannot support;
    4. to prevent the presentation of false or misleading information that could lead to the allegation that you are engaged in a scheme to cover up the fraud; and
    5. to avoid claiming the Fifth Amendment or otherwise alerting the revenue agent to the fraudulent aspects of the returns.

    There is a world of difference between an ordinary audit and a tax fraud investigation. The objective of most civil audits is to present as much evidence as possible to convince the agent or conferee that an adjustment is not appropriate. However, our goal in a tax fraud investigation is to limit the scope of the investigation to purely civil matters where possible.

    You should also know that although federal authorities file most criminal tax charges, California also has laws prohibiting both individual and corporate tax evasion and tax fraud. Criminal Tax Law Defense is a specialized area of practice. It is important for the practitioner to be familiar both with the applicable tax laws and the criminal statutes applicable for failure to follow those laws and effective defense strategies.

    Our Role as Criminal Tax Defense Attorneys

    If a revenue agent suspects tax fraud, the agent is directed to notify his manager and a Fraud Enforcement Advisor (FEA) may be associated into the case. The role of an FEA is to serve as a resource and liaison to tax compliance employees (e.g., revenue agents) and assist in fraud investigations and offer advice on matters concerning tax fraud. Thereafter, the goal of the revenue agent and the FEA working on the case will be to establish sufficient affirmative acts to confirm a finding of tax fraud. In all likelihood, the revenue agent will seek to gather as much information as possible before making a referral to the IRSCriminal Investigation Division because once such a referral is made, IRS policy generally mandates that the civil audit cease. The revenue agent will not ordinarily volunteer the fact that he is working with an FEA to build a case for criminal tax referral.

    Our role will include becoming involved in the criminal tax investigation, eggshell audit or reverse eggshell audit at the earliest possible time. Initially, we will strive to protect you by not furnishing incriminating information to the special agents or at least limiting the amount of information that must be voluntarily given to the Service. This is because we would need time to discern the nature of every client representation and to review relevant records (evidence).

    Our job as dually licensed criminal tax defense attorney & CPAs also includes weaving a defense from the sources of available information. Special agents are much more likely to accept a defense premised on the third party’s written and oral information. This will require me to interview third parties during the investigation. There is no need to wait for the special agents to interview a particular witness first. Any key witness, such as the preparer or accountant, should be interviewed as soon as possible and copies of any documents held by these persons obtained. Oftentimes, witnesses give their original documents to the special agents, thus foreclosing their later availability to the taxpayer’s attorney. Correspondingly, this would foreclose an attorney from determining what knowledge or belief is in the mind of the special agent.

    We truly understand how the IRS and California Tax authorities function and run their civil audits and criminal tax investigations. We are well conversant with the background information that IRS, CDTFA, FTB, and EDD have on the oil and gas industry and how it familiarizes and trains its examiners with the issues they need to understand when auditing or criminally investigating/prosecuting you.To schedule a confidential, reduced-rate initial consultation, call our Irvine or Los Angeles law firm at 800-681-1295 or schedule online today HERE.

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