Friday, October 1, 2010

New Gas Wealth Complicates Estate Planning for Landowners

New Gas Wealth Complicates Estate Planning
By Jeffrey A. Marshall, Attorney, and the Gas Planning team at Marshall, Parker & Associates©
Updated January 17, 2011
These are interesting times for landowners in the northern and western  mountains of Pennsylvania. The amount of gas produced from new wells being drilled into Pennsylvania shale formations may create more wealth for Pennsylvania landowners than earlier anticipated. Regrettably, many landowners are not taking the steps needed to protect their developing wealth from avoidable loss.   

In the Beginning
Underlying much of northern and western Pennsylvania are layers of sedimentary rock formed long ago during periods when the area was covered by a shallow sea. These rocks contain abundant organic matter – the remains of dead plants and animals that were compressed with the muddy bottom of the sea and hardened to form layers of petroleum rich shale. 
Pennsylvania residents have long known that a lot of natural gas is trapped under our feet. I’m old enough to remember an earlier gas rush that took place when I was growing up in Clinton County and the excitement that was caused when a gas well blew up. The legendary Red Adair was called in to battle the fire that raged. I was five at the time, and fires were a big deal to me. When a fire whistle went off, my dad would pack the family into the car and off we would go to watch the fireman work. That was the state of entertainment in Clinton County in the pre-TV days.  And, it was actually pretty cool.  
Red Adair was eventually able to put out the fire. (John Wayne portrayed Red Adair in the film “Hellfighters.”) If you are interested, the story of the gas boom in Clinton County in the 1950s has been recounted with enjoyable relish by the Lock Haven Express
Some of Pennsylvania’s gas pooled in easily-tapped pockets referred to as conventional reservoirs which could be accessed with 1950’s technology. However, in the shale layers the gas is locked in the shale rock. This low permeability meant that it was difficult and uneconomical to extract the natural gas from the shale. But recently, advances in horizontal drilling and hydrofracing have opened up this previously inaccessible treasure and created unanticipated wealth for landowners.  
The layer known as the Marcellus is receiving the most attention right now. The black shale of the Marcellus formed from rich organic matter laid down approximately 365 million years ago. About 300 million years ago, the pressure of the gas caused fractures to form in the shale. Drillers can now take advantage of these natural fractures to recover large amounts of gas.
It looks like the Marcellus play is going to be even more significant than earlier estimates. Production rates on new Pennsylvania shale wells are higher than initially expected – and substantially exceed the rate of comparable wells in the Barnett Shale play in Texas according to Penn State Cooperative Extension educator Tom Murphy. In September 2010, Seneca Resources announced that its new gas well in Lycoming County - where I live - had an eye-popping initial production rate of 15.8 million cubic feet per day.

An Economic Game-Changer for Landowners
The Marcellus Shale is proving to be an economic game-changer for many of my law office’s landowner clients. The estimated value of this reserve has been conservatively estimated over two trillion dollars at current natural gas prices, which are very low.
Leasing and drilling in the Pennsylvania portion of the Marcellus Shale resulted in over $1.75 billion dollars in lease bonus and royalty payments to landowners in 2009 alone. Royalty payments will continue for decades as the gas of the Marcellus and other shale formations are brought to the surface. (Landowners can get a free royalty calculation estimate of their gas interests at 
For many of my clients, the Marcellus Shale marks the single biggest economic opportunity of a lifetime. But the development of our natural gas using the new technologically-advanced drilling methods has added great complexity to the estate planning needed by landowners in the areas of Pennsylvania where my law firm’s 4 offices are located.

Uncertainty Creates Opportunity
With effective planning, the wealth created can limit future financial concerns for landowners and their children and grandchildren. But this opportunity can easily be squandered. Poor or delayed planning can result in loss due to otherwise avoidable taxation, poor management, family disputes, divorces, and other problems.
Estate planning for this new source of wealth is complicated by a number of current uncertainties, among them:
          When, if ever, will any particular lease begin producing royalties?
          How many wells will be placed on the property?
          Will shale layers other than the Marcellus be tapped?
          How much gas will ultimately be produced? and
          Where will gas prices be in the future?
In addition, uncertainty over the future of Federal Estate and Gift Taxes makes it difficult to predict which landowners will be subject to potentially confiscatory transfer taxes.  For 2011 and 2012 the estate and gift tax thresholds are temporarily set at $ 5 million dollars. But, the current law terminates on December 31, 2012. Congress and the President must agree on new tax rules or else the exemptions will revert to only $ 1 million.

No one knows whether the estate and gift tax exclusions will revert to $ 1 million dollars on January 1, 2013 or whether some other threshold will be established. But we do know that the current temporary high levels of tax exemption create an opportunity for tax savings that may never be repeated. This is especially true for anyone who would like to make  tax free lifetime gifts of royalty interests or other assets to younger generations. And for those with more substantial wealth current rules allow the $5 million dollar exemptions  to be leveraged  further to protect even greater amounts from being subjected to death taxes, at least if planning is completed by the end of 2012.

The current uncertainties turn out to be quite beneficial for the potential royalty owner. They provide the landowner with an unlikely to be repeated opportunity to reduce taxes. One benefit of uncertainty is that it lowers appraisal valuations. This means that landowners who act early can transfer future gas royalties to the next generation at low valuations and reduced gift tax cost. 

In this complicated environment, some landowners with royalty interests may be receiving questionable estate planning guidance. It is obvious to everyone that failing to plan is a mistake. And it has become customary to recommend that a gas landowner establish a family limited partnership (FLP) or LLC to hold gas interests.
But while creation of a FLP or LLC is often appropriate planning, it  may not be sufficient planning. It does not protect a family’s potential gas wealth from confiscatory estate and gift taxes. The creation of a business entity is just one step in planning. If a goal is to protect the family from inter-generational transfer taxes, lawyers need to move the process forward and guide the landowner through a number of critically important but much more complicated additional steps that will remove the FLP/LLC interests from the landowner’s taxable estate.
Setting up a FLP or LLC is relatively easy. Transferring interests in these entities to children and grandchildren is where things get confusing and mistakes can be costly. Planning that involves gift and generation skipping taxes, discounts, grantor trusts, and the like, while critical to effective planning is not within the skill set of all lawyers. And a lawyer without these skills may be unable to help the landowner develop and implement the comprehensive planning needed in order to reduce or eliminate wealth transfer taxes.     
Whatever the reason, landowners are frequently advised to set up a partnership or LLC and then just “wait and see.” But this will not help the landowner's family save on death taxes.  Waiting until the drill rig shows up at the property means that the landowner has forever lost an opportunity to transfer gas interests to future generations at greatly reduced transfer tax costs. Planning becomes much more difficult and taxes are harder to avoid once the property is developed. With the potential that federal estate taxes could rise in future years missing that early pre-development planning opportunity can be a devastating mistake.  

A Partnership is Not Enough   
What should the typical estate plan for a gas landowner look like? Well, there is no typical plan. When you are talking about the future of land that may have been in a family for generations, each planning situation is unique. It requires that the lawyer have an intimate familiarity with gas production, the ability to foresee and prevent pitfalls that lead to family disputes, and a thorough knowledge of relatively sophisticated estate planning and tax avoidance techniques. This is an unusual combination of skills but landowners need to search carefully for a law firm that can provide them all.  
Common estate planning tools include: 
A Will and/or Revocable Living Trust. The revocable trust, despite popular misconceptions, does not lower taxes of any kind, but may be appropriate for other reasons. But, whether the royalty owner’s estate plan is based on a Will or a revocable trust or both, it is critical that the plan ensures a means of using each spouse’s federal estate tax exemption equivalent (for married couples) and provides for a smooth distribution of your assets after your death.
Powers of Attorney for both health and financial matters. Powers of attorney can allow your named agent(s) to act for you in the event of your incapacity and may provide guidance as to your health care and other preferences. Including appropriate gifting provisions in a financial power of attorney is crucial if the implementation of a landowner’s tax wise gifting plan is to be continued in the event of the landowner’s incapacity.
A Family Limited Partnership (FLP) and/or Limited Liability Company (LLC). An FLP and LLC can provide many benefits to the royalty owner’s family.  They provide a vehicle for management of the royalties and can reduce liability risk. These family business vehicles can also serve as the platform for reducing taxes if they are combined with effective and timely lifetime transfers.
• Lifetime Transfers. Removing assets from the royalty owner’s estate through lifetime gifting is crucial to the goal of reducing federal and state death taxes.  But this may be the most complicated and difficult step in implementing the estate plan. Lifetime gifting involves perplexing tax laws including gift taxes and generation skipping taxes that are often misunderstood by both the landowner and his and her advisors. As a result, royalty owners may fail to obtain tax savings from their planning. The financial consequences of this failure can be catastrophic for the royalty owner’s family.  
Appropriate Beneficiary Designations. Beneficiary designations on retirement accounts, annuities, and life insurance policies are an integral part of any estate plan since these legal designations direct how these assets are distributed after the owner’s death. Reviewing and updating beneficiary designations is an often overlooked but critically important part of the planning needed to achieve the goals of the planning.  

Planning Goals go beyond Tax Savings 
If the complications of gas leases and royalties and taxes weren’t enough to befuddle the landowner, there are usually many other interests and goals that need to be addressed to create the right estate plan. Here are just a few examples: 
  1. Landowners often want to control the property and any related farming or other operations and maintain income for themselves until death.
  2. There may be a need to provide income to younger family members who participate in the operation of the farm or other property, or who have other financial needs.
  3. A landowner may want to recognize and reward the contributions of children who stayed on a farm and worked with the senior generation to maintain it as a viable economic unit—or provided other support to the family.
  4. A Landowner may have children who did not participate in the farming operation who need to be treated fairly (which may be quite different than treating them equally).
  5. Landowners usually want to limit their risk in the event that the gas operations create liabilities.
  6. The Landowner and family may want to provide for management of the property’s gas resources in a manner that minimizes the potential for future family disputes.
  7. Landowners often are concerned with protecting the wealth that they pass on from future loss resulting from the three D’s: Divorce, Death or Disability of the recipient. 
  8. Landowners may want to limit the future taxation that will be imposed when the royalty wealth ultimately passes from their children to their grandchildren.
Gas royalties can allow a landowner to build a lasting legacy that was not possible (or even contemplated) only five years ago. That legacy can be one of financial security and loving memories. Or it can be one of large death tax payments and years of bitter family struggle over money and control of gas rights. Effective planning now can help ensure the former and avoid the latter.
Right now, gas royalty owners in Pennsylvania need to sift through the confusing information that is circulating regarding what is and what is not effective gas royalty estate planning. The reality is that the wealth produced from gas royalty interests has the potential  to push many landowners into whatever federal estate tax brackets finally emerge in 2013. 

The loss of this new family wealth to federal and state inheritance, estate, gift ,generation skipping, and other taxes and costs can be minimized through sophisticated estate planning that is fully implemented.  Unfortunately, many landowners who set up family limited partnerships and LLCs are failing to follow through with the additional steps that are required to reduce taxes. They may even be advised to “wait and see” when the more cautious and prudent approach is to move forward with planning and turn current uncertainties into an advantage.    
The best strategy is for the landowner to work with the most knowledgeable estate planning law firm they can find in the gas estate planning field in order to develop a strategy that custom fits the family’s circumstances and needs. This is not a good time to choose the cheapest planning around – that is penny wise and dollar foolish, and the dollars lost to incomplete or improvident planning may end up in the millions. 
IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
© 2011 by Jeffrey A. Marshall and Marshall, Parker & Associates. This article may be duplicated and distributed provided no changes are made to its content and attribution is given to Jeffrey A. Marshall, Marshall, Parker & Associates, Williamsport, Pennsylvania. Short quotations from this article are also permitted with such attribution. This general information is not intended, and should not be construed as legal advice. Its dissemination does not create any attorney client relationship. Its authors are licensed to practice law in Pennsylvania. For specific advice about your particular situation, consult a lawyer who is licensed to practice in your jurisdiction.

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