One of the largest tax deductions a mining operation may receive is for the depletion of the mineral which it is mining.  The tax rules for depletion are different than those used for Financial Statement reporting.  For Federal Income tax reporting, a deduction is allowed using either cost depletion or percentage depletion, whichever is greater.  Cost depletion is calculated by assigning each unit produced during the year or estimated to be in reserves at year-end a portion of the property’s basis.  The amount of basis allocated to units produced during the year is allowed as a deduction not to exceed the cost of the property.  Under the percentage depletion method the taxpayer may deduct a statutorily defined percentage of gross income from mining (10% for coal mining).  The percentage depletion deduction is limited to 50% of net income from mining on the property, but is not limited by the basis in the property.  Therefore, even after the entire cost basis in the property has been recovered through percentage depletion, a taxpayer may continue to take percentage depletion as long as there is net income from mining.

One caveat to the depletion deduction, especially as it relates to percentage depletion, is the Alternative Minimum Tax (AMT).  The AMT can significantly limit the usefulness of percentage depletion when the deduction exceeds the basis of the depletable property.  Once percentage depletion exceeds the net cost basis in the depletable property, the excess must be added back as a tax preference item for AMT.  This can typically cause either a corporation or individual who uses percentage depletion to be subject to AMT and effectively lose the benefit of the percentage depletion deduction for tax purposes.  The limitation for AMT enhances the importance to make the correct choice in determining whether to use percentage or cost depletion.

The depletion deduction can be highly beneficial for tax purposes, but also adds complexity to many taxpayers.  It is advantageous to properly use the most effective method of depletion given the tax situation of the operation and the operations shareholders.  If you have any questions please contact Melissa Coombs at mcoombs@ddfky.com or Mike McCreary at mmcreary@ddfky.com.