Understanding royalties, death taxes and ownership entities
Reprinted with permission from the “February 5, 2013 edition of the “Legal Intelligencer”© 2013 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, firstname.lastname@example.org or visit www.almreprints.com.
While the Marcellus and Utica shales present a boon to the Pennsylvania economy, the negotiation of a lease should not be the only legal consideration for a landowner. There are a multitude of estate and income tax issues to consider both before and after signing a lease and before drilling commences.
Landowners should consult with an attorney knowledgeable in the shale gas area before signing a lease. After signing a lease, a title search is conducted and, upon completion, landowners may receive a cash bonus or advance rental which is treated as ordinary income for income tax purposes. Records filed by the gas company with the county will determine the landowner’s decimal interest and percentage of royalties. Once the landowner knows the nature and extent of his royalties, planning can be personalized. Landowners should consider which type of entity is best suited to receive bonus payments and royalty interest.
There are non-tax related reasons to plan for bonus and royalty payments. If a landowner decides to retain the land, then estate plan documents such as wills or revocable trusts should be reviewed to ensure that the land, monies already received, and/or future bonus or royalty payments pass to the intended heirs in a sensible manner. For example, if landowners simply want to ensure that the land or royalty payments or family assets stay within the family unit and are not subject to the claims of creditors or the divorce of a child or grandchild, then a trust of some sort might be incorporated into the estate plan.
Some landowners have expressed a desire to share some or all of the bonus and/or royalty payments with their heirs while they are alive. Some of the more popular strategies include separating the ownership of the surface and subsurface rights and the utilization of family limited partnerships and Dynasty trusts.
The first thing to consider is whether the landowner wants to separate the ownership of the surface (the land itself) and subsurface rights (oil, gas and other mineral rights). This could aid in gifting interests in property or in preparing for a sale of the land.
If the landowner wants to sell the land, subsurface rights can be sold along with the land or be retained by the seller. If the landowner wants to share the potential income stream that can be derived from the subsurface rights, those oil and gas rights can be gifted separate and apart from the land which in turn can be gifted in whole or in part.
Let’s now explore the benefits of separating the surface and subsurface rights and the planning vehicles that can be utilized. As stated previously, if the subsurface rights are separated from the land and then gifted to a trust, partnership, etc., the cash flow generated from the natural gas exploration can be shielded from death taxes, divorce, and other creditors. In addition, if done in a timely manner, the income can be removed from being an “available resource” for Medicaid qualification purposes and the use of a partnership or similar vehicle can allow a landowners to treat their children differently (whether they want them to share equally or in different shares, in trust, or outright distributions, etc.).
Severing the surface rights from the subsurface rights, however, can have a negative impact on the overall value of the property. It can also affect the rights of ingress and egress and may limit the use and enjoyment of the property.
Should a landowner choose to separate the surface and subsurface rights, a number of options are available to pass subsurface rights onto the next generation, including: a will or revocable trust, an LLC (limited liability company), LP or FLP (limited partnership or family limited partnership), trust, or life estate deed. Landowners should always consult with their estate attorney to determine the best option for their situation.
Death Tax Issues
The American Taxpayer Relief Act of 2012 (ARTA) was recently signed into law and it contained a host of tax law changes. One of the taxes that was addressed was the federal estate and gift tax. Prior to the enactment of ARTA, the federal estate and gift tax was a conglomeration of piecemeal extensions to existing laws with expiration dates that had the effect of reverting the tax rates and credits back to 2001 levels. More specifically, had ARTA not been signed into law, the top marginal tax rate for federal estate tax purposes would have increased to 55% (and in some instances 60%). In addition, the amount that a taxpayer can transfer free from the federal estate and gift tax (the credit equivalent amount) would have fallen to $1,000,000 (indexed to inflation) from the 2012 level of $5,120,000.
Based upon the foregoing, each taxpayer now has the ability to transfer up to $5,250,000 free from the federal estate and gift tax. A married couple can therefore transfer $10,500,000 free from the federal estate and gift taxes. Any transfers in excess of this amount will be taxed at a flat 40% for federal purposes. Pennsylvania also imposes an inheritance tax that is 0% on transfers to a spouse, 4.5% on transfers to lineal ascendants and descendants (e.g., parents, grandparents, children, grandchildren), 12% to siblings, and 15% to anyone else (except charity, of course).
With the increase in the federal estate tax credits, not all royalty owners will need sophisticated federal estate tax planning. For most, the potential cost of entering a nursing home is a much greater concern. In other words, the individual that owns 20 or 50 or 100 acres could certainly receive a substantial sum of money for leasing his or her property and not have to worry about a 40% death tax. Owners of larger tracts may still find it necessary to explore more sophisticated options.
For those who do need some more sophisticated options, a variety of vehicles should be reviewed. Both Pennsylvania and federal law provide that there is no tax upon the death of the first spouse if the surviving spouse receives all of the property (either outright or in certain trusts). Tax will not be due until the death of the surviving spouse. One way to maximize savings and reduce taxes owed is to create a Credit Shelter Trust (“CST”) upon the death of the first spouse. A CST enables the first to die to leave part of his/her estate to his/her spouse in a trust for life with a remainder to his/her children. The CST can be funded with an amount up to the federal estate tax credit amount (currently $5,250,000), will provide income and financial support to the surviving spouse for life, and then pass to heirs free from federal estate tax.
The first to die can then leave the remainder of his/her estate to the survivor either outright or in trust. A “QTIP” trust is a viable choice as it provides financial support to the survivor but protects the trust assets in the event of the second marriage or if the surviving spouse becomes incapacitated.
A Dynasty Trust is another viable option. If properly constructed and funded, Dynasty Trusts can put the assets in the trust beyond the reach of estate taxes (and creditors and divorces) for the life of the trust – which can be perpetual! Dynasty Trusts can be established by the landowners while they are alive or at death and, if drafted properly, are not subject to realty transfer taxes when land or subsurface rights are transferred into them.
Other types of trusts that can be considered are Charitable Remainder Trusts, where the grantor gets income from the trust for life and the remainder goes to the charity, and Charitable Lead Trusts, where the charity receives income during the grantor’s lifetime and the remainder is passed to heirs.
The limited partnership (or Family Limited Partnership, “FLP”) is another very popular strategy when planning for bonus and royalty payments. The FLP is established with a general partner and one or more limited partners. The general partner controls the FLP and is typically owned by the landowner. The limited partnership interests can be given to the landowner’s children, grandchildren, etc and can be given outright or in trusts (even Dynasty Trusts).
The FLP is flexible as it allows the landowner to give away less than all of the limited partnership interests so the landowner can still enjoy some of the bonus and royalty payments yet share them with family members as well.
One word of caution about the use of the FLP. Transfers of land or subsurface rights to an FLP are subject to realty transfer taxes based upon the value of the interest transferred- even if it is a gift. The realty transfer tax is generally 2% of the value of the interest transferred. Therefore, the transfer of land or subsurface rights with a value of $1,000,000 would trigger a $20,000 tax payment. Unfortunately, landowners are not always advised that the transfer tax is due and owing.
Sometimes an FLP makes sense, but other times, a CST, QTIP or Dynasty Trust is more advantageous. And for some, nursing homes costs are a much larger concern than all the tax aspects. Only one thing is sure, the earlier in the process planning begins, the better – and, choose and advisor that knows this area so you can avoid pitfalls.