Landowners in the Marcellus Shale formation are participating in one of the greatest economic opportunities for Pennsylvanians in our lifetime. This new wealth is generated through the sale of oil and gas rights, the leasing of oil and gas rights, surface damage payments and production-related royalties. To paraphrase Benjamin Franklin, “The only two certainties in life are death and taxes,” and for these landowners, the certainty of taxes is real, both during life and at death by virtue of the estate tax.
Income Tax Considerations
In order for landowners to have the most efficient tax outcome, careful tax planning must be completed before a deal is finalized. Before selling or leasing your oil and gas interests, you must speak with a qualified tax advisor. Some things to consider from an income tax prospective:
- Plan for Tax Rates
- Ordinary tax rates apply to leasing transactions. Maximum individual ordinary tax rates are currently 35% for the 2011 and 2012 tax years.
- Capital gain rates apply to sale transactions when the landowner has no retained economic interest. Maximum individual long-term capital gain rates are currently 15% for the 2011 and 2012 tax years.
- Production payment structures can achieve similar results to traditional lease/royalty arrangements while allowing for the usage of favorable capital gain tax rates.
- Without Congressional action, maximum individual ordinary income and long-term capital gain rates are scheduled to increase to 39.6% and 20%, respectively.
- As a result of the Patient Protection and Affordable Care Act, beginning in 2013, royalty income will be subject to an additional tax of 3.8% for individuals with modified adjusted gross income greater than $200,000 ($250,000 for married taxpayers). This will increase the maximum individual tax rate to 43.4% for royalty income, an 8.4% increase over current tax rates.
- Income Deferral Opportunities
- Consider a structured oil and gas lease bonus agreement.
- Surface damage payments may be a reduction of basis instead of income to the recipient.
- Percentage Depletion
- Landowners may qualify for a special provision of the Internal Revenue Code §613A, effectively taxing 85% of royalty payments.
- Coordination with Passive Loss Rules
- Lease payments are considered non-passive land rental income and cannot be used against other passive activity losses.
Estate Tax Considerations
Estate taxes are imposed based on the fair market value of a decedent’s assets. As many of us are aware, the value of landowners’ oil and gas rights in the Marcellus Shale formation has dramatically increased in recent years. With the increase in oil and gas right values, the potential estate tax burden related to the ownership of oil and gas rights has also increased; however, careful tax planning can help mitigate the estate tax burden of oil and gas rights ownership. Some things to consider from an estate tax planning perspective:
- Gifting Opportunities
- Currently, individuals can transfer up to $5 million (married taxpayers have a combined $10 million exemption) tax-free to their heirs, whether during their lifetime or upon passing.
- Unless Congress agrees to extend the exclusion, it is scheduled to expire December 31, 2012, reverting back to a $1 million lifetime exemption.
- Gifting of oil and gas rights today will allow the asset’s future appreciation to occur in the estate of the individual who received the gift. Gifting assets that have a high potential for appreciation will maximize the benefit of current gifts.
- Limited Production Data
- Appraisals are required to value land holdings.
- The most generally accepted appraisal methodology for proven gas reserves projects is the stream of royalty income over the lifetime of a well, reduced to its present value.
- Non-producing properties inherently have a lower value due to limited production data.
- Increased Estate Tax Exposure Over Time
- The most favorable gifting exclusions in our nation’s history potentially will be phased out.
- As more gas is produced and production reports are filed with the Pennsylvania Department of Environmental Protection, the appraised value of oil and gas rights, including non-producing oil and gas rights, is likely to increase dramatically.
- Advancement in the technologies and techniques utilized in the drilling and extraction of natural gas will contribute to future increases in the fair market values of oil and gas rights.
The taxation of the sale and/or lease of oil and gas rights can be confusing. Landowners who choose to design a tailor-made plan to monetize Marcellus Shale oil and gas rights will realize the benefits of minimizing income and estate taxes while maximizing wealth for large expenditures such as:
- College education
- Major purchases
- Charitable giving
- Medical expenses
Schneider Downs has the experience necessary to develop a plan that maximizes your after-tax return on oil and gas rights. To learn more about potential favorable tax outcomes for landowners, contact a trusted Schneider Downs advisor today.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.