IRC Section 613A: Oil and Gas Percentage Depletion Limits and Rules

Percentage depletion for oil and gas lets independent producers and royalty owners deduct 15% of the gross income from a qualifying property each year, but the benefit is boxed in by three limits: a daily production ceiling of 1,000 barrels (or the gas equivalent), a cap of 65% of overall taxable income, and disqualifying thresholds for retail sales and refining activity.¹ Section 613A of the Internal Revenue Code draws a sharp line between small operators, who can still use the deduction, and large integrated companies, which cannot.

Unlike cost depletion, which stops once a property’s basis reaches zero, percentage depletion can continue year after year as long as the property produces income. That is what makes it worth qualifying for, and what makes the eligibility rules matter.

Who Qualifies as an Independent Producer or Royalty Owner

Eligibility turns on what you don’t do. Two activities knock a taxpayer out for the entire tax year: retailing petroleum products above a dollar threshold, and refining crude oil above a volume threshold.

The Retail Sales Test

You lose eligibility if you or a related person sell oil, natural gas, or products made from them through retail outlets and combined gross receipts from those outlets exceed $5 million during the tax year.¹ A retail outlet, for this purpose, is any location where petroleum product sales make up more than 5% of total gross receipts. The rule also catches indirect retailing through someone selling under your trademark or occupying an outlet you control. Bulk sales to commercial or industrial users and sales outside the United States are excluded from the calculation.

The Refinery Test

You are also disqualified if you or a related person refine crude oil and combined average daily refinery runs for the tax year exceed 75,000 barrels.¹ The average is total refinery runs for the year divided by the number of days in that year. A small refining operation that stays below that daily average can still qualify.

The 1,000-Barrel Daily Production Cap

Even a qualifying producer can only apply percentage depletion to a limited volume. The statute sets a tentative depletable quantity of 1,000 barrels of oil per day.¹ Production above that line must fall back to cost depletion.

Average daily production is your total domestic crude oil and natural gas output for the year divided by the days in the year. If you own a partial interest in a property, only your share of revenues counts. When production exceeds 1,000 barrels a day, the percentage depletion allowance is prorated across your producing properties based on the ratio of your depletable quantity to your total production.

The 1,000-barrel cap applies to oil and gas combined. You can elect to convert some or all of the depletable oil barrels into a natural gas equivalent at 6,000 cubic feet of gas per barrel.¹ Each barrel converted reduces the depletable oil quantity by one, so the total never exceeds 1,000 barrel-equivalents.

The 15% Rate and the Marginal Property Bump

For most qualifying production, the percentage depletion rate is 15% of gross income from the property. Gross income for this purpose excludes lease bonuses and advance royalties, which must be subtracted before figuring the deduction.²

A higher rate can apply to production from marginal properties when crude oil prices are low. The formula adds one percentage point to the 15% base for each whole dollar by which $20 exceeds the reference price of crude oil for the prior calendar year, up to a maximum of 25%.³ When the reference price is $20 or higher, the adjustment does nothing and the rate stays at 15%.

The Two Taxable Income Ceilings

After the rate and quantity calculations, two income-based caps apply: one at the property level, one at the return level.

100% of Property-Level Income

Percentage depletion on an oil or gas property cannot exceed 100% of your taxable income from that property, figured before subtracting depletion or any Section 199A deduction.⁴ That is more generous than the 50% cap that governs most other minerals; a property that just breaks even after expenses can still generate a full deduction. This is a hard ceiling with no carryover. Anything cut here is gone.

65% of Overall Taxable Income

Total percentage depletion across all properties cannot exceed 65% of your taxable income from all sources.¹ When computing the base for this cap, exclude the percentage depletion deduction itself, any net operating loss carryback, and any capital loss carryback, so the math does not run in circles.

Any amount cut by the 65% rule carries over indefinitely and is treated as an allowable percentage depletion deduction in the next tax year, subject again to the same ceiling.⁵ A lean year followed by a recovery can make that carryover meaningful.

Aggregation Among Related Parties

The 1,000-barrel quantity is meant for small independents. To keep larger enterprises from splitting into pieces to multiply it, Section 613A aggregates related parties so the cap applies once across an economic unit.

Members of the same controlled group of corporations share a single 1,000-barrel depletable quantity, allocated by each member’s proportionate share of domestic crude oil production.¹ The controlled-group definition borrows from Section 1563(a) but uses a more-than-50% ownership threshold instead of the usual 80%. Outside the corporate context, aggregation applies whenever 50% or more of the beneficial interest in two or more corporations, trusts, or estates is owned by the same or related persons (counting only 5%-or-greater owners).

Family members share a single quantity too. Family here is narrow: the taxpayer, their spouse, and their minor children. Transferring interests to a spouse or a minor child does not create a fresh 1,000-barrel allotment.

Partnerships and S Corporations

When oil and gas properties are held through a partnership or S corporation, the entity does not claim depletion. Each partner or shareholder computes it individually.¹ The entity allocates each owner’s share of adjusted basis in each property, and the owner tracks that basis, adjusting it every year for depletion taken. The qualification tests, the 1,000-barrel cap, and the 65% ceiling all apply at the owner level. Ten partners do not get ten caps.

Alternative Minimum Tax Treatment

Excess percentage depletion over a property’s adjusted basis is ordinarily a tax preference item for alternative minimum tax purposes under Section 57(a)(1). Depletion computed under the Section 613A(c) independent producer exemption is carved out and is not treated as a preference item.⁶ For a producer whose depletion routinely runs past remaining basis, that exclusion is one of the most valuable pieces of qualifying under Section 613A.

How to Claim the Deduction

Individuals claim depletion on Schedule E of Form 1040 in the expenses section for supplemental income and loss.⁷ Interests held through a partnership or S corporation flow through Schedule K-1, and you use those figures to compute your own depletion.² Track adjusted basis in each property separately. Cost depletion sets the floor whenever it exceeds the percentage calculation, and your gain or loss on any future sale will depend on that running basis figure.

1
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
2
Internal Revenue Service. Publication 535 – Business Expenses
3
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells – Section: Oil and Natural Gas Produced From Marginal Properties
4
Office of the Law Revision Counsel. 26 USC 613 – Percentage Depletion
5
eCFR. 26 CFR 1.613A-4 – Limitations on Application of Percentage Depletion
6
Office of the Law Revision Counsel. 26 USC 57 – Items of Tax Preference
7
Internal Revenue Service. Tips on Reporting Natural Resource Income