The transfer of a mineral interest before production represents a significant succession and estate planning opportunity.
Types of Mineral Interests
Ownership of a mineral interest has been referred to as a "bundle of sticks" because it is made up of various components, each of which may be independently held and conveyed from the others. In Texas, for example, the components of a mineral estate are:
1) the right to develop (right of ingress and egress)
2) the right to lease
3) the right to receive bonus payments
4) the right to receive delay rentals
5) the right to receive royalty payments
This bundle of rights can be divided and given to various recipients through a number of transfer methods. Therefore, when making initial decision regarding wealth transfers using mineral interests, a threshold question is: What do you own: surface rights, mineral rights, or a combination of both? And, do you want to sever the interests so that you can transfer some interests while retaining others?
If you own a tract of land that is being explored and considered for drilling, you must determine whether you indeed own the mineral rights. There may be surface owners and sub-surface owners of a particular tract of land. The general rule in many states is that the mineral rights pass with the surface rights, unless they are specifically "carved out" in the document transferring the property (typically, a deed of conveyance). For example, a deed transferring "all rights, title, and interest in and to the following described land" would likely include both the surface and sub-surface rights. If the surface and sub-surface owners are different, however, the sub-surface owner (the owner of the mineral rights) typically has a dominant interest because the surface owner has no claim to any oil, gas, or other minerals that may ultimately be produced from the land. The owner of the mineral rights often holds the more valuable asset.
Succession and Estate Tax Planning
Why Transfer Ownership Interest Now?
A transfer can over time remove an asset with a high future value from your estate and potentially avoid or lesson the estate tax burden.
A transfer can maximize use of lifetime unified credit / annual exclusion gifting at lower value of the property vs. after bonus / royalties paid.
Additionally, it can gift membership interest to each child on an annual basis with a value of up to $13,000 / $26,000 split without affecting the unified credit.
Estate Freeze / Discounts
A transfer today will freeze values of assets at today's value so that all future appreciation occurs outside of a person's estate.
Estate Tax Benefit of Creating an LLC or Other Protected Entity
The first level of discounting occurs when the donor's property is transferred into the LLC or partnership. This discount is for equity in a "private illiquid company."
The LLC or partnership interests that are transferred to the donor's children (or a trust) are discounted for "lack of marketability" and for a "minority interest." The total discounts could range from 20% to 40%.
Please note that if the 2012 budget is adopted, it will minimize discounts for estate planning.
Estate Tax Benefit of Creating an LLC or Partnership
The value of the gifted interest is fixed as of the date of transfer at the discounted value.
All future appreciation of the gifted interest will be attributed to the gifted interest, and thus, will not be included in the donor's estate.
The donor still has some control over the LLC or Partnership, as the LLC Manager or General Partner.
Valuation Methods to Determine Fair Market Value
- Cost or Comparable Sales
- Present Value Method
- Analytical Appraisal Methods
- Other Arbitrary Methods
Valuation of Mineral Rights Without a Lease in Place
- Only the Comparable Sales Method should be used (Market Method).
- Mineral rights should be considered.
- While entering into a lease, drilling and production are speculative.
- It is the lowest possible valuation of mineral rights.
Valuation of Mineral Rights With a Lease in Place, But No Production
- Comparable Sales or Present Value Method can be used.
- Mineral rights must be considered.
- Discounts due to drilling and production speculation are allowed as well as discounts for undivided fractional interests.
- Middle of the road valuation of mineral rights.
Valuation of Mineral Rights (O.R.R.I.) With Active Wells in Production
- Comparable Sales or Present Value Discounted Cash Flow Method can be used.
- Mineral rights must be considered.
- Only discount is for future production risk.
- Highest valuation of mineral rights.
Lifetime Transfer Methods
A. Outright gift.
B. Partnership or LLC holds the interest and then interests in the entities are gifted to a recipient.
1. Valuation Discounts - currently approaching 40-45%.
2. Must have a valuation because it is necessary to place a value on the gift tax returns.
3. Marketability and minority discounts.
a. Generally, no matter how small of an oil and gas interest is held, there is no marketability or minority discount because the interests are readily saleable. Perhaps another discount for undivided fractional interests may be available.
b. However, if the oil and gas interest is placed in a partnership, then marketability and/or minority discounts may be available.
C. Intra-family sales (sales to Intentionally Defective Grantor Trusts).
1. This type of transfer is used to lower gift and estate taxes, but does not affect federal income taxes.
2. Remember that in non-grantor trusts, the rates increase rapidly to 35% for any income over $7,500, so it is wise to distribute the interests out to the beneficiaries.
D. Installment sales.
1. Another way to freeze value for estate purposes.
2. Value of the interest is frozen at the time of the installment sale and the income received from interest is deferred until the time when it is actually received.
3. This method of freezing value is only relevant for relatively small interests because there is currently for year 2011, a $5 million cap on the deferral amount.
E. Private Annuity / Self-Canceling Installment Notes (SCINs) - two of the disappearing value techniques.
1. This technique is extremely efficient when the senior generation family member has an impaired life expectancy.
2. The income tax consequences of the SCIN and private annuity are quite different.
3. The dividing line between SCIN and private annuity income tax treatment is based on the maximum term of the agreement. A term that is either equal to or greater than the seller's life expectancy will be taxed as a private annuity, while a maximum term that is less than the seller's life expectancy will result in installment sale reporting rules.
4. Cost depletion will be based on the actuarial value of the seller's private annuity interest on the date that agreement is entered into. For older sellers, it will often be advantageous to use cost depletion. For younger annuitants, percentage depletion may be more effective.
5. Because there is some uncertainty over the buyer's basis under a SCIN, if cost depletion appears to be an important consideration, you should carefully consider whether either §483 or §1274 will apply to the SCIN. If those sections apply, then the SCIN's basis will be determined under the contingent payment debt instrument regulations, and the buyer will only be able to include payments in their basis in the acquired property as those payments are made.
6. If security is an important consideration, a private annuity is generally not the technique of choice if there is a substantial gain in the oil and gas property being sold.
7. A secured private annuity results in immediate recognition of gain/loss.
F. Grantor Retained Annuity Trust - GRATs.
1. A GRAT is a trust to which the grantor transfers assets in exchange for an annuity payable for a fixed term. At the end of the trust's term, the assets are either transferred to or held for the continuing benefit of other family members. The transfer results in a taxable gift. The gift is measured by comparing the fair market value of the assets at the date of creation to the present value of the grantor's retained annuity as computed using the current §7520 rate.
2. The circumstances that can produce successful GRATs would be a healthy grantor who is adverse to paying gift tax, expects to live well beyond the retained term, and owns assets which are expected to appreciate substantially in excess of the hurdle rate, and is willing to forego any future appreciation from the transferred assets. Producing oil and gas interests, or interests in entities which hold substantial producing oil and gas interest can generate large wealth transfer results in a period of bullish energy prices.
3. Unlike the wealth disappearing planning techniques, the GRAT places the investment risk on the transferor. There is no obligation on the part of the younger generation family members to make payments to the transferor with the GRAT.
4. The family of Sam Walton's brother and sister-in-law popularized the "Zeroed-Out GRAT" when they prevailed in the Tax Court. 115 T.C. 589. (2000). Since the IRS has now acquiesced in the Tax Court's Walton decision, it is possible to structure GRATs with little or no gift tax consequences. Notice 2003-72, 2003-44 IRB 964.
5. One of the practical points when the oil and gas producing property is held directly in the GRAT, rather than through an interest in an entity which holds the oil and gas interest, is that the property may be generating considerable cash flow. That cash flow, if sufficient, can avoid the need to have multiple valuations done at each anniversary of the GRAT. When dealing with oil and gas interests that don't require annual valuations, this will generate a transactional cost savings, which could be quite significant.
G. The 2012 budget, if passed, will extend the GRAT period to a ten-year period.
H. Charitable planning for oil and gas interests.
1. Unitrusts may not be appropriate vehicles because of the annual valuation requirement when producing or non-producing oil and gas assets are contributed to a split interest trust.
2. Gifts to private foundations require careful scrutiny to determine whether the oil and gas interest may be potentially an excess business holding. It is possible to structure royalty type interests that will avoid this issue. However, any oil and gas interest contributed to the private foundation may create practical problems from an administrative standpoint, such as the need for an annual valuation.
3. A Charitable Lead Annuity Trust can be another wealth disappearing technique. However, the use of the actuarial tables is predicted on the grantor's health being sufficiently good and that there is a 50% or greater probability of him/her living at least one year at the time the technique is implemented.
We have extensive experience with oil and gas valuations to include Tax Court experience.
We have a full-time landman on staff who can also broker and initiate leases and provide second opinions on the lease bonus values being offered as well as title searches.
We have the ability to work in 40 states of the continental U.S. including Alaska.