Gifts of Black Gold:

Transcription

1 Gifts of Black Gold: Charitable Giving with Oil and Mineral Interests Minnesota Planned Giving Council Wednesday, November 5, 2014 Brianna M. Mooty & Jessica B. Johnson With special thanks to James D. Lamm Gray, Plant, Mooty, Mooty & Bennett, P.A. 500 IDS Center 80 South 8 th Street Minneapolis, MN

2 TABLE OF CONTENTS I. Ownership of Oil and Mineral Rights... 1 a. Leases of Oil and Mineral Interests... 1 b. Ownership of Royalty Interests... 2 II. Potential Tax Issues with Gifts of Oil and Mineral Interests... 2 a. Partial Interest Rule... 2 b. Unrelated Business Taxable Income... 3 c. Substantiation... 4 III. Types of Charitable Gifts of Oil and Mineral Interests... 4 a. Gifts of Donor s Interest in Real Property... 4 b. Gifts of Reminder Interest in Real Property... 5 c. Charitable Remainder Trust... 5 IV. Due Diligence in Accepting Gifts of Oil and Mineral Interests... 6 V. Case Study: Comparing Charitable Giving Options... 7 Schedule A: Glossary Schedule B: Due Diligence Checklist i

3 Gifts of Black Gold: Charitable Giving with Oil and Mineral Interests Planning for gifts of oil and mineral interests has become more important for Minnesota advisors, as oil production in the Bakken Shale formation in North Dakota has increased tenfold in the last decade 1 and as more than 20 formations throughout the U.S. actively produce oil. Property owners may be examining their ability to gift or bequeath their oil and mineral interests to charitable organizations. These types of gifts raise a number of issues, so it is important for development officers to understand the terminology and basic kinds of oil and mineral interests, the types of charitable gifts that are best suited for these interests, and the due diligence that should be involved in accepting gifts of oil and mineral interests. I. Ownership of Oil and Mineral Rights Landowners in the United States generally own a fee simple estate, which is the broadest property interest and includes both surface rights and the right to the subsurface minerals, such as oil, gas, coal, precious stones, gold, silver, or other minerals. The fee simple owner has the right to sell, lease, gift, or bequeath the surface rights and mineral rights together, or the surface rights and the mineral rights may be severed. The owner of the mineral rights has the ability to exploit, mine, and produce any or all of the minerals and water below the surface. The surface interest includes every right in real property other than the mineral rights, including the right to use, farm, and build on the surface. a. Leases of Oil and Mineral Interests Much of the oil-producing property in the U.S. is farmland or ranching property. For landowners who want to avoid the cost and effort of actually extracting the oil and minerals, or who want to continue their farming or ranching on the property, they may decide to lease the mineral rights to an oil company that then handles the extraction and production of the oil or minerals. This relationship allows the landowner to continue owning both the surface and mineral rights, while avoiding the effort and expense of oil production. In exchange for entering into a lease that grants an oil company the right to drill and produce the oil for a term of years, the landowner will generally receive an upfront lease bonus payment. And the landowner typically retains a royalty interest in the mineral rights, which is a right to receive a portion of the value of any production. The most common royalty amounts are 1/8, 3/16, or 1/4 of the value of the minerals extracted. 2 The lease may also include a delay rental payment, payable if drilling does not occur during the lease term. 1 North Dakota Department of Mineral Resources, Oil and Gas Division Website, General Statistics, Historical annual oil production totals. Last accessed September 14, GiftLaw Pro, Section 4.7.7, Oil, Gas and Mineral Interests. Last accessed December 16,

4 b. Ownership of Royalty Interests Rights to royalties can be divided and there are several different types of royalty interests a donor may have. For example, a donor may own a non-participating royalty interest, which entitles the owner to a portion of the royalty payments but no executive or management rights. A donor may also have an overriding royalty interest which is carved out of a lessee s interest in a mineral lease (generally stated as a percentage of production). It is important that the development officer gather information to determine the precise type of ownership interest the donor has. Most U.S. oil is extracted through hydraulic fracturing. This process often results in high initial production that tapers off over a course of years, as the oil nearest the well is extracted first before production moves horizontally away from the well. For this reason, royalty interest holders will often receive high payments in the early years of the lease that decrease to low payments towards the end of the lease. The lease bonus and royalty payments are considered ordinary income, so the high initial payments may push the owners into the highest tax brackets, subjecting them to a 43.4% federal income tax rate, plus any applicable state income tax rates. II. Potential Tax Issues with Gifts of Oil and Mineral Interests Gifts of oil and mineral interests have certain tax complications unique to the nature of these property interests. Before discussing a potential gift with the donor, consider the following rules regarding gifts of partial interests in property, unrelated business income tax, and substantiation. a. Partial Interest Rule Gift planners must consider the impact of the partial interest rule for income, gift, and estate taxes when navigating gifts of oil and gas interests. 3 The partial interest rule requires assignment of all or an undivided fractional interest in a taxpayer s entire interest in property (each and every substantial right the donor owns over the entire term of the donor s interest). Congress enacted this rule out of concern that taxpayers who donate only a partial interest in property would receive a double benefit from taking a deduction for the present value of the interest while excluding from income subsequent receipts from the donated interest. Congress was also concerned about situations in which the amount of the charitable deduction would be more than the value of the benefit ultimately received by the charity. See Rev. Rul , C.B. 97. A helpful analogy is to think of the donor s property interest like a multi-layer cake. The donor can cut a vertical slice through all of the layers a 1/8 share or a 1/3 share, for example and still receive a charitable income, gift, and estate tax deduction for the 3 See IRC 170(f)(3), 2055(e), and 2055(e)(2); see also Treas. Reg (e)(2) and (c)-3. The rules for deductibility of partial interest gifts are somewhat different for income tax purposes than for gift and estate tax purposes, so it is necessary to consider the code sections applicable to all three types of taxes to ensure deductibility where desired. 2

5 donation. But, the donor cannot cut a horizontal slice through the cake (just cutting off the frosting, to use the analogy). For land with oil and gas interests, the layers include the surface rights and mineral rights. The donor can also divide the mineral rights into the following smaller layers: rights to develop, rights to lease, rights to receive payments, and so on. The partial interest rule of the tax code says that the donor does not get an income tax charitable deduction if he or she gives charity a horizontal slice and keep any other interest. This means that the donor cannot give away only the surface rights and retain the mineral rights, for example, and receive an income tax charitable deduction. The donor does get a deduction if he or she gives charity a percentage vertical slice of everything he or she owns. See Rev. Rul , C.B. 52 (no income tax charitable deduction for gift of surface rights without mineral rights); PLR (denying a charitable income tax deduction to a donor who gifted to charity the donor s surface rights to real property but not the oil, gas, and mineral rights); PLR (allowing charitable income tax deduction for gift of fractional interest in mineral rights provided donor retains no interest in the lease payments related to the donated fractional interest); Rev. Rul , C.B. 97 (denying a charitable income tax deduction where a donor gives only the overriding royalty interest and not the working interest in mineral property to charity). b. Unrelated Business Taxable Income If a public charity is operated primarily for exempt purposes, it will not lose its exempt status provided that it carries on only an insubstantial amount of for-profit activities unrelated to its tax-exempt purpose. It will, however, be required to pay unrelated business income tax ( UBIT ) on the organization s income derived from an unrelated trade or business. IRC 511. The organization will also need to report the income from the unrelated business on Form 990-T (Exempt Organization Business Income Tax Return). Three conditions must exist before UBIT will be imposed: (1) The income must be from a trade or business. IRC 511. Generally any activity that is carried on for the production of income from the sale of goods or performance of services is a trade or business. (2) The trade or business must be regularly carried on by the exempt organization. IRC 512. (3) The trade or business must not be substantially related (other than through the production of funds needed by the exempt organization) to the exercise of the organization s exempt functions. Treas. Reg (d)(1). Under the tax code, mineral royalties are a passive source of income and excluded from UBIT, whether measured by production or by gross or taxable income from mineral property, as long as the organization does not own a working interest in the mineral property. IRC 512(b)(2); Treas. Reg (b)-1(b). A working interest in mineral property is one where the owner of the interest is liable for the development and operating 3

6 expenses of the property (drilling, plugging, and abandoning wells, for example). A charity may convert its interest in mineral property profits from a working interest to a royalty interest by leasing the property to an oil company who would be responsible for the development and operating expenses. See Rev. Rul , C.B. 158; PLR The IRS has stated, however, that it will consider the substance of the royalty income over its form, meaning that it will characterize the royalty income as UBIT if it is in fact derived from a working interest, even if that interest is labeled a royalty interest by the organization. Rev. Rul , 1969 C.B c. Substantiation Gifts of over $5,000 of real estate, mineral, or royalty interests to a charitable organization require an appraisal. The donor must satisfy the following conditions: (1) The donor must receive a qualified appraisal of the donated property before the due date (including extensions) of the tax return on which a charitable deduction is first claimed with respect to the donated property. Note that, if the donated property is a partial interest in property, the qualified appraisal must be an appraisal of the donated partial interest. An appraisal of the entire property is not sufficient. (2) The donor must also attach a fully completed appraisal summary, IRS Form 8283, to that tax return. In the case of any contribution for which a deduction of more than $500,000 will be claimed, the donor must attach the qualified appraisal to the return on which the deduction is claimed. The donor must also maintain certain records regarding the gift. III. Types of Charitable Gifts of Oil and Mineral Interests The most common types of gifts of interests in real property include a gift of all or a portion of all of the donor s interest in the property; a gift of a remainder interest in the land; and a transfer to a charitable remainder trust. While each of these may be effective charitable gifts, as described below, the charitable remainder trust can provide a unique and highly attractive planning opportunity for donors with oil and mineral interests. a. Gifts of Donor s Interest in Real Property A donor may make a gift of the donor s entire interest in the property (surface rights and mineral rights) or an undivided percentage of the donor s entire interest. IRC 170(f)(3)(A)-(B). The donor will receive a charitable deduction for the value of the interest gifted subject to contribution limits. If the interest was a fractional interest in the property, a discount may apply to the value. The donor will need to meet the substantiation requirements described in Section II.c above to get a charitable deduction. As described in Section II.a above, however, if the donor gifts only part of their interest (mineral rights but not surface rights that the donor owns), the donor will be denied a charitable deduction. 4

7 For example, Donna Donor is allowed a deduction if she gives charity 25% of her entire property interest in a certain parcel of land. But she does not get a deduction if she gives charity 25% of her royalty interest but none of her underlying mineral rights because it s not a complete vertical slice of everything Donna owns. On the other hand, if Donna only owns a royalty interest in that parcel, but doesn t own any surface rights or any other interest in that property, she can give charity 25% of that interest and get a deduction because it s a vertical slice of everything she owns in that property. b. Gifts of Reminder Interest in Real Property A donor may also deed the remainder interest in the property to charity and retain a life estate, which is an exception to the partial interest rule discussed in Section II.a. To qualify, the donor must own the land in fee simple and the land must be a personal residence or a farm. For a donor who owns property with oil and mineral interests and makes a gift of his or her remainder interest in the property, the donor as the holder of the life estate also retains the right to receive any rent and most of the royalties from the property, with a portion of the royalties passing to the charity. Query whether the royalties must be allocated strictly in accordance with the IRS tables or if they can be allocated in another way. To clarify the responsibilities of both the life estate holder and the remainder interest holder regarding the maintenance of the property and the allocation of royalties, the donor and the charity will need to enter into an agreement as to how those items will be handled. In preparing this agreement, applicable state law will need to be addressed, but it is generally acceptable for the donor and charity to create an allocation formula for the royalties. The agreement must also create a depletion or depreciation reserve in accordance with Generally Accepted Accounting Principles. See Rev. Rul , C.B The donor retaining a life estate and gifting a remainder interest will receive a charitable income tax deduction for the present value of the remainder interest. IRC 170(f)(3)(B)(i). The donor may also divert some of the royalties to the charity, reducing his or her taxable gross income in the year of the gift and in future years. The donor will also receive a charitable deduction for gift tax purposes for the present value of the remainder interest. IRC 2522; Treas. Reg (c)-3(c)(2)(ii) (iii). c. Charitable Remainder Trust A charitable remainder trust is an irrevocable trust that the donor creates during lifetime or at his or her death. IRC 664. The trust makes a defined annual payment to one or more noncharitable beneficiaries for their lives or a term of 20 years or less, then distributes its remaining property to charitable organizations defined in IRC 170(c). There are two main types of charitable remainder trusts. The first are charitable remainder annuity trusts ( CRATs ), which pay a noncharitable beneficiary a fixed dollar amount for life or a period of years. IRC 664(d)(1). The second are charitable remainder unitrusts ( CRUTs ), which pay the noncharitable beneficiary a fixed percentage of the value of the 5

8 trust property for life or a period of years. IRC 664(d)(2). There are also several variations of CRUTs: (3) Standard CRUT: Pays a fixed percentage (at least 5 percent and no greater than 50 percent) of value of trust property as redetermined each year to the noncharitable beneficiary. Payments are made out of trust principal to the extent that trust income is insufficient. Treas. Reg (a)(1)(i)(a). (4) Net income CRUT: The annual payment is the lesser of the unitrust percentage amount or actual trust accounting income. One variant allows a deficiency in prior years payments below the aggregate unitrust percentage amount to be made up out of excess income. Treas. Reg (a)(1)(i)(b). (5) Flip CRUT: This trust changes from a net income CRUT to a standard CRUT upon the occurrence of a triggering event, which must be nondiscretionary. For example, the regulations classify a sale of an unmarketable asset as a nondiscretionary event. Treas. Reg (a)(1)(i)(c) and (d). For a lifetime CRUT, there is an income tax charitable deduction allowed for the present value of the charitable remainder interest subject to contribution limits. IRC 170(f)(2)(A). 4 Annual payments to the income beneficiary carry out various categories of trust income in a prescribed order carrying out ordinary income first, then capital gains, then other income, and, finally, trust corpus. IRC 664(b). The trust itself is exempt from federal income tax. IRC 664(c)(1). A CRT pays a 100 percent UBIT on any unrelated business taxable income it receives. IRC 664(c)(2). Applied to a donor who owns oil and mineral interests, a charitable remainder trust is an income-tax deferring strategy. It can also spread out income so that it may be taxed in future years at lower brackets. Because of the four-tiered way that income flows out to the beneficiaries, the unitrust payments to the donor (or other noncharitable beneficiary) will probably be ordinary income for the term of the trust, as the amount of ordinary income the CRUT receives annually will likely be well in excess of the unitrust amount. By transferring the property to the trust, however, the portion of the royalty payments in excess of the unitrust amount will accumulate tax-free. Because the tax code deems the royalty interests passive, they do not create UBIT for the charity. See Section II.b above. For an illustration of the tax benefits obtained by using a CRUT with oil and mineral interests, see the case study in Section V below. The IRS has questioned whether there are self-dealing concerns if a donor transfers an undivided fractional interest in real property to a charitable remainder trust and retains the other interest. It is important for prospective donors to review those issues with their counsel. 4 For transfer tax purposes, a similar gift or estate tax deduction is allowed under IRC 2522(c)(2)(A) and 2055(a)(2)(A). 6

9 IV. Due Diligence in Accepting Gifts of Oil and Mineral Interests A charity must do its due diligence prior to accepting any gifts involving oil and mineral interests given the potential issues that may arise. The primary concern for the charity is to determine what type of ownership the donor has in the property, whether the gifted interest is something the charity is able to accept, and whether the donor will achieve his or her goals by gifting that interest. To aid gift officers in navigating the acceptance of these types of gifts, a charity should specifically address gifts of oil and mineral interests in the charity s gift acceptance policy. Before considering accepting a gift of oil and mineral interests, the gift officer and charity should determine: (1) What type of ownership interest does the donor have? (2) Is the gift currently structured, or can it be structured, to avoid any UBIT? (3) Does the donor s proposed gift meet the requirements for deductibility under the partial interest rule? (4) If the donor s interest is subject to a lease of the mineral rights, are the terms of the lease acceptable to the charity? The charity may want to consider implementing a minimum value for accepting these gifts and include in the policy that the charity will not accept working interests without a review by the charity s counsel. Counsel can then assess the charity s ability to restructure the interest as a passive royalty interest to avoid UBIT. A checklist to assist gift officers in gathering information to evaluate a potential gift of an oil or mineral interest is attached at Schedule B. V. Case Study: Comparing Charitable Giving Options Assume Don and Donna Donor are each 60 years old, married, and longtime supporters of your organization. Donna inherited farm property in the Bakken Shale region of North Dakota worth approximately $1 million after consideration of current mineral interests. The property is titled in Donna s name alone, and she would like to make a significant gift to charity. She wants to retain an income stream for both her and Don s remaining lifetimes. The Donors are in the highest marginal income tax bracket before receipt of any income from the property or the CRUT. Don and Donna have a joint life expectancy of 27 years. Donna began leasing the mineral rights to the land to an oil company just this year. For the lease contract, Donna anticipates high initial cash flows for the first years of production that decline as the years pass. Donna expects to receive royalty payments based on a percentage of the land value (including appreciation at 4%) for 21 years as follows: Year 1: 25% 7

10 Years 2-5: 20% Years 6-10: 15% Years 11-21: 10% Years 21 and after: Royalty payments end, assumed income of 2% only from farming activities. Donna s options are: (1) Do nothing; (2) Give charity a remainder interest in the farm with a retained life estate; or (3) Transfer the farm to a charitable remainder unitrust 5 of which she and Don would be the life income beneficiaries. 6 Which option should Donna choose? Income tax charitable deduction (equal to value of remainder) Total assets held by the surviving spouse at death (in year 27) Total assets to charity in year 27 Total benefit to donor(s) and charity Option 1: Do Nothing $8,389,456 (land value plus net investments) Option 2: Retained Life Estate / Donation of Remainder Option 3: CRUT $0 $562,060 $274,360 $6,399,014 (net investments only but subject to capital gain too) $4,920,148 (net investments, including unitrust payments) $0 $2,883,369 $5,420,019 $8,389,456 $9,282,383 $10,340,167 Analysis: Both Options 2 and 3 offer an overall benefit to the charitably-minded donor by transferring more overall dollars to charity by offsetting some of the tax payments to the government. The CRUT is a particularly powerful tool to accomplish both charitable giving and to help the donors build their net worth. The CRUT defers significant income taxes in the early years the Donors would otherwise pay from the income received under the royalty contract. The 5% CRUT distributions start small in the first few years of the trust, but they grow because of the high initial cash flows into the trust from the lease arrangement. E.g., $250,000 of income the first year of production and $50,000 of distribution out to the donor based on the $1 million initial value of the trust. So, trust assets grow rapidly and income tax free in the early years, which builds up the trust account so that future 5% unitrust distributions are larger. Of course, these results depend on the production, the price of oil, and the investment returns in the trust. 5 One variation of this plan would be to use a FLIP CRUT if the oil and gas interest is not producing royalty income at the time the donor transfers the property to the CRUT. The donor can have the CRUT pay the lesser of net income or the 5% unitrust amount and then flip to a straight 5% payout when production starts. 6 We are assuming here that Donna transfers the entire farm to the CRUT. Note that the IRS has questioned whether putting an undivided fractional interest in land in a CRUT raises self-dealing concerns. 8

11 If donors were in a lower income tax bracket, they would receive additional benefits from the CRUT strategy because the high income payments in early years would be deferred through the CRUT unitrust payments, and there would be an advantage to running the lower amount of ordinary income (CRUT payments) through the income tax brackets. This outline is based on the law in effect on the date it was completed: September 29, It is only a summary of the subject matter it addresses, and it is intended to provide information of a general nature only. It should not be construed as a comprehensive treatment or as legal advice or legal opinion on any specified facts or circumstances. Readers are urged to consult with an attorney concerning their own situations and any specific legal questions they may have. GP: v7 9

12 Schedule A: Glossary Decline Curve: A decline curve illustrates the production history of a particular well, and is also used to predict future performance. Fee Simple: Absolute ownership of real property, including the surface rights and mineral rights. Fracking: The common term for hydraulic fracturing, which is the technique commonly used in oil wells to extract the oil. The technique involves injecting a high-pressure fluid into rock to create cracks to increase the flow rate. Mineral Rights: The rights to search for, develop, and produce minerals, including oil and gas, from the property. Non-participating Royalty Interest: A royalty interest where the owner does not have management or executive responsibilities. Overriding Royalty Interest: A royalty interest carved out of a lessee s interest in a mineral lease, generally stated in terms of a percentage of the production. Production Payment: A right to oil, gas, or other minerals that entitles the owner to a specified fraction of production until a specified amount of money or minerals has been received. This is payable out of the working interest owner s share of production. Royalty Interest: A non-possessory real property interest that is free of production and operating expenses. The most common royalty interest is the right to a specified amount of gross production for a period of time, which is retained by a landowner in a mineral lease. Surface Rights: Rights included in a fee simple estate to the surface (separate from mineral and air rights), including the right to construct buildings, etc. Working (or Operating) Interest: The rights to the mineral interest obtained in a mineral lease, which include the responsibility for all costs involved in the exploration for oil and minerals and the extraction and production of those minerals. 10

13 Schedule B: Due Diligence Checklist Preliminary questions: What is the legal description of the property? What is the donor s ownership interest (fee simple, royalty interest, working interest)? How is the donor s interest held (individually, joint tenancy with right of survivorship, tenants-in-common, trust, partnership, LLC, corporation)? Does the donor have the deed or agreement creating the donor s interest? Does the donor have the title history? If the donor owns the mineral interest: What is the donor s ownership of the mineral interest full or percentage? Were the mineral and surface interests severed? Is the mineral interest currently being leased? If so, to whom? Does the donor have a copy of the lease? What are the donor s responsibilities under the lease? What due diligence did the donor do before entering into the lease? If the donor owns the surface interest: Is the surface being used? What type of use (farming, ranching, etc.)? Is there income from that use? If so, what is the approximate annual income on the property? What are the donor s long-term plans for the use of the surface? Is the donor concerned about potential damage to the surface? If the donor owns a royalty interest: What type of royalty interest does the donor have (full royalty, non-participating)? If the interest is non-participating, does the donor have a copy of the agreement? Who has the management and executive responsibilities? Is the property currently in production? If so, what is the approximate annual income on the property? Questions regarding gift: What type of gift is being considered? What are the donor s goals (retention of surface rights, income flow)? Is the donor seeking a charitable deduction? 11