Estate and Gift Planning for Mineral Interests

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1 The following information and opinions are provided courtesy of Wells Fargo Bank N.A. Wealth Planning Update Estate and Gift Planning for Mineral Interests AUGUST 2017 Patrick Neil Senior Wealth Planning Strategist Lonnie Whitehead Senior Wealth Planner Matthew Smith Wealth Planner In this Wealth Planning Update:» Discovering what type of interests you own is an imperative first step toward determining when and how you transfer such interests to the next generation.» Holding mineral interests in corporate form may have advantages beyond creating tax efficiencies, allowing families to consolidate ownership and greatly simplify the process of passing such interests to the next generation.» Certain planning strategies designed for transferring mineral interests can be extremely complex and deserving of a conversation with your relationship manager before getting started.» Regardless of the method of transfer chosen, oil and gas interests present owners with an opportunity to leave a financial legacy that spans multiple generations. Once asked for the formula for his success, oil baron Jean Paul Getty quipped, Rise early, work late, strike oil. For many families, this same motto has afforded current and future generations the access to considerable wealth resulting from substantial oil and gas holdings. The efficient transfer of oil and gas interests from one generation to the next requires significant foresight and planning. With the volatility of oil prices, coupled with the difficulty in valuing oil and gas interests, the when is every bit as important as the how with regard to the transfer of minerals to the next generation; however, first, we must begin with what. What Type of Interests Do you Own? Oil and gas interests are often referred to as a bundle of sticks with the mineral interests0f1 an amalgamation of various components, each of which can be independently held and transferred (mineral estate). In most states, the surface rights and mineral rights are transferred together, whereas other states, including Texas, treat the minerals and surface as separate property interests. The mineral estate, separate and apart from the surface 2 rights, includes five essential elements:1f 1 Recognizing that states vary on what is considered a mineral interest, note that for purposes of this paper, mineral interests includes oil and gas. See for example the Dunham rule in Pennsylvania. Dunham and Shortt v. Kirkpatrick, 101 Pa. 36 (1882). See also Lesley et al. v Veterans Land Board of the State of Texas, et al. No (Tex. August 26, 2011). 2 Altman v Blake, 712 S.W.2d 117, 91 O.&G.R. 346 (Tex. 1986).

2 1. The right to develop (right of ingress and egress) 2. The right to lease (executive right) 3. The right to receive bonus payments 4. The right to receive delay rentals 5. The right to receive royalty payments Because each of these elements can be divided and transferred separately, it is imperative to understand whether you own some, or all, of the above elements. For instance, the right to explore, produce, or develop minerals, or the right to lease those interests to others is owned by the holder of the rights to develop and lease above (Operating Interests). Conversely, if you own 100 percent of the Operating Interests, your interest will consist of the total production less the Non-Operating Interests above. When to Transfer Oil and Gas Interests Once you have established what you own, the success or failure of a transfer of mineral rights to the next generation often hinges upon when to make a transfer. Generally, mineral interests are valued through two approaches: Market Approach and Income Approach. Market Approach The IRS 3 provides guidance with regard to valuing mineral interests and establishes the Market Approach as the preferred method for valuation. Ultimately, the Market Approach looks to the recent transfer or sale of similar mineral interests as an attempt to establish a fair market value for the minerals in question at the date of transfer. However, the Market Approach requires data that is often not available, as mineral interests are much like snowflakes no two are alike. As a result, in the absence of data sufficient to make a determination under the Market Approach, appraisers turn to the Income Approach to value both Operating and Non-Operating mineral interests. Income Approach The Income Approach is reliant upon data that is readily available by focusing upon the net cash flow that the subject mineral interest is expected to generate, including the estimated economically recoverable amounts of oil, gas, or natural gas; NYMEX oil and gas future pricing; the timing at which such minerals will be produced and sold; expected capital expenditures for drilling additional wells; and projected leasing and operating costs to tap the reserves. From this data, a present value of the projected cash flow resulting from such interests is created with a discount to that present value applied to account for the riskiness of such cash flow. How to Transfer Oil and Gas Interests Before exploring the various options available to transfer mineral interests, one must first consider how the interests are owned. In many instances, a family s ownership in mineral interests began in an individual name. However, as the bundle of sticks that composes a mineral estate are separated and spread among different 3 IRS Regulation Sect

3 owners, the situation can become incredibly complex. This is especially true of owners of Non-Operating Interests who can be subject to a seemingly non-stop merry-go-round of operators as the Operating Interests pass hands multiple times. Once Non-Operating interests are passed through multiple generations, ongoing management of the overall mineral interests can become a daunting task for even the most tightly knit families. Consolidating a family s ownership into a limited partnership (LP) or limited liability company (LLC) offers four potential benefits with respect to Operating and Non-Operating Interests alike. 1. Consolidating ownership of either form of mineral interest provides for streamlined management and unity of purpose when negotiating with oil and gas operators. 2. The consolidation of the mineral interests can help streamline the transfer process to the next generation as owners can assign a percentage of the LP or LLC instead of retitling the mineral interests. 3. Maintaining ownership of oil and gas interests within an LP or LLC may also decrease the transfer value of such interests for those owners transferring them via gift or sale to the next generation. Because the LP or LLC interests transferred often lack control or marketability, discounts on the value transferred may be applicable, thereby increasing the tax efficiency of the transfer. 4. Because of the potential for personal liability for those holding Operating Interests in an individual name, maintaining ownership of such interests in an LP or LLC may provide a level of liability protection not otherwise available to those holding such interests in an individual name. Despite the above, the process with regard to transferring title to the mineral interests can be timeconsuming and tedious especially with interests that have multiple oil and gas operators. Vehicles for the Transfer of Oil and Gas Interests Gift to Irrevocable Trust More often than not, the right time to transfer an asset does not correspond to the right time for the potential beneficiaries to receive such an asset. Trusts afford an individual with the flexibility to transfer an asset at a time that works best for the transferor and dictate how and when a potential beneficiary has access to the transferred asset. Beyond that, by transferring oil and gas interests to an irrevocable trust for the benefit of children/grandchildren, the value of such interests is essentially frozen at the value established upon the date of transfer. Thus, any growth and/or income accumulated in the hands of the trust after the date of transfer are excluded from the transferor s gross estate. Additionally, such an arrangement may also protect such assets from the creditors of the trust beneficiaries. This protection can be especially important in instances where a beneficiary becomes subject to personal liability and/or divorce. In either case, the assets held in the trust may be protected from such creditors, thereby maintaining ownership of oil and gas interests within the family unit. Nevertheless, upon transfer of oil and gas interests to an irrevocable trust, the transferor will generally lose the ability to receive the income from those interests. As a result, transferors should carefully consider the impact that such a transfer will have on their personal cash flow when determining the proper amount to transfer. 3

4 Gift/Sale to Intentionally Defective Grantor Trust (IDGT) A twist on the gift to the irrevocable trust involves structuring such a trust as an Intentionally Defective Grantor Trust (IDGT or Grantor Trust). The same principles with regard to the irrevocable trust apply to the IDGT, with the primary difference found in how the trust is taxed for income tax purposes. In an ordinary irrevocable trust, the trust itself is the taxpayer for income tax purposes. With an IDGT, the transferor (Grantor) remains the income tax owner of the assets held in the IDGT, yet the trust assets grow free from income tax liability since the assets are no longer in the Grantor s estate. Given the significant cash flow generated by mineral interests, the IDGT provides an opportunity to further enhance the tax efficiency of a transfer of such interests to the next generation. An IDGT also affords a Grantor the opportunity to sell oil and gas interests to the trust in exchange for a promissory note, which is equal to the value of the oil and gas interests transferred, with any appreciation over and above the interest rate payable on the note retained in the IDGT. The sale of the mineral interests to the trust is not a taxable event, with interest paid on the note not taxable to the Grantor. The sale to an IDGT could be a worthwhile strategy for individuals with little remaining Applicable Exclusion or those seeking to transfer mineral interests with a value that exceeds their available Applicable Exclusion amount. One caveat to the advantages associated with the IDGT is that its success is dependent upon the cash flow from the asset sold. Therefore, if the mineral interests sold to an IDGT do not produce sufficient cash flow to support the promissory note, the IDGT will have to either look to other assets to make the note payments or satisfy those payments inkind, thereby reducing the effectiveness of the strategy as a whole. Speak with your relationship manager as they have access to planning resources that can assist you in learning more about this strategy. Grantor Retained Annuity Trust A Grantor Retained Annuity Trust (GRAT) is also a common wealth transfer technique often used in conjunction with highly appreciating assets. A GRAT involves a Grantor transferring assets to a trust in exchange for a payment (annuity) back to the Grantor for a term of years. If the Grantor survives the GRAT term, any assets remaining in the GRAT may be transferred either to beneficiaries outright or to trust(s) without incurring any transfer taxes upon transfer. Often, the GRAT is structured with very little gift upon transfer (Zeroed-Out GRAT) and thus may afford a Grantor the opportunity to leverage a relatively nominal amount of his/her Applicable Exclusion amount for the transfer of a relatively large amount of oil and gas interests to beneficiaries upon termination of the GRAT. Finally, much like the sale to an IDGT described above, oil and gas interests are very well-suited for GRATs as the significant cash flow allows the GRAT to satisfy its annuity payments back to the Grantor without transferring assets in-kind. Nevertheless, much like the sale to an IDGT, if the cash flow from the minerals is not sufficient to satisfy the annual annuity payment, such payment will have to be made in-kind, thereby decreasing the effectiveness of the strategy. 4

5 Summary As a mineral owner, you should understand what you own before determining how you will make transfers to the next generation. As you go through that exercise, you can explore which structure may be most tax efficient while helping protect against certain risks inherent in operating these interests. Working with an advisor who is familiar with these types of assets and the different estate planning strategies that can be utilized to pass ownership to the next generation is critical. Your Wells Fargo relationship manager, along with our team of experienced specialists, and your legal and tax advisors, can help you determine an appropriate strategy for your individual situation to help you realize the opportunity to leave a financial legacy that spans multiple generations. Disclosures Wells Fargo Wealth Management and provide products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries. Wells Fargo affiliates may be paid a referral fee in relation to clients referred to Wells Fargo Bank, N.A. Wells Fargo Bank, N.A. (the Bank) offers various advisory and fiduciary products and services. Financial Advisors of Wells Fargo Advisors may refer clients to the Bank for an ongoing or one-time fee. The role of the Financial Advisor with respect to Bank products and services is limited to referral and relationship management services. The Bank is responsible for the day-to-day management of non-brokerage accounts and for providing investment advice, investment management services and wealth management services to clients. The Financial Advisor does not provide investment advice or brokerage services to Bank accounts, but does offer, as applicable, brokerage services and investment advice to brokerage accounts held at Wells Fargo Advisors. The views, opinions and portfolios may differ from our broker dealer affiliates. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. Wells Fargo affiliates may be paid a referral fee in relation to clients referred to Wells Fargo Bank N.A. The information and opinions in this report were prepared by Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Wells Fargo & Company and its affiliates do not provide legal advice. Wells Fargo Advisors is not a tax or legal advisor. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Trust services available through banking and trust affiliates in addition to non-affiliated companies of Wells Fargo Advisors. Any estate plan should be reviewed by an attorney who specializes in estate planning and is licensed to practice law in your state Wells Fargo Bank, N.A. All rights reserved. CAR