Deduction of Mineral Exploration Expenses

Internal Revenue Code Section 617(a) gives taxpayers engaged in exploring for deposits of ore or other minerals the option to deduct the entire cost of “exploration expenditures.” These expenditures would otherwise have to be capitalized. For a corporation that makes the election, the deduction is cut back 30%. The 30% cut back amount must be capitalized and amortized ratably over the 60-month period beginning with the month the costs were paid or incurred.  

Exploration expenditures defined.

Exploration expenditures are the costs that are incurred directly or through a contract, before the beginning of the development stage of the mine. They are expenses made to ascertain the existence, location, extent, or quality of any deposit of ore or other mineral (other than oil and gas) that qualifies for percentage depletion. Development expenses, on the other hand, are subject to the election under Code Sec. 616.

If a taxpayer incurs exploration costs when he acquires a share of a working or operating interest in a mine, the costs are deductible only to the extent that they are not attributable to the cost of the operating interest. However, if a taxpayer agrees to explore, develop, and operate mineral properties in return for all income from the property until recoupment of its costs (payout), he may deduct all his exploration expenses if he made the Code Sec. 617(a) election. In that case he held 100% of the operating interest in the mineral property throughout the complete payout period.

Considerations in making the election.

Making the election has the following tax consequences:

(1) Any deduction taken pursuant to the election is recapturable, either by way of offset against depletion deductions or an election to include these expenditures in gross income in the year that the mine to which they were chargeable reaches the production stage.

(2)  The deduction is an adjustment for alternative minimum tax purposes.

(3)  Electing to reduce taxable income by deducting exploration expenditures currently may trigger the application of the 50% of taxable income limitation on percentage depletion, thus deferring the otherwise allowable deduction for depletion and offsetting some of the benefit sought to be realized from the election.

(4)  On the sale or other disposition, the deduction is recaptured as ordinary income.

(5)  Corporate taxpayers must capitalize and write the deduction off over a 120-month period for purposes of computing earnings and profits.

Who can make the election.

The election is available to an owner of an economic interest in the mineral property who, as stated above, paid or incurred the exploration expenditures directly or through a contract. Where the expenditures are incurred by a partnership or an S corporation, the election is not made by the partnership or the S corporation, but must be made by each partner or shareholder separately.

How and when to make the election and to attach the required information.

The election may be made at any time before the expiration of the period prescribed for claiming an income tax credit or refund for the tax year in which the expenditures were paid or incurred.

The election is made by deducting exploration expenditures on the taxpayer's income tax return for the first tax year for which he desires to deduct exploration expenditures. If the election wasn't made on the original return for that year, it may be made by taking the deduction on an amended return filed before the end of the refund claim period for the election year. In the latter event, if post-election year returns have been filed before the amended return for the election year is filed, amended returns also must be filed for all post-election years affected by the election to reflect any increase or decrease in tax attributable to the election. And where appropriate the recapture rules must be applied in recomputing the tax on the post-election year amended returns.

The return for each tax year for which the taxpayer deducts exploration expenditures must clearly state the deduction claimed under Code Sec. 617(a) for each property or mine. Each property or mine must be adequately described and identified to permit application of the recapture rules.

Once made, the election applies to all mine exploration costs paid or incurred by the taxpayer during the tax year and in all subsequent tax years, and can be revoked only with the prior consent of the Commissioner. Consent will not be granted where the principal purpose of the revocation is to circumvent the recapture rule described above.

If consent is granted, a copy of the letter granting the consent must be filed with the director of the IRS service center with which the taxpayer's income tax return is required to be filed and must be accompanied by an amended return or returns, if necessary.