As a result of the Utica Shale formation under Tuscarawas County and counties east of Tuscarawas, landowners are receiving significant figure offers from oil and gas companies to lease their oil, gas, and mineral rights (hereinafter referred to throughout this article as “mineral rights”. In fact, many people are becoming instantly wealthy overnight as a result of executing these leases. If you receive an offer to lease your mineral rights, what should you do?
You need to obtain solid legal, tax planning, and financial planning advice to make sure that you understand the terms of the lease and appreciate what you will net after taxes. Although the signing bonus and anticipated royalties are large, these funds should be put to their best use or else they could be lost through poor planning.
Before signing any lease documents, the offer and lease should be reviewed by an attorney who is familiar with oil and gas law. The attorney should be able to tell you if the offer is an amount in accordance with the current going lease rates. Offers are increasing every day as more and more oil and gas companies get involved. The attorney may recommend that you become involved in a group of landowners who are pooling their interests to get a higher lease offer. The attorney may recommend various changes to the lease which may or may not be able to be made. However, you will at least know the meaning of the various provisions in the lease and can make a decision as to whether or not you can accept the terms, or if you would like to change any of the terms. Even slight changes to the lease agreement can have significant ramifications on your expected royalties and in some events your renewal signing bonus.
From an income tax perspective, generally, revenue from mineral rights, i.e. royalties, is subject to federal and Ohio income tax. However, you may be able to take a depletion expense which can be deducted from the income. Mineral rights are considered capital assets for tax purposes. The key is to determine whether or not these types of assets have a cost basis. A cost basis in real property is the purchase price for the real property, mineral rights, equipment, buildings, and timber. Most people did not allocate cost basis to mineral rights when they purchased their land. Therefore, unless a cost basis was established for your mineral rights at the time of purchase or at the time of receipt if inherited or received as a gift, the mineral rights have no-cost basis. The cost depletion expense may only apply to landowners who have established a basis in their mineral rights. However, landowners without a cost basis may be able to use a percentage depletion expense instead.
If you sell mineral rights, for tax purposes, this is treated as a long-term capital gain, as long as the land has been owned for more than one year. More commonly, the landowner enters into a lease agreement with a third party for his mineral rights. Payments received from these types of leases can be an upfront cash bonus payment payable upon the execution of the lease or actual royalty payments when the well finally starts to produce.
Up-front cash bonus payments for signing the lease are usually received when the lease is executed, and they are treated as ordinary income for tax purposes. Up-front bonus payments do not qualify for percentage depletion deductions. If drilling results in a productive well, the landowner will receive periodic royalty payments for his share of the production in accordance with the terms of the lease. This royalty interest may be anywhere from 12% to 18%, and it is suggested that this payment is on the gross amount. Royalty payments are considered ordinary income to the landowner and are subject to the percentage depletion deduction.
Your CPA will be able to estimate what your taxes may be as a result of entering into a lease for your mineral rights. Ways to defer or reduce the amount of taxes that will be paid exist, however, sometimes this benefit comes at a cost. The most common way is for you to gift all or a fraction of your interest to your children or other relatives. This needs to be done before the lease is signed in order to spread out the bonus payments among various individuals. This is a gift, but in all likelihood, unless it is a very large gift (currently over $5,000,000), no gift taxes will be owed. This will provide cash flow/liquidity to your children and may also spread out the income tax liabilities into people’s hands with lower tax rates. However, even though this is very simple planning, the parent loses control and may not like this. Additionally, if the mineral rights are owned by a corporate entity, losses may exist to offset this income. Farmers may also be able to purchase certain farm equipment in the year the signing bonus income is received and use the cost as an income tax deduction. The specifics concerning these items are beyond the scope of this article but should be discussed with your CPA and attorney.
You should also consider other estate planning techniques in order to make sure that family land passes on to the next generation. The key is to explore these options sooner, rather than later. Unexpected illnesses, deaths, or divorce in a family may lead to the sale of family land in order to resolve these issues and/or tax issues. Some families are forming limited liability companies “(LLCs”) and the LLC owns the real estate. The parents and children are the owners, however, the parents maintain voting control of the entity. The LLC owns the lease, the funds are transferred into the LLC, and the parents control the distribution of the funds. The funds are taxed at each individual member’s tax rates. An LLC allows for centralized family management with potential tax savings.
After you receive the funds, you need to speak with your financial advisor. You should understand your available investment options including but not limited to savings accounts, certificates of deposits, stocks, bonds, annuities, and life insurance. You need to invest the funds in accordance with your investment risk tolerance. Your financial advisor will be able to provide detailed options.
After receiving an offer to sell your mineral rights, please make sure to engage the appropriate professionals to assist you with an estate, tax, and financial planning matters before entering into the lease agreement.
NOTE: This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.
James F. Contini II, Esq.
Certified Specialist in Estate Planning,
Trust & Probate Law by the OSBA
Krugliak, Wilkins, Griffiths & Dougherty Co., LPA
158 North Broadway
New Philadelphia, Ohio 44663