Recent technological advances in drilling and hydraulic fracturing, also known as fracking, have led to a tremendous increase in U.S. oil and natural gas production. According to the U.S. Energy Information Administration, from 2002 to 2012, the domestic production of gas from shale increased from less than 5 billion cubic feet per day to more than 25 billion.
The increase in production has also led to significant economic growth. Farmers and ranchers whose properties sit on top of oil and natural gas deposits, have seen sudden, tremendous income increases as a result of oil and gas companies leasing their land for drilling. However, with this new income from royalties and leases comes additional tax and financial planning obligations, which if left unaddressed could result in substantial income and estate taxes.
“Property owners can protect their financial future by lowering their tax burden by utilizing wealth transfers.”
Policies specific to the oil and gas industry make landowners particularly vulnerable to high taxes. Oil companies often pay the property owner a bonus when the lease is signed. This bonus would be considered regular income and could face federal income taxes of up to 39.6 percent. Additionally, these leases may also be subject to the net investment income tax and state income taxes. All told, this could add up to as much as a 50 percent tax on the bonus, which is often the only significant source of revenue for the property owner until the well begins producing and royalty payments are made.
However, there are tools property owners may utilize in order to protect the financial future of their families by lowering their estate tax burden and securing their children’s futures through wealth transfer.
Understanding tax protections
Beginning in 2013, the U.S. Congress increased the exclusion for federal transfer taxes, which allows property owners to gift $5.45 million in assets before estate or gift taxes are owed. Gift taxes include any property or assets bequeathed during the estate holder’s lifetime, whereas estate taxes cover any assets or property passed on after the estate holder’s death. Under the current federal tax laws, any inherited or gifted assets valued beneath the basic exclusion will not be subject to federal gift or estate tax.
For married couples, both spouses will be able to utilize the $5.45 million exemption individually. Additionally, if the one spouse uses less than the $5.45 million exclusion during his or her lifetime, the remainder may carry over and be combined with the other spouse’s exclusion. This transfer of estate tax exclusion is called portability and is only applicable to surviving spouses.
Establishing a trust
One tool for wealth management is to establish a trust, which allows for the legal transfer of property to another person during the property holder’s lifetime. Trusts offer the grantor the option of transferring wealth to his or her children with the flexibility of establishing specific rules. For instance, the terms of the trust may set restrictions on when the funds will be accessible. The trust may also set limits on how children can spend their inheritance, such as setting aside a fixed amount for education or philanthropy.
Family limited partnerships
Additionally, high net worth individuals may utilize a Family Limited Partnership (FLP). Unlike a conventional trust, under an FLP, family members would pool assets into a single family-owned business and own partnership interest.
FLPs allow the advantage of transferring wealth between generations at lower taxation rates. Partnership interest in the company can be gifted to children and would be covered by the gift tax exemption. Children may be set up as limited partners in the FLP, allowing them financial security but still restricting their ability to spend these funds until maturity.
When to get started
The changing nature of the oil and gas industry has expedited the need for families receiving royalties and leases from oil companies to make sound financial planning decisions. Oil production from hydraulic fracturing has led to a decrease in the cost of oil per barrel, and the industry has responded by decreasing production. As such, landowners may see decreased revenue from their well location, especially if production on the well has ceased.
High net worth individuals can contact LaPorte tax services professionals to learn more about how CPAs and attorneys can work to reduce the tax burden of oil leases and royalties and transfer wealth for the family’s future financial security.