Presented by:Presented by:

Ambrose Wealth ManagementAmbrose Wealth ManagementThomas K. Ambrose, CEAThomas K. Ambrose, CEA

Peter N. BlokPeter N. Blok

Investing in Domestic Gas Drilling &

Income PartnershipsTax Deductions, Cash Flow, and an Alternative to

the Stock & Bond Markets

Gas Drilling & Income Partnerships Gas Drilling & Income Partnerships may be of interest to you if you are…may be of interest to you if you are…

• In a high tax bracket

• Expecting to sell an asset for a significant gain this year or next.

• Looking for investment alternatives to the stock market

• Looking to benefit from rising energy prices

• A Believer in a long-term need for domestic fuel sources

Today’s ChallengesToday’s ChallengesTaxes

• Income Taxes– Salary

– Bonuses

– RMD: Required Minimum Distributions

– IRD: Income in Respect of a Decedent

• Capital Gains Taxes– Plus Depreciation Recapture Taxes

• Estate Taxes

Take Advantage of Take Advantage of Rising Gas Prices & Tax DeductionsRising Gas Prices & Tax Deductions

Your investment choices should be shaped by your personal financial situation, your financial goals, and your comfort level with different investment types. This presentation is an introduction to some of the features of Domestic Natural Gas Drilling Income Programs. The

information included may help you decide if this is the right investment for you.

Investment OverviewInvestment OverviewWhy Domestic Natural Gas?Why Domestic Natural Gas?

• We have Limited Resources – The Government Wants It!

• Middle East Instability

• Environmentally Friendly, and

• Profitable & Deliverable

Developmental

• Less risk – (high completion %)

• More predictable income

• More predictable cost

• Investment Goal: Income

Exploratory

• High risk– (greater dry wells)

• Less predictable results

• Unpredictable cost

• Investment Goal: High ROI

Investment OverviewInvestment OverviewExploratory vs. DevelopmentalExploratory vs. Developmental

Investment OverviewInvestment OverviewExploratory vs. DevelopmentalExploratory vs. Developmental

Developmental infill & offsetting

Developmental

Exploratory (Wildcat)

Productive WellDry Well

Investment OverviewInvestment OverviewCash Flow BasicsCash Flow Basics

• Each partnership uses funds to drill new wells• Wells target primarily natural gas (some produce oil)• Revenue from sale of oil and gas from successful wells is distributed

monthly or quarterly– Begins roughly 8-12 months after the investment offering closes.– Cash flow/production historically follows a hyperbolic curve

• Historically, 50% of expected production returned in first 5-8 years of partnership, balance for 20-30 years.

• Production from advanced drilling techniques may increase the volume and longevity of cash flows.

• Historical returns of prior partnerships are not entirely relevant to current & future offerings due to the changes over time of the following factors:– Price Fluctuations– Drilling Costs & Techniques– Geography/Geology– Tax Incentives

Investment OverviewInvestment OverviewPrice FluctuationsPrice Fluctuations

•Price is dictated by demand, supply, and deliverability!

•Managing General Partners may pre-sell gas distributions as a price risk hedge at their discretion.

• IMMEDIATELY UPON INVESTMENT• May be entitled to deduct up to 95% of investment in the current year.

• Or spread deduction over 5 years• May also reduce:

• State income taxes (not PA)• Self-employment taxes (Schedule C)• Alternative Minimum Tax• Phase-out of deductions and exemptions

• TAX-SHELTERED INCOME DISTRIBUTIONS• 15-25% Tax-Free Depletion Allowance on income distributions• May be available for the life of the well, under current law

• Clients receive a schedule K-1, details placed on Schedule E, part 2• Make sure deduction is reflected on 1040 line 17!

Investment OverviewInvestment OverviewTax SavingsTax Savings

May be entitled to deduct up to 95% of investment in the current year. Reduce withholding or quarterly

payments May also reduce:

State income taxes (not PA) Self-employment taxes

(Schedule C) Alternative Minimum Tax Phase-out of deductions and

exemptions

17. Rental Real Estate, royalties, partnerships….. 17._____

Did you know that the IRS allows you to

deduct IDCs?

TaxesTaxesImmediate Tax SavingsImmediate Tax Savings

A “depletion” deduction is allowed for oil and gas production

The deduction may reduce the tax you owe on the income from the investment by about 15%-25%

And the deduction may be available for the life of the wells under current law

$8,000

-2,000

$6,000

-1,200

$4,800

Gross Income from wells

Less lease operating costs & taxes

Net Income from wells (cash to distribute)

Less percentage depletion (15% of gross income for 2003, 20% of Net Income from wells)

Taxable income from wells

This example is for illustrative purposes only. Actual results will vary depending upon the performance of the wells and each investor’s individual circumstances. Depletion deductions may be subject to recapture upon the sale of the depleted

asset or upon the sale of an investor’s investment in the partnership.

TaxesTaxesSheltered DistributionsSheltered Distributions

Investment OverviewInvestment OverviewGeneral Partner vs. Limited PartnerGeneral Partner vs. Limited Partner

• General Partners (most investors): – May utilize deductions from the program against income from any

source

– Convert to LPs upon drilling completion (6-12 months)

• Limited Partners:– May utilize deductions from the program only against passive income,

and

– C Corporations may use passive losses against active income

Investment OverviewInvestment OverviewGeneral Partner LiabilityGeneral Partner Liability

• General Partners (most investors): – Have unlimited liability during drilling (approx 6-12 months)

• Converted to LP status when drilling is done

• Insurance– Partnership indemnification to investors

– Sub-contractor (separate insurance policy)

• Assets of the General Partner and the Investment Partnership

• A personal umbrella policy would cover general partner investors.

• Geographical diversification

Investment OverviewInvestment OverviewCostsCosts

• Intangible Drilling Costs (IDC)– Expenditures made for wages, fuel, repairs, hauling and supplies necessary for

the drilling or recompletion of an oil or gas well and the preparation of such well for the production of oil or gas, but without any salvage value.

• Tangible Drilling Costs (TDC), and– Expenditures necessary to develop oil or gas wells, including acquisition,

transportation and storage costs, which typically are capitalized and depreciated for federal income tax purposes.

• Organizational & Offering Costs– Legal, tax, investment structuring costs

Geology: Marcellus ShaleGeology: Marcellus Shale

Risks and other ConsiderationsRisks and other ConsiderationsMinimizing Investment RisksMinimizing Investment Risks

• Subordination (Clients Come First!)– 50% preferred return (before GP receives profit) in first 5 years (without depletion tax

benefits)

• Presentment Feature– In case of client emergency, GP will buy back shares at present value after 5 years

• Geography– Direct Pipeline Accessibility & High Demand from Northeastern region

• Gas Marketing Strategy– Hedging & Diversification by End User

• Due Diligence at the Sponsor Firm & Broker-Dealer Level– Officer Interview, Business Model, Operational Costs, Distribution Records

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income Programs

• High-Income Taxpayers

Most investors in gas drilling income programs have substantial annual income resulting in equally substantial income tax burdens. In addition to diversification, investors seek the initial year tax deduction of 90% on the invested amount each time an investment is made.

• Reduce Alternative Minimum Taxes

The intangible drilling cost deduction from a gas drilling program can help reduce a taxpayer's alternative minimum taxable income by up to 40%.

• Investors Selling Highly Appreciated Assets

As long as the program investment is made during the same tax year as the sale of the highly appreciated stock, real estate, or stock, the 90% tax deduction can offset the income and capital gains taxes due on the asset sale.

• Clients Taking Retirement Plan Withdrawals

Those taking Required Minimum Distributions can offset related income taxes by investing a portion into a tax deductible, income-producing gas drilling program.

• Roth IRAs:

Conversions from a traditional IRA to a Roth IRA or initial Roth IRA contributions are only eligible to those under a certain threshold of Adjusted Gross Income. For those seeking to reduce their AGI below the threshold, an investment in gas drilling programs can make them eligible for conversion or contributions to Roth IRAs as well as offer a reduction in their taxes for the year invested.

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income Programs

• Family Gifting

Investors in high tax brackets can take the first year tax deduction. Subsequent years of taxable partnership income can be used to pay income taxes or may be gifted to family members in lower tax brackets.

• College Education Planning

Investors benefiting from the first year tax write-off can direct the subsequent year's monthly income flows towards college education savings accounts.

• Closely Held & C Corporations

Most closely held corporations can use the initial year tax write-off to reduce operating income. C Corps may invest as a limited partner in order to limit investor liability while offsetting passive losses.

• Financial Planning Reinvestment

Consider using the cash distribution to invest in other diversified investment vehicles, annuities, or insurance premiums.

• 1031 Exchange Alternative

Often real estate replacement is done solely to defer capital gains taxes. As an alternative, consider selling the real estate, directing a portion of the real estate proceeds into a gas drilling program, using the 90% tax deduction to offset the recognized capital gains, with the remaining proceeds diversifying into additional non-real estate investment vehicles.

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #1 – AMT Income ReductionHypothetical #1 – AMT Income Reduction

With No With $75,000Drilling DrillingInvestment Investment

Income $750,000 $750,000Intangible Drilling Cost Deduction - ($67,500)Adjusted Gross Income $750,000 $682,500Itemized Deductions ($31,781) ($33,795)Personal Exemptions - -Regular Taxable Income $718,219 $648,705Federal Tax $128,038 $106,700

AMT Income $710,000 $642,875AMT $130,300 $112,148

Additional AMT $2,262 $5,448Total Taxes $130,300 $112,148

Potential Tax Savings $18,152% of Total Investment 24.20%

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #2 – 1031 AlternativeHypothetical #2 – 1031 Alternative

Situation: Client sold rental propertyNet Sale Proceeds of $1,000,000

Basis $500,000 Additional Depreciation of

$200,000 L-T Capital Gain of $500,000 $250,000 Ordinary Income Exposed to AMT due to income and capital gains level

Goals: Reduce federal income and long-term capital gains taxes,

Annual Income,

Asset diversification, and

Low Maintenance!

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #2 – 1031 AlternativeHypothetical #2 – 1031 Alternative

1031 Exchange Solution

$1,000,000 Proceeds

$500,000 Basis

$1,000,000 Purchase

$500,000 Basis

1031 Exchange

Capital Gains & Depreciation

Recapture Tax Deferred

$60,000 Annual Rental

Income

$60,000 Annual Rental

Income

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #2 – 1031 AlternativeHypothetical #2 – 1031 Alternative

Pay Taxes and Re-Invest

$1,000,000 Proceeds

$500,000 Basis

$875,000 Stock/Bond Portfolio

$50,000 Depr. Recapture & $75,000

Cap Gains Tax

$43,750 5% Systematic

Investment Withdrawals

Net Proceeds

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #2 – 1031 AlternativeHypothetical #2 – 1031 Alternative

Advanced Planning with Gas Drilling Programs

$1,000,000 Proceeds ($500,000 Basis)

$95,000 Gas Drilling

Income Program

$56,647 Partially-Sheltered Income

$50,000 Depr. Recapture & $75,000 Cap Gains Tax

$29,925 Saved against Ord. Income!

$904,925 Retirement Distribution Strategy

$95,000 Prof. Managed

Real Estate

$714,925 Prof. Managed Stocks/Bonds

15% 5% 7%

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #3 – RMD GiftingHypothetical #3 – RMD Gifting

Situation: Client must take $50,000 RMD

Doesn’t need the income

Doesn’t want the tax bill!

Goals: Reduce taxes

Put the income to the benefit of the family

Reduce the taxable Estate

Applications of Gas Drilling Income ProgramsApplications of Gas Drilling Income ProgramsHypothetical #3 – RMD GiftingHypothetical #3 – RMD Gifting

IRAYear 1

$50,000RMD

$50,000

Yr. 1 Tax Due $17,500

$45,000 Deduction

Tax reduction $15,750

$1,750 Due on RMD

Year 2+

$50,000 FLP Trust

(out of estate)

70% Discount $15,000 gift

LPs

529 Plan Contributions

~$7,500

Hypothetical AssumptionsHypothetical Assumptions

• 35% Federal Tax Bracket

• 15% income from gas partnerships beginning in same year as investment

• 5% annual systematic investment withdrawals taken from stock & bond portfolios

• 7% income distribution rate from managed real estate portfolios

The above assumptions may not apply to your particular case or need. Peformance and other market-related rates will very. The advantages and disadvantages of investing in gas drilling income partnerships must be determined through an in-depth consultation with your financial advisor.

Investor Partnership OverviewInvestor Partnership OverviewRisk Factor DisclosuresRisk Factor Disclosures

• Drilling natural gas & oil is speculative. The wells might not produce gas or oil. As a result, your investment in the partnership may not be profitable and could result in the total loss of your investment.

• The Managing GP has not selected any prospects for acquisition, therefore the investor partners will be unable to evaluate any prospects prior to their investment.

• Investors can anticipate an extended period (7-17 years) before their achieve payout of their original investment.

• Any fluctuations in oil and gas prices will affect the cash distributions and profitability of the investment.

• Additional GPs have unlimited liability for partnership obligations beyond insurance, partnerships assets, and the assets of the Managing GP.

• Since there is no public market for partnership units, the investment has limited liquidity.

• Through their involvement in various activities, the Managing GP has interests that conflict with those of the investor partners.

• The partnership may drill exploratory wells which have a much higher risk of loss than development wells.

• Reduced availability of drilling rigs, due to increased equipment demand may delay the drilling of wells and distribution of cash to investors.

• Fluctuating prices, increased competition, and government regulation may increase operating costs and adversely affect profits of the partnership.

• Environmental hazards may adversely affect the profitability of the partners.

• An investor who subscribes for Units may not revoke the subscription.

• Increased drilling costs may adversely affect the profitability of the partnership.

Thank You

• Ambrose Wealth Management– Thomas K. Ambrose, CEA & Peter N. Blok– 810 Baltimore Pike, Suite 1

Chadds Ford, PA 19317– (610) 388-4424– www.ambrosewm.com– tambrose@ambrosewm.com– pblok@ambrosewm.com