Drilling fund investors can’t enjoy limited liability if they want to claim the initial writeoffs these investments offer. Therefore, many drilling funds offer investors “working interests” (ownership shares in the pool of capital), which qualify for the upfront deduction. Holders of these working interests, though, must be willing to bear operating as well as financial risks.
Fortunately the tax code allows drilling fund sponsors to offer these protections:
- They can fully indemnify investors.
- They can provide insurance.
- They can to pledge all of the company’s assets to safeguard investors from losses.
For investors, therefore, it’s necessary to consider the sponsor’s financial strength and whether it will take the above steps to protect investors. In most deals, investors are given the opportunity to convert to limited partnership interests–with limited liability–after most of the drilling has been done and the tax deductions no longer will be meaningful.
