July 2013 Tax Alert. Gifts of Mineral Rights: What do charities and donors need to know about gifts of mineral rights? What are mineral rights?

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1 July 2013 Tax Alert Gifts of Mineral Rights: What do charities and donors need to know about gifts of mineral rights? This tax alert will outline several different aspects of this problem: what are mineral rights, how are mineral rights transferred, what tax treatment do mineral rights receive, and what are the most common problems charities experience after receiving mineral rights. What are mineral rights? Traditionally, a landowner possessed rights in his property from the center of the earth to the heavens. Modernly, the interest in real property may be divided in several ways. A landowner may possess rights in from the center of the earth to the heavens. The landowner may have the right to sell or lease the surface interest or the mineral interest. A landowner may possess only rights to the surface of the land. The surface right interests do not entitle the owner to mineral rights. The surface owner may be affected by the development of mineral rights due to the use of the surface to access the minerals. The surface owner retains the right to enter land for non-production uses and may negotiate and receive compensation for damage to the land. The mineral owner's interest is in the minerals under a particular tract of land The mineral owner has the right to: use as much of the surface area of the real property as is reasonably necessary to exercise the owner's rights over the minerals; sell, lease, or convey ownership of the mineral rights; and receive payment from third parties with whom the owner enters into a mineral lease or oil and gas lease. Two legal theories have developed to deal with the division of surface and mineral rights. They are outlined below: 1. Non-ownership theory a. A landowner does not own the oil and gas under the land he owns. b. Not subject to the rule of capture 1. The landowner has the right to extract the oil and gas beneath the property, 2. Acquires ownership only upon actual capture c. Not considered a real property interest

2 1. May be abandoned d. There are no immediate tax implications for land owners in non-ownership states. 2. Ownership-in-place theory a. Followed in Texas and Ohio a. The landowner has a qualified ownership all the oil and natural gas in place under the surface b. Subject to the rule of capture 1. The landowner will lose ownership if someone else extracts the oil or gas first c. The tax implications of ownership-in-place theory deem proven oil and gas reserves as owned and thus subject to property taxation. d. Considered a real property interest 1. Tort claims available 2. Cannot be abandoned Mineral rights can be created by grant, reservation mineral deed, or conveyance with exception. A grantor may transfer his rights during life or at the time of death. The transfer is accomplished when the owner of the rights transfers their mineral rights by signing a deed of conveyance, delivers that deed to the other party and records this deed with the appropriate government office. Mineral rights are categorized into - Hard minerals (coal, gold, or other precious metals), and Natural Gas, Natural Gas Liquids, and Oil (Natural Gas: Dry gas or Wet gas). Utica Shale Play contains significant wet natural gas. These Natural Gas Liquids (NGL) have a higher market value. What are the benefits of having mineral rights? The lessor receives an initial bonus, royalty interest, and possibly delay-rental and shut-in royalty from the lessee. The following outlines possible payments and monetary interests potentially available to holders of mineral rights: 1. Bonus Payment is the amount paid to the lessor for entering into an oil and gas lease 2. Royalty Interest a share in the profits free of the cost of producing a. The lessee pays the lessor a percentage share of the revenue as consideration for the lease b. 12.5% is a common percentage c. Unlike the working interest a royalty interest is not required to pay out, advance, or become liable for the cost of production d. Gross profit interest-royalty percentage is based on production companies gross profit e. Net profit interest -royalty interest is payable only if there is a net profit f. Net profit interest is more common than a gross profit interest 3. Delay Rental is an amount paid to the lessor during the primary term of the lease a. The purpose of the delay rental payment is to extend the primary term without commencing drilling b. The lease may or may not limit the extent of delay rental payments 4. Shut-In Royalty is an amount paid to the lessor during the secondary term of the lease

3 a. The purpose of the shut-in payment is to extend the secondary term without continuing production b. The well is capable of producing oil or gas in paying quantities but lack of suitable production facilities or lack of a suitable market makes production less desirable 5. Non-participating royalty interest is carved out of the mineral interest. 6. A working interest is the operating interest under an oil and gas lease 7. An overriding royalty interest is carved out of the lessee's working interest What unique features occur in leases of mineral rights? The Habendum Clause- term clause, The primary term is the option period for the lessee. The lessee may hold for the period of the option without drilling. This gives the lessee adequate time to acquire additional leases in the area, do geological tests to assess the land, and arrange for financing, and other supports, for drilling. The length of time of this term, usually, is what the market will bear. The secondary term grants the lessee the right to hold the producing lease as long as it is economically viable to do so. The term is an undefined period of time because it is impossible to determine how long the lease will be profitable at the time it is granted. Force Majeure Clause This term means superior force. The clause makes defined events, which cause a lessee to fail to perform specific actions, a substitute for production. Most oil and gas leases include such a clause to enable easy preservation of the lease when circumstances beyond the lessee s control prevent it from operating or producing. Pooling and Unitization Pooling refers to the joining of small tracts of land in order to meet the minimum spacing requirements under law. Unitization refers to the joint operation of all or a portion of the producing reservoir as a single unit. In voluntary pooling the pooling is done pursuant to an express provision in the oil and gas lease. Mandatory pooling is provided for in O. R.C Here the requirements demonstrate that the tract of land is of insufficient size and shape to meet Ohio's spacing regulations. You must demonstrate that the mineral interest owner could not be leased or voluntarily pooled on a just and equitable basis Process Drilling permit application and separate mandatory pooling application are filed with ODNR's Division of Oil and Gas Resources Management. Notice is then provided to the affected property owners. A hearing is held before the Oil and Gas Technical Advisory Council. The chief of the Division of Oil and Gas Resources Management issues an order. Forced Unitization is provided for in O. R.C It requires a 65% Threshold (oil and gas company controls at least 65% of the mineral rights, either in fee or under lease). This process is similar to that of Mandatory Pooling.

4 Tax Treatment of Mineral Rights Federal Personal Income Tax Treatment A. What is the Partial Interest Rule? 1. All donors must comply with the Partial Interest Rule or fall within one of its exceptions to insure the donation will be deductible a. The rule is violated if a donor that is the current owner of both the surface estate and the mineral estate is contemplating a gift of the surface interest to charity but is planning to retain ownership of the mineral rights b. A three layered dessert has a crust a filling and a topping. A donor can't just scrape out the filling because it's delicious and donate the crust and the topping to charity 2. Exceptions to the Partial Interest Rule a. Transfers of property to charitable remainder trusts, charitable lead trusts, and pooled income funds may be entitled to an income tax deduction, estate tax deduction, and/or gift tax deduction, provided the strict requirements for those types of trusts are met. b. A partial interest in property where all of the donor s interests in such property are given to one or more charities c. A remainder interest in a donor s personal residence or farm d. An undivided portion of a donor s entire interest in property 1. This allows a donor to cut a complete slice of the dessert, crust, filling, and topping, and receive a deduction for donating that to charity 2. A donor owning only the crust of the dessert can give just the crust because it s all he has e. A qualified conservation contribution f. A contribution of property in exchange for a gift annuity g. A bargain sale to charity h. A piece of artwork transferred without its copyright (but only with respect to gift and estate tax contributions 3. Valuation a. The donor's deduction for the charitable contribution of a partial interest in property is generally the fair market value of that interest at the time of contribution, less any reductions under Sec. 170(e). 1. The FMV of property is the price at which a willing and knowledgeable buyer and seller would agree. 2. A partial interest may be further reduced in value where there is a restriction on the use of that property, such as a restrictive covenant or other limitation. Planned Giving Vehicles Commonly Used in Giving Mineral Rights Outright Gift-The donor could of course receive the royalty payment, pay the taxes that are due and then make a deductible gift of some or all of the cash to charity. Charitable Gift Annuity -The annuity is the subject of an agreement between the donor and the charitable donee. The donor agrees to make a gift and the donee agrees, in return, to provide the donor with an annuity. With one payment, the donor is thus engaging in two transactions, the

5 purchase of an annuity and the making of a charitable gift. One sum is transferred; the money in excess of the amount necessary to purchase the annuity is the charitable gift portion. Charitable Remainder Annuity Trust (CRAT)-A type of gift transaction where an individual transfers assets to a charity in exchange for a tax benefit and a lifetime annuity. Income payments are a fixed amount based on the annuity contract. As with any other lifetime annuity, when the beneficiary dies, the annuity payments are stopped, and the charity retains the remaining funds. Charitable Remainder Unitrust (CRUT)-Income payments from a charitable remainder unitrust are in the form of an amount equal to a percentage of the fair market value of the assets in the trust, determined annually. Charitable Lead Trust (CLT)-It is called a lead trust because the charities are entitled to the lead interest in the trust asset, and the non-charitable beneficiary receives the remainder interest. This irrevocable trust is made in favor of a charity and that allows the charity to receive income from the trust property for a specific length of time then leaves the remainder of the trust to designated beneficiaries, usually family members. Consider the Ownership to determine the best option: Option A: Donor owns the surface and the mineral rights 1. To avoid the partial interest rule the donor must transfer an undivided interest (both the land and the minerals) to charity. 2. The gift may be made outright or to fund a life income arrangement, such as a charitable remainder trust (CRT) and charitable gift annuity (CGA) gifts. Option B: Donor owns only the mineral interest 1. Gifting his or her entire ownership interest, there is no partial interest rule problem. 2. The donor can gift the minerals alone to charity or to a charitable trust. Option C: Donor has signed a lease of land or mineral interests for royalties 1. There is no issue of income avoidance under Lucas v. Earl because a royalty is not earned income. If the royalty payment is assigned, the donor avoids income tax on the royalty payment. Even if the donor has leased the mineral interests, he or she may assign the royalty stream to charity or fund a trust and receive income payments. How to decide which planned giving vehicle is best: Will the annual income produced from the mineral interest be well suited to allow the payout feature of a specific planned giving vehicle to be fully realized? 1. The Charitable Remainder Unitrust and the Charitable Lead Unitrust provide a viable option because the trust must be evaluated annually based on fair market value of the interest, this accommodates changes in production easily 2. The Charitable Gift Annuity has a fixed obligation that will continue for the duration of the life expectancy of the donor. Charities should carefully consider the feasibility of retaining a gifted interest in oil and gas and relying upon the annual production to satisfy the annual annuity obligation over the long term.